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Quantitative Methods in Companies’
ValuationOffered to: Securities & Commodities AuthorityTrainer: Dr. Anis Samet, American University of
Sharjah
2
Day 11. Workshop pre-assessment (5 mn.)2. Session 1: Introduction to values (90 mn)3. Session 2: Discounted cash flow 1(135 mn)4. Session 3: Discounted cash flow 2 (60 mn)5. Day-1-assessment (10 mn)6. Case study, part 1 (45 mn) Day 21. Session 1: Multiples 1 (90 mn)2. Session 2: Multiples 2 (135 mn)3. Alternatives and latest methodologies (60 mn)4. Final-assessment (5 mn)5. Case study, part 2 (45 mn)
Schedule & Outline
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Day 1
Quantitative Methods in Companies’ Valuation
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Please answer the pre-assessment questions!
Workshop Pre-Assessment
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Financial Statements: A review
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Financial Statements: Key Words العمومية Balance sheetالميزانية
) ( العمومية/ الميزانية موجودة Asset (balance sheet)أصل / المال رأس استثمار الملكية Equityحقوق
/ التزامات/ / خصوم مطلوباتديون
Liabilities
الدخل/ قائمة Income statement (US)بيانRevenuesاإليراداتExpenseمصروف
النقدي/ التدفق قائمة Cash flow statementبيان / الوارد ) النقد الوارد النقدي التدفق
المقبوض(Cash inflow
/ المدفوع الصادر Cash outflowالنقد / مدمجة/ موحدة مالية قوائم Consolidated financial statementبيانات
المالية Financial statementsالقوائم ) ملحقة ) إيضاحات مالحظات
المالية بالقوائمNote to financial statements
حقوق المساهمين، مال رأسالمساهمين ملكية
Shareholder’s capital, shareholder’s equity
العام Initial Public Offerings (IPO)الكتتاب
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Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements:
1. Balance Sheet - statement of financial position at a given point in time
2. Income Statement - revenues minus expenses for a given time period
3. Statement of Owner's Equity - also known as Statement of Retained Earnings or Equity Statement
4. Statement of Cash Flows - summarizes sources and uses of cash
Financial Statements
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The balance sheet is based on the following fundamental accounting model:
Assets = Liabilities + Equity Assets can be classed as either current assets or
fixed assets. Liabilities (current & long term) represent the
portion of a firm's assets that are owed to creditors
Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation
Financial Statements: Balance Sheet
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Balance Sheet: Tabreed
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The income statement presents the results of the entity's operations during a period of timeNet Income = Revenue - Expenses
Revenue refers to inflows from the delivery of a product/service and expenses are outflows incurred to produce revenue
Financial Statements: Income Statement
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Income Statement: Tabreed
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The equity statement explains the changes in retained earnings.
The statement of retained earnings uses information from the Income Statement and provides information to the Balance Sheet
The following equation describes the equity statement for a sole proprietorship:Ending Equity = Beginning Equity +
Investments - (Withdrawals/Paid Dividends) + Income
Financial Statements: Statement of Owner's Equity
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The statement of cash flows is useful in evaluating a company's ability to pay its bills. For a given period, the cash flow statement provides the following information:
Sources of cash Uses of cash Change in cash balance The cash flow statement breaks the sources
and uses of cash into the following categories:1. Operating activities2. Investing activities3. Financing activities
Financial Statements: Cash Flow Statement
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Cash Flow Statement: Tabreed
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Refer to the financial statements of Tabreed in Arabic and English
Arabic English
Financial Statements: Tabreed
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Session 1: Introduction to Values
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Valuation may be done by the seller prior to entertaining prospective buyers, by the buyer who identifies a specific target or by both parties during negotiations to resolve a dispute over price
Company valuation is not an exact science. There are numerous acceptable valuation methods and, in most situations, each will yield a different result
The formal mathematical valuation should only play one part in the overall pricing of the deal and in determining the transaction's true value to the parties
Introduction to Values
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While all methods should, in theory, yield the same result, they rarely do, because of factors including, but not limited to, market conditions, the industry in which the target company operates and the type and nature of the business
All valuations are biased. The only questions are how much and in which direction
Simpler valuation models do much better than complex ones
Introduction to Values (cont’d)
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Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -- in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business
A sound investing is that an investor does not pay more for an asset than it is worth
Importance of Valuation
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The firm’s value is driven by:1. Earnings capacity2. Growth opportunities3. Real corporate performance, as compared
to market benchmarks4. Sales, operating margin, return on
investment
Key Values Drivers
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Valuation Models
Asset based valuation: Liquidation
value/ Replacement
cost
Discounted Cash Flow models:
Relying on future expected cash flows and determining the
appropriate discount rate to
use
Relative valuation: Using
comparable companies in
the same sector/industry.
Multiples
Alternative and latest
methodologies:Break-even
methodDividend
Discount ModelEconomic-Value
Added (EVA)Adjusted Present
Value (APV)Cash Flow Return on
Investment (CFRI)
Real options
Principal Valuation Methodologies
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Accounting valuation is important, because the value of assets on a company’s financial statements needs to be reliable
Analysis of this valuation is just as important as the valuation itself
Some assets, such as real estate, which is carried at cost less depreciation, can be carried on the balance sheet at far from their true value
Accounting vs. Market Values
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Session 2: Discounted Cash Flow (DCF) 1
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Discounted Cash Flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money
All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management
Discounted Cash Flow
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The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions
Discounted Cash Flow (cont’d)
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CFt: Cash flow in period t r: discount rate T: life of the firm
Discounted Cash Flow (cont’d)
T
T
tt
t
rr
CF
)1(
Value Terminal
)1(Value Firm T
1
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For an asset to have value, the expected cash flows have to be positive some time over the life of the asset
Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate
Discounted Cash Flow (cont’d)
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Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement
Process of DCF calculation: Step 1
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Step 2—Estimate the Discount Rate: the next order of business is to estimate the company's weighted average cost of capital (WACC), which is the discount rate that's used in the valuation process
Process of DCF calculation: Step 2
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Step 3—Calculate the Value of the Corporation: the company's WACC is then used to discount the expected cash flows
Process of DCF calculation: Step 3
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Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value
Process of DCF calculation: Step 4
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Operating cash flow (OCF) =Earnings Before Interest and Taxes (EBIT) + depreciation* - taxes
= EBIT(1-T) + depreciation
FCF= OCF – reinvestment= OCF - capital spending - working capital
spending = OCF - capex – ΔNWC
• Depreciation, or more generally any non-cash charges• Capital spending: changing in fixed assets• Working capital=total current assets-total current liabilities
Free Cash Flow: A Reminder
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Firm value = PV of FCF during forecast period +
PV of terminal value
Terminal value = proxy for all cash flows after the forecast period.
Valuing a Firm Using DCF
TT
T
tt
t
WACCWACC
FCF
)1(
Value Terminal
)1(Value Firm
1
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Statement of Income — Example(figures in thousands)
Revenue
Sales Revenue $20,438
Operating Expenses
Cost of goods sold $7,943
Selling, general and administrative expenses $8,172
Depreciation and amortization $960
Other expenses $138
Total operating expenses $17,213
Operating income $3,225
Non-operating income $130
Earnings before Interest and Taxes (EBIT) $3,355
Net interest expense/income $145
Earnings before income taxes $3,210
Income taxes $1,027
Net Income $2,183
EBIT: Example
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FCF1=390 FCF2=600 FCF3=694 Terminal Value=500 WACC: 10% Find the firm’s value using DCF
Valuing a Firm Using DCF: SCA company
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SCA Company’s Value: Using DCF
48.747,1$)1.1(
500
)1.1(
694
)1.1(
600
1.1
390ValueSCA
332
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Session 3: Discounted Cash Flow 2
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As seen before the discount rate that we have used to discount the future cash flow is the WACC
The WACC is the weighted average of the cost of equity and the cost of debt. The weights depend on how much of the firm’s activity is financed by debt and equity
The higher the cost of debt, the higher the WACC The higher the cost of equity, the higher the
WACC The higher the WACC, the lower the firm’s value
Weighted Average Cost of Capital (WACC)
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Where: Ke = cost of equity Kd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt T = corporate tax rate
WACC
DE KTV
DK
E
DWACC *)1(**
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D=2000 E=3000 Ke=12% Kd=8% T=20% Find WACC
WACC: Example
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%76.9%)201(*%8*5000
2000%12*
5000
3000WACC
WACC: Example
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Two companies that are different in term of risk should they have the same WACC?
No! Why? Shareholders investing in the riskier company
require a higher return and therefore a higher Ke
Banks lending money to the riskier company require a higher interest rate and therefore a higher Kd
So the riskier company has a higher WACC A higher WACC lead to a lower value
How Risk is perceived in DCF?
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The cost of debt depend on the interest paid by the company on the outstanding loans
The cost of debt is the weighted average of the costs of different debt instruments used by the company (e.g., bonds, sukuk, bank loans, ..)
WACC Components: Cost of Debt
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The cost of equity represents the rate of return required by shareholders to invest in a company
The required rate of return depends on the riskiness of the company
If the company is a public company, we can estimate the cost of equity using the Capital Asset Pricing Model (CAPM)
If the company is a private company, we try to find a comparable public company to estimate the cost of equity using the CAPM
WACC Components: Cost of Equity
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CAPM is used to determine a theoretically appropriate required rate of return of an asset
E(R):is the expected return on the asset Rf: is the risk-free rate of interest such as
interest arising from government bonds Β: is the sensitivity of the expected excess
asset returns to the expected excess market returns
E(Rm): is the expected return of the market
Capital Asset Pricing Model (CAPM)
))((*)( fmf rRErRE
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Rf: 5% Β: 1.4 E(Rm): 12% Find E(R) E(R)=5%+1.4*(12%-5%)=14.8%
CAPM
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Strengths1. CAPM is based on the idea that investors demand
additional expected return if they are asked to accept additional risk
2. the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium.
Weaknesses:1. The model assumes that asset returns are normally
distributed2. The model assumes that all investors have access to
the same information3. The model assumes that the variance of returns is
an adequate measurement of risk
Strengths and Weakness of CAPM
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Terminal value is quite large compared to expected annual cash flows
DCF valuation is sensitive to the terminal value
It is difficult to estimate the terminal/residual value of a company
Residual and Terminal Value
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Strengths of DCF Weaknesses of DCF
DCF offers the closet thing to the company’s intrinsic value
Length of projection period?
DCF allows to find out which companies are overpriced and which ones are underpriced
Confidence about future cash flows
DCF analysis is a great tool to analyze what assumptions and conditions have to be fulfilled in order to reach a certain company value
Other sources of value (cash, holdings in other firms, non-operating assets)
DCF is a valid method to assess the company’s value if special precaution is put on the validity of the underlying assumptions
DCF valuation depends on the quality of inputs: forecasted CFs and WACC. Garbage-in garbage-out principle holds
Strengths & Weaknesses of DCF
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It is very easy to manipulate the DCF analysis to result in the value that you want it to result in by adjusting the inputs
This is even possible without making changes that would be significant from an economist’s point of perspective, e.g. a change in the perpetual growth rate or in the WACC by just a few base points
Analysts or business professionals have no tools to estimate the input factors with that kind of exactness
Manipulation of Values
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Session 4: Case study
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Case Study: SCA Company Year 1 Year 2 Year 3
Revenues 1000 1500 2000Cost of goods sold 500 700 1000
Depreciation 100 100 150
EBIT 400 700 850
Interests 100 100 120
Taxable income 300 600 730
Taxes 60 120 146
Net Income 240 480 584
∆ in capital spending
0 100 100
∆ in working capital
50 -20 60
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Terminal value=500 Tax rate=20% Ke= 14% Kd=7.5% D/V=50%, E/V=50% Find the firm’s value using DCF What would be the firm value if the WACC is
12% or 15%?
Case Study: SCA Company
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Day 2
Quantitative Methods in Companies’ Valuation
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Valuation Models
Asset based valuation: Liquidation
value/ Replacement
cost
Discounted Cash Flow models:
Relying on future expected cash flows and determining the
appropriate discount rate to
use
Relative valuation: Using
comparable companies in
the same sector/industry.
Multiples
Alternative and latest
methodologies:Break-even
methodDividend
Discount ModelEconomic-Value
Added (EVA)Adjusted Present
Value (APV)Cash Flow Return on
Investment (CFRI)
Real options
Principal Valuation Methodologies
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Session 1: Multiples 1
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Relative valuation models: Comparable companies valuation
(trading market valuation) Comparable transactions valuation
1. Define a set of publicly traded comparable companies
2. Observe how those companies are valued by the market
3. Apply that valuation to the firm
Multiples
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Mostly used multiples:1. Price-to-earnings ratio2. Price-to-book ratio3. Enterprise value to Earnings before
Interest, Taxes, Depreciation, and Amortization (EBITDA)
4. Enterprise value to revenues
Mostly Used Multiples
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Definition of 'Price-Earnings Ratio - P/E Ratio'
A valuation ratio of a company's current share price compared to its per-share earnings
Calculated as: Market Value per Share Earnings per Share (EPS)
Price-to-Earnings Ratio
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For example, if a company is currently trading at $43 per share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95)
The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings
Price-to-Earnings Ratio
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A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the book value per share
Also known as the "price-equity ratio” and calculated as:
A lower P/B ratio could mean that the stock is undervalued
Price-to Book Ratio
Shares of s)/#Liabilitie and Assets Intangible -Assets (Total
PriceStock Ratio P/B
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For example, if a company is currently trading at $43
Total assets $1,000,000 Total liabilities $400,000 Intangible assets $100,000 Number of outstanding shares: 10,000 Find price-to-book ratio Price-to-book ratio
=43/($500,000/10000)=0.86
Price-to-Book Ratio
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It represents the enterprise value per dollar of EBITDA. It is calculated as:
Enterprise Value to EBITDA
Shareper EBITDA
PriceStock MultipleEBITDA
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For example, if a company is currently trading at $43
EBIT=$400,000 Amortization & Depreciation=$50,000 Number of outstanding shares: 10,000 Find enterprise value to EBIT (1.075) Find enterprise value to EBITDA (0.96)
Enterprise Value to EBITDA
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It represents the enterprise value per dollar of revenues. It is calculated as:
Enterprise Value to Revenues
Shareper Revenues
PriceStock Multiple Revenues
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For example, if a company is currently trading at $43
Revenues=$600,000 Number of outstanding shares: 10,000 Find the enterprise value to revenues
(0.716)
Enterprise Value to Revenues
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A well-designed, accurate multiples analysis can provide valuable insights about a company and its competitors. Conversely, a poor analysis can result in confusion
Building Effective Multiples
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To apply multiples properly, use the following four best practices:
Building Effective Multiples
Choose comparables with similar prospects
Use enterprise
value multiples
Use multiples based on forward
looking data
Eliminate non-operating items
Step 1
To analyze a
company using
comparables, you
must first create an
appropriate peer
group.
Step 2
Use an enterprise
value multiple to
eliminate effects from
changes in capital
structure and one
time gains and losses
Step 3
When building a
multiple, the
denominator should
use a forecast of
profits, rather than
historical profits
Step 4
Enterprise-value
multiples must be
adjusted for non
operating items
hidden within
enterprise value and
reported EBITA
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Session 2: Multiples 2
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When you gather the information for comparables, you should make sure that the multiples are determined in the same manner and then applied consistently to the subject company
Many analysts remove non-recurring items from earnings before calculating these ratios so to get a better picture of the underlying earnings of a company
Consistency and Comparability
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According to best practices it is necessary to identify peers with the same business concept, accounting principles, growth, ROIC and financial and operational risk
It is important not to base a multiple valuation on a single year’s estimates. Sales, EBITDA etc. are different between years. DCF catch this volatility but a one-year multiple doesn’t
A multiple valuation should always be based on estimates from multiple years
Peers and Historic Analysis
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Strengths Weaknesses
Easy to produce Measures relative, not intrinsic value
Different estimates of value, depending on which multiple you use
Availability of comparables?
Vulnerable to manipulation (definition of comparables)
Multiples: Strengths and Weaknesses
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Session 3: Alternative and Latest Methodologies
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It represents the number of years required to get back the initial investment
For instance, an investment costs you $100,000 and you will be receiving $25,000 each year so it takes you 4 years to break-even
The shorter the time to break-even, the better the project
Some investors care about the number of years it takes to get back their initial investment
Break-Even Method
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Dividend Discount Model (DDM) uses predicted dividends divided by (the discount rate –the dividends’ growth rate)
This procedure has many variations, and it doesn't work for companies that don't pay out dividends
As some companies do not change their dividends from year-to year, then an average growth over a certain number of years will be used
E.g., dividend per share=1$, discount rate=10$, dividend growth rate=3%, so the value is $14.28
Dividend Discount Model
RateGrowth Dividend - RateDiscount
SharePer DividendStock of Value
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Adjusted Present Value (APV) is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing
This method is often used for a highly leveraged project
The APV method is not used as frequently in practice as is the DCF analysis
Adjusted Present Value Method
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CFRI is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings
Example: Cash flow=$5,000 and the capital employed has a market value of $6,000 so the CFROI=20%
Cash Flow Return on Investment
Employed Capital of ValueMarket
FlowCash CFROI
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For the corporation, it is essentially the internal rate of return (IRR)
CFROI is compared to a hurdle rate to determine if Investment is performing adequately
The hurdle rate is the total cost of capital for the corporation (WACC)
The CFROI must exceed the hurdle rate to satisfy both the debt financing and the investors expected return
Example: CFROI=12% and WACC=8% so do we accept the investment?
Cash Flow Return on Investment
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The Economic Value Added (EVA) is a measure of surplus value created on an investment
Define the return on capital (ROC) to be the cash flow return on capital earned on an investment
Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment
EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)
Economic Value Added
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EVA is a measure of dollar surplus value, not the percentage difference in returns
It is closest in both theory and construct to the net present value of a project in capital budgeting
The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projectsValue= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects
Economic Value Added
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Example: Return on Capital (2010)= 12.77% Cost of Capital (WACC) (2010)= 8.85% Capital in Assets in Place (2010): $29,500 EVA? EVA (2011)=(12.77%-8.85%)*$29,500=
$1,154.5
Economic Added Value
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Real options analysis (ROA) is widely recognized as a superior method for valuing projects with managerial flexibilities
There are cases in which a firm may enter a new product market or region by making a relatively small investment in order to establish a foothold and acquire the option to either expand it or exit this market when more information is obtained
Real Options
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For example the opening of a new oil field involves a series of decisions about whether to lease an area, how to explore it, what wells and pipelines to build, and so on
This perspective contrasts with the traditional view of a project as set of decisions made once at the beginning and unchanged during the life of the project
In general, projects do not correspond to the situation assumed by traditional analyses, and the options view is much more realistic
Real Options: Example
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Real options approach recognizes that risks can be managed, to avoid bad outcomes or take advantage of good ones are they become apparent
The use of real options practically always leads to higher values for the same project than the traditional methods, precisely because the options perspective recognizes that managers make future decisions about a project as uncertainties become resolved
Real Options
85
Valuation Method Usefulness Comments
DCF Widely used Easy to implement
Multiples Widely used Depends on the accounting information
Break-Even Not frequently used Does not take into account future cash flows that occur after the break-even point
DDM Not frequently used Used for firms paying dividends
APV Not frequently used Used for a highly leveraged project
EAV Increasingly used Depends on accounting and economic data
CFROI Not frequently used Similar to DCF
Real Options Not frequently used Suitable for specific projects
Summary of Valuation Methods
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Final assessment
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Session 4: Case study
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Royal Ahold is a global retail supermarket group based in Europe and the United States with company headquarters in Amsterdam, The Netherlands
There are six comparables to Royal Ahold Find the value of Royal Ahold using Sales,
EBITDA, EBIT, and PER 2008 Multiples
Case Study: Royal Ahold
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Case Study: Royal Ahold
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Royal Ahold data for 2008
Case Study: Royal Ahold
Sales/Share EBITDA/Share EBIT/Share Net Income/Share $ 100.00 $ 6.00 $ 3.00 $ 2.50
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Thank you!