Valuations Final

7/28/2019 Valuations Final

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www.marketsecret.net

LectureBusiness Valuations TechniquesSep 2012

Inspired by Warren Buffett


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Corporate Valuation: A Summary

Class Notes from Market Secret


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Concept about Valuation

?

Market Secret


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Concept about Valuation

Intrinsic Value or true value of Business.

How to reach at that?

Value lies in the eyes of be holders

Market Secret


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Misconceptions about Valuation

Myth 1: A valuation is an objective search for true value bias in your valuation is directly proportional to who pays you and how much

you are paid.

Myth 2.: A good valuation provides a precise estimate ofvalue there are no precise valuations

Myth 3: . The more quantitative a model, the better thevaluation too much analysis leads to paralysis.

Market Secret


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Approaches to Valuation

Valuation Models

Asset BasedValuation

Discounted Cashf lowModels

Relat ive Valuation Contingent ClaimModels

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capitalapproach

APVapproach

Excess ReturnModels

Stable

Two-stage

Three-stageor n-stage

Current

Normalized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option t oliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Firm

Market Secret


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Basis for all valuation approaches

The use of valuation models in investment decisions (i.e. indecisions on which assets are under valued and which are overvalued) are based upon a perception that markets are inefficient and make mistakes in assessing

value

an assumption about how and when these inefficiencies will get corrected

In an efficient market, the market price is the best estimateof value. The purpose of any valuation model is then thejustification of this value.

Market Secret


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Discounted Cash Flow Valuation

What is it: .. present value of the expected cash flows onthe asset.

Philosophical Basis: Every asset has an intrinsic value that

can be estimated, based upon cash flows, growth and risk.

Information Needed: to estimate the life of the asset

to estimate the cash flows during the life of the asset

to estimate the discount rate to apply to these cash flows to get presentvalue

Market Secret


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Discounted Cashflow Valuation: Basis forApproach

where CFt is the cash flow in period t, r is the

discount rate appropriate given the riskiness ofthe cash flow and t is the life of the asset.

Proposition 1: For an asset to have value, the expected cash flows have to bepositive some time over the life of the asset.

Proposition 2: Assets that generate cash flows early in their life will be worth morethan assets that generate cash flows later; the latter may however have greatergrowth and higher cash flows to compensate.

Value =CFt

(1+ r)t

t =1

t = n

Market Secret


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Equity Valuation versus Firm Valuation

Value just the equity stake in the business

Value the entire business, which includes, besides equity, theother claimholders in the firm

Market Secret


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11

Two Measures of Discount Rates

Cost of Equity: This is the rate of return required byequity investors on an investment. It will incorporate apremium for equity risk -the greater the risk, the greaterthe premium. This is used to value equity.

Cost of capital: This is a composite cost of all of thecapital invested in an asset or business. It will be aweighted average of the cost of equity and the after-taxcost of borrowing. This is used to value the entire firm.


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Market Secret12

Categorizing Cash FlowsCash Flow Statement Amt

Cash Flow From Operation

Net Income

Add: Dep & Amortization

Less: Other Non-Op Income (Inc Int Exp)

Add/Less: Changes in Working Capital

Cash Flow From Operations

Cash Flow From Investing Activity

Less: CapexAdd: Income from Inevstment (Strategic)

Less: Purchase of Investment

Cash Flow From Investing

Cash Flow From Financing Activity

Add: Issue of Equity (Inc SP)

Add: Issue of Debt

Less: Repayment of Debt

Less: Divident Paid

Cash Flow From Financing

Net Inc/(Dec) in Cash

Opening Cash Balance

Closing Cash Balance


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Market Secret 13

Equity Valuation

Assets Liabilities

Assets in Place Debt

Equity

Discount rate reflects only thecost of raising equity financing

Growth Assets

Figure 5.5: Equity Valuation

Cash flows considered arecashflows from assets,

after debt payments andafter making reinvestmentsneeded f or future growth

Present value is value of just the equity claims on the firm

Free Cash Flow to Equity = Net Income + Depreciation + Amortization Net Reinvestment (capex + change inworking capital) Net Debt Paid (or+ Net Debt Issued)


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Market Secret 14

Firm Valuation

As s ets Liabilities

Assets in Place Debt

Equity

Discount rate reflects the costof raising both debt and equityfinancing, in proportion to their

useGrowth Assets

Figure 5.6: Firm Valuation

Cash flows considered arecashflows from assets,

prior to any debt payment sbut aft er firm hasreinvested to create growthassets

Present value is value of the entire firm, and reflects the value ofall claims on the firm.

Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) + Depreciation + Amortization NetReinvestment (Capex + Changes in Working Capital).

The tax benefits of debt are not included in FCFF because they are taken into account in the firms cost of capital.


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Market Secret 15

Difference between FCFF v/s FCFE ?

FCFF is the cash available to bond holders and stock holders after all expense and investments have taken place.FCFE is the cash available to stock holders after all expense, investments and interest payments to debt-holders.

The basic difference is consideration of interest payment in FCFE (v/s FCFF), subtract the interest expense fromthe cash flow to do valuations.

FCFF shows the obligations for both stockholders as well as bondholders whereas FCFE consider only the obligations

for stockholders.

Factors FCFF FCFE

Cash Flow Pre Debt Cash Flow (alreadymentioned)

Post Debt Cash Flow(already mentioned)

Expected Growth Growth in Opertaing Income =Reinvestment Rate * ROC

Growth in net income = Retentionratio * ROE

Discount Rate WACC Cost of Equity

Beta Bottom-up Bottom- up


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Market Secret 16

Valuation with Infinite Life

Cash flows

Firm: Pre-debt cashflowEquity: After debt

cash flows

Expected Growth

Firm: Growth inOperating EarningsEquity: Growth inNet Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:

Grows at constant rateforever

Terminal Value

CFn.........

Discount Rate

Firm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Growth


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Market Secret 17

Valuing the Home Depots Equity

Assume that we expect the free cash flows to equity atHome Depot to grow for the next 10 years at rates muchhigher than the growth rate for the economy. To estimatethe free cash flows to equity for the next 10 years, we makethe following assumptions: The net income of $1,614 million will grow 15% a year each year for the next10 years.

The firm will reinvest 75% of the net income back into new investments eachyear, and its net debt issued each year will be 10% of the reinvestment.

To estimate the terminal price, we assume that net income will grow 6% ayear forever after year 10. Since lower growth will require lessreinvestment, we will assume that the reinvestment rate after year 10 willbe 40% of net income; net debt issued will remain 10% of reinvestment.


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Market Secret 18

Estimating cash flows to equity: The HomeDepot

Year Net Income Reinvestment Needs Net Debt Paid FCFE PV of FCFE

1 $ 1,856 $ 1,392 $ (139) $ 603 $ 549

2 $ 2,135 $ 1,601 $ (160) $ 694 $ 576

3 $ 2,455 $ 1,841 $ (184) $ 798 $ 603

4 $ 2,823 $ 2,117 $ (212) $ 917 $ 632

5 $ 3,246 $ 2,435 $ (243) $ 1,055 $ 662

6 $ 3,733 $ 2,800 $ (280) $ 1,213 $ 693

7 $ 4,293 $ 3,220 $ (322) $ 1,395 $ 726

8 $ 4,937 $ 3,703 $ (370) $ 1,605 $ 761

9 $ 5,678 $ 4,258 $ (426) $ 1,845 $ 797

10 $ 6,530 $ 4,897 $ (490) $ 2,122 $ 835

Sum of PV of FCFE = $6,833


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Market Secret 19

Terminal Value and Value of Equity today

FCFE11 = Net Income11 Reinvestment11 Net Debt Paid (Issued)11= $6,530 (1.06) $6,530 (1.06) (0.40) (-277) = $ 4,430 million

Terminal Price10 = FCFE11/(ke g)= $ 4,430 / (.0978 - .06) = $117,186 million

The value per share today can be computed as the sum of the present values ofthe free cash flows to equity during the next 10 years and the present value ofthe terminal value at the end of the 10th year.Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978)10

= $52,927 million


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Market Secret 20

Valuing Boeing as a firm

Assume that you are valuing Boeing as a firm, and that Boeinghas cash flows before debt payments but after reinvestmentneeds and taxes of $ 850 million in the current year.

Assume that these cash flows will grow at 15% a year for thenext 5 years and at 5% thereafter.

Boeing has a cost of capital of 9.17%.


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Market Secret 21

Expected Cash Flows and Firm Value

Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049 million

Year Cash Flow Terminal

Value

Present

Value

1 $978 $895

2 $1,124 $943

3 $1,293 $9944 $1,487 $1,047

5 $1,710 $43,049 $28,864

Value of Boeing as a firm = $32,743


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Market Secret 22

What discount rate to use?

Since financial resources are finite, there is a hurdle that projects have to crossbefore being deemed acceptable.

This hurdle will be higher for riskier projects than for safer projects.

A simple representation of the hurdle rate is as follows:

Hurdle rate = Return for postponing consumption +Return for bearing risk

Hurdle rate = Riskless Rate + Risk Premium

The two basic questions that every risk and return model in finance tries toanswer are: How do you measure risk? How do you translate this risk measure into a risk premium?


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Market Secret 23

The Capital Asset Pricing Model

Uses variance as a measure of risk

Specifies that a portion of variance can be diversified away, and that is only thenon-diversifiable portion that is rewarded.

Measures the non-diversifiable risk with beta, which is standardized around one.

Relates beta to hurdle rate or the required rate of return:

Reqd. ROR = Riskfree rate + b (Risk Premium)

Works as well as the next best alternative in most cases.


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Market Secret 24

From Cost of Equity to Cost of Capital

The cost of capital is a composite cost to the firm of raisingfinancing to fund its projects.

In addition to equity, firms can raise capital from debt


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Market Secret 25

Estimating the Cost of Debt

If the firm has bonds outstanding, and the bonds are traded, the yield tomaturity on a long-term, straight (no special features) bond can be used as theinterest rate.

If the firm is rated, use the rating and a typical default spread on bonds withthat rating to estimate the cost of debt.

If the firm is not rated, and it has recently borrowed long term from a bank, use the interest rate on

the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to

arrive at a default spread and a cost of debt

The cost of debt has to be estimated in the same currency as the cost of equityand the cash flows in the valuation.


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Market Secret 26

Estimating Cost of Capital: Boeing

Equity Cost of Equity = 5% + 1.01 (5.5%) = 10.58%

Market Value of Equity = $32.60 Billion

Equity/(Debt+Equity ) = 82%

Debt After-tax Cost of debt = 5.50% (1-.35) = 3.58%

Market Value of Debt = $ 8.2 Billion

Debt/(Debt +Equity) = 18%

Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%


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Market Secret 27

Estimating the Expected Growth Rate

Expected Growth

Net Income Operating Income

Retention Ratio=

1 - Dividends/NetIncome

Return on Equity

Net Income/Book Value ofEquity

X

Reinvestment

Rate =(Net CapEx + Chg in

WC/EBIT(1-t)

Return on Capital =

EBIT(1-t)/Book Value ofCapital

X


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Market Secret 28

Expected Growth in EPS

gEPS = (Retained Earningst-1/ NIt-1) * ROE= Retention Ratio * ROE= b * ROE

ROE = (Net Income)/ (BV: Common Equity)

This is the right growth rate for FCFE Proposition: The expected growth rate in earnings for a

company cannot exceed its return on equity in the long term.


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Market Secret 29

Expected Growth in EBIT AndFundamentals

Reinvestment Rate and Return on CapitalgEBIT= (Net Capex + Change in WC)/EBIT(1-t) * ROC

= Reinvestment Rate * ROC Return on Capital =

(EBIT(1-tax rate)) / (BV: Debt + BV: Equity)

This is the right growth rate for FCFF Proposition: No firm can expect its operating income

to grow over time without reinvesting some of theoperating income in net capital expenditures and/orworking capital.


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Market Secret 30

Getting Closure in Valuation

A publicly traded firm potentially has an infinite life. Thevalue is therefore the present value of cash flows forever.

Since we cannot estimate cash flows forever, we estimatecash flows for a growth period and then estimate a terminal

value, to capture the value at the end of the period:Value =

CFt

(1+ r)tt = 1

t =

Value =

CFt

(1+r)t

Terminal Value

(1+ r)Nt = 1

t = N


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Market Secret 31

Stable Growth and Terminal Value

When a firms cash flows grow at a constant rate forever, the present value ofthose cash flows can be written as:Value = (Expected Cash Flow Next Period) / (r - g) where,

r = Discount rate (Cost of Equity or Cost of Capital)g = Expected growth rate

This constant growth rate is called a stable growth rate and cannot be higherthan the growth rate of the economy in which the firm operates.

While companies can maintain high growth rates for extended periods, they willall approach stable growth at some point in time.

When they do approach stable growth, the valuation formula above can be usedto estimate the terminal value of all cash flows beyond.


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Market Secret 32

Relative Valuation

In relative valuation, the value of an asset is derivedfrom the pricing of 'comparable' assets, standardizedusing a common variable such as earnings, cashflows,book value or revenues. Examples include --

Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples, Cash Flow

multiples)

Price/Book (P/BV) ratios and variants (Tobin's Q)

Price/Sales ratios. EV/EBITDA


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Market Secret 33

Valuing Unlisted, start-up, Young &Growth Companies

Valuation Issues

Limited /No history

Negative operating cash flow ( in some cases)

No market value for debt/equity

More holes is given details

Cash flow from existing assetsEst growth from new and improved efficiency on existing assets

Discount rates emerged from assessment of risk business/equity

Assesstment when the firm will become a stable growth firm

Importance

Value transactions (1) Public v/s Pvt, (2) IPO, and (3) VC


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Market Secret 34

Life Cycle of Early Stages Co.

Characteristics No history Small/No-revenues, Operating losses

Dependent on Private EquityMany dont surviveMultiple Claims on Equity Illiquid Investment Vs Public


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Market Secret 35

Example:Valuing Unlisted,start-up,Young Co.

Illustration 1: Valuing Secure Mail

Venture Capital Approach (Relative valuation approach)

Secure Mail is a small software company that has developed a new computer virus

screening program that it believes will be more effective than existing anti-virusprograms. The company is fully owned by its founder and has no debt outstanding. Thefirm has been in existence only a year, has offered a beta version of the software forfree to online users but has never sold the product (revenues are zero). During itsyear of existence, the firm incurred $ 15 million in expenses, thus recording anoperating loss for the year of the same amount. As a venture capitalist, you have beenapproached about providing $ 30 million in additional capital to the firm, primarily to

cover the commercial introduction of the software and expanding the market for thenext two years. To value the firm, you decide to employ the venture capital approach.

1.The founder believes that the virus program will quickly find a market and thatrevenues will be $ 300 million by the third year.2. Looking at publicly traded companies that produce anti-virus software, you come upwith two companies that you feel are relevant comparables.


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Market Secret 36




PEERS AVERAGE

Company ($ MN) Mcap Debt Cash EV Rev EV/salesSymantec 9388 2300 1890 9798 5874 1.67x

McAfee 4167 0 394 3773 1308 2.88x

Average 6778 1150 1142 6786 3591 2.28x

VENTURE CAPITAL TARGET RATE OF RETURN - STAGE INLIFE CYCLE

STAGE

TARGETRATE OFRETURN

START UP 50% - 70%

FIRST STAGE 40% - 60%

SECOND STAGE 35% - 50%

BRIDGE /IPO 25% - 35%


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Market Secret 37


Illustration 1: Solution


A TARGET REVENUE (mn) $300

B TARGET EV/Sales (AVG PEERS) 2.28x

C CAPITAL INFUSION $30

D TARGET RETURN 50%

A*B ESTIMATED VALUE IN 3YRS $682.89

VALUE TODAY

ESTIMATED VALUE IN 3YRS $682.89TARGET RETURN 50%


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Market Secret 38




VALUE TODAY = ESTIMATED VALUE IN 3YRS

(1+ TARGET RETURN)

= $202.34

POST MONEY VALUE = VALUE TODAY + CAPITAL INFUSION

= $232.34

PROPORTIONAL SHARE OFEQUITY

=

CAPITAL INFUSION

POST MONEY VALUE

= 14.8%


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Market Secret 39



TOP Down Approach (Valuing using DCF)

1. Potential market size for the product/service2. Market Share3. Operating expenses/margins

4. Investments for growth5. Compute tax effect6. Check for internal consistency7. FCFF8. Beta9. Cost of Capital10. Terminal Value

11. Corpoarate Value


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Market Secret 40

Economic Value Added (EVA)

EVA is the profit earned by the firm less the cost of financing the firm'scapital. The idea is that value is created when the return on economic capitalemployed is greater than the cost of that capital.

NOPAT = Operating Income (1-Tax Rate)

Adj NOPAT = NOPAT + Other Income

Adj Capital = S Debt + L Debt + Minority Int + Equity

EVA = Adj NOPAT/Adj Capital


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Market Secret 41

How to value cash and cross holdings

Many students believe that valuing surpluscash on a companys balancesheet is an easy task. Just add the nominal value of the surplus cash tothe value of the operating business derived from method like DCF orEnterprise Value (EV).


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Market Secret 42


know what is surplus andwhats not

Cash provided by customers (e.g advance or deposits on the liabilities) arenot surplus. Surplus means that if you take it out, you dont have to

replace it.

For example,

ENGINEERS INDIA LTD (EIL)

BHARAT ELECTRONICS LTD (BEL)

(has large advances from customers as source of cash)

1


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Market Secret 43


Cash in seasonal businesses

Cash in some seasonal businesses may be surplus in lean seasons butrequired for conducting business for busy seasons.

For Example,

Cox & Kings Limited

MAHINDRA HOLIDAYS & RESORTS INDIA LTD

(Cash must not be treated as surplus even if BS show surplus cash in a leanseason)

2


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Market Secret 44


Cash in hand of the value creator

A $100 bill in the hands of a value creator is worth more than $100 to his investors.

Conversely, the same $100 is worth less than $100 in the hands of a value

destroyer.

Be wary of cash on BS of companies which have a track record of value destruction (e.g.

dividend policy, acquisitions, expansion, and diversifications).

3


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Market Secret 45


Capital allocation skills matter

A $100 bill in the hands ofscoundrel is worth less than $100 to his investors.

Conversely, the same $ 100 is worth more than $100 in the hands of the honest

manager.

For Example,

Cash on Infosys v/s Afteks balance sheet

(Be wary of cash on the balance sheets of companies run by crooks)

4


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Market Secret 46


Corporate governance matters

In other words, the closer the cash resides near the pockets of the investors, the closer

to its nominal value, should be its fair value to investors, other things remaining the

same

This happens, for example, in the cash of holding companies which have subsidiarieswhich have subsidiaries which have the cash.

For Example,

STERLITE Group

5


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Market Secret 47

Options/Warrants/Convertibles

Simple capital structure

Complex capital structure


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Market Secret 48




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Market Secret 49




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Market Secret 50


Dilutive

Antidilutive


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Market Secret 51


For Example: Dilutive/Antidilutive


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Market Secret 52


For Example: Dilutive/Antidilutive


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Market Secret 53


For Example: Warrants/Options/Convertibles


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Market Secret 54




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Market Secret 55




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Options/Warrants/ConvertiblesComplex Capital Stucture


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Market Secret 57


For Example: Options/Convertibles

O ti /W t /C tibl


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Market Secret 58


Solutions

Basic EPS = Net Income Preferred DividentWeighted average number of common shares outstanding


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Market Secret 59



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Market Secret 60

M&A

Swap Ratio


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Examples

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