On Valuation

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					An overview on valuation methods

Asset Valuation Model: can we
find the true value of a
project using DCF?
Discounted Cash Flow methods
Multiples: Price/earning Ratio, Market to book ratio
Option pricing model
Piece meal approach: evaluate firm part by part

Sources of Uncertainty in Asset valuation:
 the asset being valued, and
 the valuation model itself and the analyst
 Hard to quantify managerial skill, human factors.
Discounted Cash Flow

where n = Life of the asset
CFt = Cash flow in period t
r = Discount rate reflecting the riskiness of the
   estimated cash flows
2 steps of the DCF methods

 Estimating the expected cash flows for
  the firm
 discounting the cash flows at an interest
  rate that reflects the default risk

 Some projects are easier to evaluate than others:
  companies with substantial uncertainties are
  harder to evaluate but more rewarding.

Book Valuation versus DCF
Calculate the Value of firm X at end of year 10
(required rate of return = 10 %)
Balance sheet 31. Dec. 09
  Fixed Assets      50,000   Equity        10,000

  Current Assets    60,000   Liabilities   100,000

                   110,000                 110,000

Determination of Free Cash
Flows: Equity Value
     -operating expenses
     = Earnings before interest, taxes and depreciation
      = EBIT (= Earnings before interest and taxes)
     -Interest expenses
     = Earnings before taxes
     = Net income
     + depreciation
     -preferred dividends
     -capital spending *
     -working capital needs*
     = Free Cash Flow to equity
     -                                                    6
Determination of Free Cash
Flows: the equity value
In the table,
the capital expenditures is :
 reinvestment: capital expenditures in high-
  growth phases exceed depreciation.
Working capital needs is:
 the difference between its current assets and
 current liabilities. Increases in working capital
 needs are cash outflows.
 I.Equity Valuation
 The value of equity is obtained by discounting expected
  cash flows to equity, i.e., the residual cash flows after
  meeting all expenses, tax obligations and interest and
  principal payments, at the cost of equity, i.e., the rate of
  return required by equity investors in the firm.

    CF to Equityt = Expected Cash flow to Equity in period t
    ke = Cost of Equity

II. Firm Valuation
1. Cost of capital approach:
  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.

Adjusted present value
2. APV approach: The value of the
   firm can also be written as the sum
   of the value of the unlevered firm
   and the effects of debt.
 Firm Value = Unlevered Firm Value
             + PV of tax benefits of debt
             - Expected Bankruptcy Cost

 More on APV Model
 In the adjusted present value approach, the value
  of the firm is written as the sum of the value of
  the firm without debt (the unlevered firm) and
  the effect of debt on firm value
   The unlevered firm value can be estimated by
    discounting the free cash flows to the firm at the
    unlevered cost of equity
   The tax benefit of debt reflects the present value of
    the expected tax benefits.
             Tax Benefit = Tax rate × Debt (1+ rd )
   The expected bankruptcy cost is a function of the
    probability of bankruptcy and the cost of bankruptcy
    (as a percent of firm value).
III. Using Multiples
the underlying belief of the multiple method is :
The value of any asset can be estimated by
  looking at how the market evaluates “similar” or
  ‘comparable” assets.

Equity versus Firm Value
  1. Equity multiples (Price per share or Market value
     of equity) e.g. 6 times Book value
  2. Firm value multiplies

 III. Valuation using                      Multiples
 The multiple method usees
   Earnings (EPS, Net Income, EBIT, EBITDA)
    e.g. 8 times EBITDA.
   Book value (Book value of equity, Book
    value of assets, Book value of capital)
   Sector specific variables
 Relative valuation is much more likely to reflect market
  perceptions and moods than discounted cash flow
 Relative valuation generally requires less information than
  discounted cash flow valuation
   Estimate the Cost of Equity:
   Competing Models
Model          Expected Return                   Inputs Needed
                                                 Riskfree Rate; Beta;
CAPM           E(R) = Rf + b (Rm- Rf)            Market Risk Premium
                                                 Riskfree Rate;
                                                 # of Factors;
APM            E(R) = Rf + Sj=1..n bj (Rj- Rf)   Betas; Factor risk
                                                 Riskfree Rate; Macro
Multi-factor   E(R) = Rf + Sj=1,,n bj (Rj- Rf)   factors; Betas; Macro
                                                 economic risk premiums

Estimating Beta
The standard procedure for estimating betas is to
  regress stock returns (Rj ) against market returns
  (Rm ) :
            Rj = a + b Rm
The slope of the regression b is the beta ( β ) of the
  stock, and measures the riskiness of the stock.

This beta has three problems:
1. It has high standard error
2. It reflects the firm’s business mix over the period
   of the regression, not the current mix
3. It reflects the firm’s average financial leverage
   over the period rather than the current leverage.
    Two stage DCF Valuation:

                                                                Expe cte d Growth
                      Cash flows                                Firm: Growth in
                      Firm: Pre-debt cash                       Operating Earnings
                      flow                                      Equity: Growth in
                      Equity: After debt                        Net Income/EPS             Firm is in stable growth:
                      cash flows                                                           Grows at con stant rate

                                                                                                 Terminal Value
                               CF1          CF2      CF3        CF4           CF5          CFn
Value                                                                               .........
Firm: Value of Firm                                                                                           Fore ver
Equity: Value of Equity
                                             Le ngth of Pe riod of High Growth

                                                     Disc ount Rate
                                                     Firm:Cost of Capital

                                                     Equity: Cost of Equity

 Stage 2: Stable Growth and Terminal
When a firm’s cash flows grow at a “constant”
  rate forever, the present value of those cash
  flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
     r = Discount rate (Cost of Equity or Cost of
      g = Expected growth rate

DDM: dividend discount model
Case study:
 ABN Amro: As a financial service institution,
  estimating FCF to equity or FCFF is very difficult.
 The expected growth rate based upon the
  current return on equity of 15.56% and a
  retention ratio of 62.5% is 15.56%× .625 =9.73%.
 This is higher than what would be a stable
  growth rate (roughly 5% in Euros)
Find more detail at:
 Market Inputs
Long Term Riskfree Rate (in Euros) = 5.02%
Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)
   Current Earnings Per Share = 1.60 €; Current DPS = 0.60 €

ABN Amro: Valuation

Multinational Capital
Cross border mergers and acquisitions
 Advantages of M&A
 Improve economies of scale
 Cost reduction
 Get rid of your competitor
 Less risky than green-field ventures
 Improved financial power

M&As – Reasons for failures

 Overoptimistic appraisal of market potential
 Overestimation of synergies (bad valuation
 Overlooking problems
 Overbidding
 Poor post-acquisition integration

CSR and firm value

 Is there such a thing as Corporate
  Social Responsibility?
 How does it contribute to firm value?

Important chapters for exam
 Exchange rate: the basic equations:
  chapter 4, and 5.
 Theories of exchange rate movement:
  chapter 7
 Economic exposure, transaction exposure, and
  translation exposure : chapter 8
 Hedging technique, and management of
  exposures: chapter 10, 11,12,13, 15
 FDI and international trade theory: chapter 20
 Capital budgeting models, NPV, APV, EVA,:
  Chapter 22, 23, 24. Test bank 4 on the book.
  Page 513.

 From our experience, the first essential trait of
  leadership is positive energy – the capacity to
  go-go-go with healthy vigor and an upbeat
  attitude through good times and bad. The
  second is the ability to energize others, releasing
  their positive energy, to take any hill. The third
  trait is edge – the ability to make tough calls, to
  say yes or no, not maybe. The fourth trait is the
  talent to execute – very simply, get things done.
  Fifth and finally, leaders have passion. They care
  deeply. They sweat; they believe.


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