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Valuation _December_ 2003_

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Valuation _December_ 2003_ Powered By Docstoc
					                             Valuation: A Primer

                                  First Year Finance
                                          w


Richard Ivey School of Business           1
 Valuation as a Tool

 • We encounter valuation in many situations:
        –   Mergers & Acquisitions
        –   Leveraged Buy-outs (LBOs & MBOs)
        –   Sell-offs, spin-offs, divestitures
        –   Investors buying a minority interest in company
        –   Initial public offerings
 • How do we establish value of assets?
 • Objective: To preview different valuation methods
   used most commonly in practice


Richard Ivey School of Business     2
 Valuation Techniques
• Discounted Cash Flow (DCF) Approaches:
     – Dividend discount models (DDM)
     – Free cash flows to equity (FCFE – direct approach)
     – Free cash flow to firm (FCFF – indirect approach)
• Relative valuation approaches:
     – P/E (capitalization of earnings)
     – Enterprise Value/EBITDA
     – other: P/CF, P/Rev, etc.
• Break-up value
• Acquisitions: special considerations

 Richard Ivey School of Business   3
 Majority vs Minority Stake

 • If purchasing a majority interest, you need to
   determine if assets or common equity is being
   purchased:
        – Buying equity implies that acquirer assumes existing
          debt obligations (usual case in M&A)
        – Buying assets implies debt obligations are retired with
          purchase and free to refinance




Richard Ivey School of Business    4
 Majority vs Minority Stake

 • If purchasing minority interest, no change of
   control takes place and determine PV of future
   “dividend” stream (DDM approach)

 • alternatively: “traditional” DCF approach then
   account for “no control”




Richard Ivey School of Business   5
Discounted Free Cash Flow (DFCF)
(“Direct” Equity Approach)

 • Buying equity of firm is buying future stream of free
   cash flows (available, not just paid to common as
   dividends) to equity (FCFE)
 • FCFE is residual cash flows left to equity after:
       – meeting interest/principal payments
       – providing for capital expenditures and working capital to
         maintain and create new assets for growth

       FCFE =                Net Income + Non-cash Expenses
                             - Cap. Exp. - Increase in WC - Princ. payments

 Richard Ivey School of Business             6
DFCF Alternative
(“Indirect” Firm Approach)

• Problem: Calculating cash flows related to debt
  (interest/ principal) & other obligations is often difficult!
• An alternative is to compute FCF to Firm (FCFF) that
  ignores cash flows related to financing but that
  incorporate financing into discount rate (using WACC
  or kc)
• Once we compute value of firm this way, we subtract
  value of debt and other financial obligations to
  determine value of equity

 Richard Ivey School of Business   7
 DFCFF Step 1: Discount Rate

       • (recall) Estimate cost of capital or WACC (kc):


              kc = wd * kd + wp * kp + we * ke




Richard Ivey School of Business   8
DFCFF Step 2: Annual Cash Flows

• (recall) FCFs are projected after-tax cash flows:

   FCFF = EBIT * (1 - tax rate)
       + non-cash expenses (depreciation, amortiz.)
       - capital expenditures
       - net increases to working capital




Richard Ivey School of Business   9
DFCFF Step 3: Calculate PVs

 • FCFs are then “discounted back” to the present
   using the appropriate discount rate (Kc)


                          FCF1        FCF2   FCF3     FCF4   FCF5   etc.
              |                   |     |         |     |      |
         t=0                      1     2         3    4       5
        today
         PV=?


Richard Ivey School of Business              10
  DFCFF Step 4: Add Terminal Value

• Beyond some point (e.g., 5 years) assume a constant
  growth rate of FCFs to estimate a “terminal value” (i.e.,
  value of FCFs for years 6, 7, 8, etc.) or alternative

Valuefirm = FCF1/(1+kc) + FCF2/(1+kc)2 +...+ FCF5/(1+kc)5
                 + [FCF6/(kc-g)]/(1+kc)5


                                     terminal
                                       value

   Richard Ivey School of Business          11
 DFCFF Step 5: Subtract Debt

       • Value of firm's equity (Ve) =
          value of assets or overall value of firm (Vf)
          – value of debt obligations (Vd)




Richard Ivey School of Business   12
 DFCFF Step 6: Final Step
 (If Appropriate)

       • Add value of any redundant assets:
               – assets not required (to be sold)
               – “excess” cash (not needed for day-to-day operations)




Richard Ivey School of Business       13
 DFCFF Example
   Year             EBIT Dep      Cap Ex W/C Chg
   1                40   4        6      2
   2                50   5        7      3
   3                60   6        8      4

   tax rate = 40%                 Kc = 10%
   growth (g) of FCFs beyond year 3 = 3%
   Vdebt = value of debt = $100 Vequity = ?


Richard Ivey School of Business      14
 DFCFF Example (cont’d)

FCFs = EBIT*(1-t) + Dep - CapEx - WCchg

1. 40*(1 - 0.4) + 4 - 6 - 2 = 20
2. 50*(1 - 0.4) + 5 - 7 - 3 = 25
3. 60*(1 - 0.4) + 6 - 8 - 4 = 30




Richard Ivey School of Business   15
 DFCFF Example (cont’d)
                    20            25   30    30*(1+g) 30*(1+g)2
   |                 |             |    |     |        |
   t=0               1             2    3     4        5
  PV = Vfirm

                                                 30*(1+g)/(Kc-g)


  Vf = 20/(1+Kc) + 25/(1+Kc)2 + 30/(1+Kc)3 +
       [30*(1+g)/(Kc-g)]/(1+Kc)3

Richard Ivey School of Business         16
 DFCFF Example (cont’d)

 Vf = 20/(1.10) + 25/(1.10)2 + 30/(1.10)3 +
      [30*(1.03)/(0.10 - 0.03)]/(1.10)3

        = 18.2 + 20.7 + 22.5 + 331.7 = 393.0

 Vfirm = Vdebt + Vequity  Vequity = Vf - Vdebt

 Vequity = 393.0 - 100.0 = 293.0


Richard Ivey School of Business   17
 Discounted FCFF Approach:
 Special Issues

• What Kc to use?
     – business risk?
     – capital structure?
• How to estimate annual cash flows?
     – projected revenues, cap ex, w/c change?
     – tax rates?
• How to estimate terminal value?
     – at what point?
     – what method?

Richard Ivey School of Business   18
   Relative Valuation:
   Capitalized Earnings Approach
• Value of equity of company (per share basis) is equal to
  price/earnings multiple (P/E) times expected earnings:
       P0 = “P/E multiple” x EPS1

• “P/E multiple” relates to growth and risk of underlying
  cash flows for firm
• Multiple often determined from “comparables” (i.e.,
  “similar” firms: industry, growth prospects, risk,
  leverage; industry average as a starting point)

  Richard Ivey School of Business   19
 Other Relative Value Approaches

 • Enterprise Value (EV) / EBITDA approach:
        – EV = MVequity - cash + MVdebt + Mvpref + minority interests
        – EBITDA: earnings before taxes, interest, dep. & amortiz
 • First step:
        EV0 = “EV/EBITDA multiple” x EBITDA1
 • Second step: solve for MVequity (see above)
 • Multiple often determined from “comparable” firms



Richard Ivey School of Business    20
 Other Relative Value Approaches
 (continued)
 • Other multiples: P/CF, P/Rev

      P0 = “P/CF multiple” x CF1
      P0 = “P/Rev multiple” x Rev1
 • Where:
        CF = cash flow
        Rev = revenue
 • Multiples often determined from “comparable” firms

Richard Ivey School of Business   21
 Other Relative Value Approaches
 (continued)
 • Comparable transactions:
        – For mergers, look at “premiums” paid in recent merger
          transactions in the industry
        – E.g., premiums over “recent” stock price, P/E multiples,
          price/book multiples, etc.




Richard Ivey School of Business    22
 “Break-Up” Value Approach
        Vequity = book value of equity + “adjustments”

        – Possible adjustments: the value of any “hidden”
          assets which may be worth more than BVs, e.g. real
          estate, brand names, copyrights, patents, etc.
        – As well, if multi-divisions, market value of each piece (if
          sold separately) in sum may be worth more than current
          whole (so firm may become an acquisition target)




Richard Ivey School of Business     23
 Acquisitions – Special Considerations:
 Why Merge or Acquire Another Firm?
 • Efficiency - “synergistic gains”

 • Information - “undervalued assets”

 • Agency problems - “entrenched management”

 • Market power - “corporate hubris”



Richard Ivey School of Business   24
 Most Mergers “Fail”!
 • McKinsey & Co. estimates 61% fail and only 23%
   succeed because:
        – Inadequate due diligence by acquirer

        – No compelling strategic rationale

        – Overpay, or projected synergies not realized




Richard Ivey School of Business   25
 Acquisition Premium Approach
 • What “premium” over intrinsic (DFCF-based) value is a
   potential buyer willing to pay for control?
        – see also (recent) comparable transactions


 • On average, evidence shows 30% premium

      Max Value = Value to + Valued + Change in Value
       to Buyer    Seller    Added    from Change in
                                         Control


Richard Ivey School of Business       26
 Applications
   • We will apply valuation principles in a variety of
     circumstances:
           –    “Project” Acquisition (Graphite Mining Corp.)
           –    Initial Public Offering (Eaton’s)
           –    International Valuation (Huaneng Power)
           –    Negotiations Exercise (BP-Amoco)
           –    Mergers & Acquisitions (Pinkerton, UGG, Interco)




Richard Ivey School of Business       27

				
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