Corporate Valuation Study Guide

Corporate Valuation Study GuideAutumn 2010

Corporate Valuation

Study Guide: Autumn 2010

Industrial and Financial ManagementDepartment of Business StudiesGteborg University

Learning objectives (from the course syllabus)The course is divided into several important topics in company valuation

i) Understanding the financial statement Financial statements provide the fundamental information describing historic events and constitute the origin of company valuation. The students will learn the accounting principles behind valuing assets, as well as breaking down the balance sheet into operating non-operating items, and, the income statement into ordinary and unordinary items.

ii) Foundations of valuation In this case, the student will learn techniques and models for estimating a firms free cash flow. Important aspects are tax effects, adjusting for R&D as well as estimating the net investment for growth calculations. The case will also discuss the correct information to be used for estimating the cost of capital.

iii) Valuation from a portfolio management perspective The objective is to understand the investment philosophy of the investor. Active and passive portfolio management has different valuation purposes adopting different techniques. In this part the importance of barriers to entry is analyzed, discussing the effect on volatility, distribution and growth in earnings.

iv) Valuation from a M&A perspective and Value enhancement The different classification of mergers and acquisitions will be discussed together with processes and steps in M&A activities. Motives behind, and synergy effects of M&A will be viewed both from theory and from empirical evidence. In the last case the students may also discuss valuation from the view of a manager. From a broad perspective, the value based management literature has brought new insight into the role of the managers, in the narrow perspective this section focus on the importance of correct depreciation schedules. The aim of the course is to give the participants a thorough knowledge in evaluating companies using DCF, Value based management models and multiples.

Learning outcomes After completing the course the student will understand and be able to

1. Analyse a companys financial performance and extract information from the financial statements.

2. Apply different valuation techniques such as FCFF, FCFE, Dividend-models and relative valuation.

3. Analyse and describe a companys value driving factors

4. In corporation with other students, and with limited information conduct a practical valuation of a chosen company. This will be carried out from different perspective.

LecturesLectures are used to highlight theory and guide you through the difficulties of valuation theory. This is a Masters level course and therefore lecturers do not directly explain what is in the textbook. Instead the focus is on topics that are discussed in the text and try to put the text in a perspective. The lecture is structured by the teacher, but we try to have open discussions. Before the lecture make sure you have prepared yourself and if there are specific preparation questions (written in this Study Guide) you can work with them as well.SeminarsAt the seminars it is the course participants who present their work. The teachers role is to provide a structure which enables everyone to get the most benefit out of group discussions. The first two seminars are practically oriented and build on each other. The third seminar concerns some more advanced valuation topics. It is very important that all students come to the seminars ready to participate in the discussions. This does not just mean that you present your own material, but also that you ask questions to others. I deduction of the score received on the case will be given to each individual not present (compare course syllabus)Signing up for a seminarA team consists of 4 students (sometimes 3, but never 5!) that work together in terms of making an analysis and presenting it at the seminar. All students sign up for the seminar in the beginning of the course. As long as you attend the lectures you will have plenty of opportunities to find other students to work with. You sign up by writing down your name and e-mail address on the seminar list which is available on the notice board at the D6 building and brought to the first lectures by the teachers. We prefer if all seminar groups consist of at least one Swedish national and one exchange student. The reason for this is that (1) this forces everyone to work in the English language, and (2) it creates an integration of exchange students in the student body. If you do not know whom to work with, just talk to one of the teachers and we will make sure that you do find a group.After you have found a few friends to work with, you have to decide what company to analyze. In the end of this Study Guide you will find a list of companies. Two groups cannot analyze the same company and they are allocated on a first come, first serve basis. The scheduled times for your teams presentations can be found in the tentative schedule.The first seminar deals with the historical analysis of your company. Your team is asked to write a paper that describes the companys past performance. You do this in a reasonably structured manner (remember that we do have a system making valuation analyses) but there is room for you to highlight particularities in your company. You find all the details in Appendix B. At the seminar all groups are given some time to present their company. The second seminar follows directly on the first seminar. The task is now to move the analysis from the past to the future. The team will then use the information of the companys historical performance relative to competitors, and discuss what the future is likely to be. You will then come up with estimates of value drivers and use them to find the appropriate value of your company. You find more information in Appendix C.The third seminar is not directly linked to the previous seminars. Information on this seminar will be handed out later during this course.

Make sure that the paper is handed in well before the deadline. Also make sure you e-mail the presentation (it must be a PowerPoint file) prior to the seminar. Please put the name of the company you analyze in the title of the e-mail.

Teachers:Stefan Sjgren (Associate Professor ph.d. finance) earned his doctoral degree at the Department of Business Studies, University of Gothenburg in 1996. He teaches a wide variety of courses in the area of corporate finance and investments. In 2005 he co-edited a book on investment decisions, relating theory to practice. Currently Stefans research interests involve corporate finance decisions, and investment practices in particular.Telephone: 031-786 1499.E-mail: stefan.sjogren@handels.gu.seJan Marton (Assistant Professor). Teaches in the area of financial accounting, accounting theory, financical statement analysis and group accounting. His research interests are 1) IFRS both from a producer and a user perspective. 2) Voluntary disclosures in accounting, especially disclosures about human resources and management control in the companies. 3) Accounting and trust, which involves a comprehensive study of how the concept of trust has been used in the accounting literature, and the result obtained to date in research on accounting and trust.

Ted Lindblom is a full professor specialized in industrial and financial management. He has long experience of education and research in corporate finance related topics. His most recent research concern capital budgeting and financial decision-making, incentive pay, the cost of trade credit, and risk management in banks.Telephone: 031-786 1497.E-mail: ted.lindblom@handels.gu.se

Hans Jeppsson is a PhD student in Finance at the University of Gothenburg, School of Business, Economics and Law. His primary research interest lies within empirical corporate finance with an application on biotech companies. In the first research paper, he is analyzing news announcements of European biotech firms and stock market reactions. In the second research paper, he examines how biotech firms source equity capital to finance investments in R&D and how they are able to time these equity issues with respect to theories of market mispricing and adverse selection costs.E-mail: hans.jeppsson@handels.gu.se

Emmeli Runesson is a PhD student in Accounting. Her research is in the area of accounting and capital market, with a main focus on the effects of international accounting standards (IFRS) on the financial reporting. The research issue is how international standards affects the reporting quality from an investors perspective and how professional investors take use of the financial reporting. E-mail: Emmeli.runesson@handels.gu.se

You can find all material that has been handed out as well as other useful information on the course web site (GUL). The course coordinator is Stefan Sjgren. Wiviann Hall takes care of most administrative matters. telephone 031-786 1507, E-mail: wiviann.hall@handels.gu.seFor master students administration is handled by Tina Alderin (tina.alderin@handels.gu.se).

Detailed lecture information

Lecture 1: Introduction, and Valuation Models and PerspectivesContentThis lecture provides an overview of different valuation perspectives. Valuation is useful from a wide range of tasks. Fund managers and outside investors are valuing companies using public information. Valuation plays an important role also in acquisition analysis. In the case of M&A the information available are often more detailed, and not only public. A third role is to value a company from a managers point of view in order to take value enhancement decisions. Analysts use a wide range of methods. We will introduce these methods briefly and discuss their pros and cons.

Things to think of1. What is the value of an investment?2. From which perspective is the valuation undertaken?3. What are the building stones of the DCF method?PreparationRead chapters 1 and 2 in Damodaran.Lecture 2: Accounting and valuationContentThis lecture provides a background to accounting information which is used as the key input in all valuation models. We discuss the role of accounting and how it can help and hurt the investor when evaluating the performance and financial position of a company. This lecture also focuses on the companys income statement. We make it useful for forecasts of future performance by learning how to remove/adjust for unsustainable elements. We distinguish between operating and financial activities. The objective is to identify and understand the operating activities in which the company has/wishes to have a competitive advantage.

Things to think of1. Have you understood everything in the Study Guide?2. Do you know any good examples of when companies deliberately have fooled investors with the help of accounting information?3. What conflicts can arise between different users of accounting information (e.g. investors and creditors)?PreparationRead chapters 1, 2 and 9 in Damodaran.

Lecture 3: Estimating risk and the cost of capitalContentThis lecture focuses on the discount rate that is used in the valuation model. We will discuss how to practically estimate all risk factors, and finally a proxy for an overall firm discount rate (WACC or return on equity). This includes repeating the CAPM model in order to estimate the cost of equity, and how to practically estimate a firms cost of debt. Using these estimates also requires an assumption on the market efficiency.Things to think of1. Are financial markets efficient? Name the classifications of market efficiency.2. What is risk? To whom?3. Should we use the WACC or the cost of equity in the valuation model?PreparationRead chapters 4,6, 7 and 8 in Damodaran.

Lecture 4: understadning the value of a firms resources

ContentAt this lecture we focus on the companys resources (assets) as measured in the balance sheet, and its obligations (liabilities). We look at different valuation techniques (e.g. historical cost and fair value), differences between different kinds of assets and potential problems when comparing different companies.Things to think of1. At the last lecture we discussed the measurement of the core operations performance. There are three conceptually different ways of manipulating this performance. Assume you are the manager of a company, your stock options will soon expire and you want to boost your companys operating profit margin. What can you do?2. A part of Electrolux corporate strategy is to acquire and integrate small local competitors. These integrations (and the continuous moving of production to low-cost countries) give rise to restructuring costs. How should such costs be handled in an analysis of past performance?3. Nokia receives about 80% of its sales revenue from the mobile phone division, and the rest from its network system division (now a joint venture with Siemens and a direct competitor of Ericsson). What alternatives exist for an analyst in terms of identifying its core business and judging performance?

Preparationsee chapters 2 and 9 in Damodaran.

Lecture 5: Adjusting Earnings and DCF methodsContentThis lecture will use the financial statement, especially the income statement, as a starting point. The items on the income statement must be normalized and corrected with the purpose of trying to give a true picture of a firms performance. Thereafter, this lecture focuses on how to estimate the free cash flow of a firm by adjusting some cost and income items.Things to think of1. What (if any) is the difference between correcting and adjusting accounting items?2. How do you adjust leasing, R&D and marketing expenses?3. What is the main difference between FCFF and FCFE?PreparationRead chapters 9 and 10 in Damodaran.

Lecture 6: ANALYZING HISTORICAL PERFORMANCEContentMost of this lecture is not going to be devoted to financial ratios, but actually to finishing lecture 5 (on financial position) and a regrouping of the financial statements. It is only when we have regrouped the financial statements that internally consistent and valuation-relevant financial ratios can be constructed. We introduce these ratios in the end of the lecture.Things to think of1. If you are going to analyze a companys profitability which is the best measure to use: (1) the return on equity, (2) the return on net operating assets, or (3) the return on total assets?2. What do you think is a normal return on financial assets and return on (net) operating assets? Why is there a difference in these two returns?3. In corporate finance you have probably have learnt that in reality there is an optimal debt ratio (mainly because of taxes and agency costs). But is it common that companies have a negative debt ratio (i.e., more financial assets than interest bearing debt)? Give examples (besides Nokia) of such companies/industries and provide theoretical arguments as to why they might keep such (negative) debt ratios.Preparation

Lecture 7: Estimating growth and closureContentThis lecture provides tools and techniques on how to estimate the future. The value of a firm is equal to the present value of all future cash flows. The most critical input in valuation is to foresee these cash flows. The valuation depends critically on two things: the size of the growth rate, and for how long the estimated growth rates will persist. We will also discuss the accuracy of financial analysts forecasts and introduce some relative comparisons.Things to think of1. How do you create expectations concerning the growth rate? What alternatives exist?2. What is the terminal value of a firm? Do you think most value is created before or beyond the forecast horizon?3. How is growth created?PreparationRead chapters 11-16 in Damodaran.

Lecture 8: Forecasting A FIRMS FUTURE PERFORMANCEContentThis lecture is about forecasting the future in a structured way. We use the framework we have introduced and learnt in the past and now we discuss it in the light of strategic considerations (performance relative to competitors in the past and in the future). The financial ratios from lecture 7 are now connected to the modeling of the future performance.Things to think of1. Many companies have in recent years performed considerably better than their long-term historical average. Can there be shifts over time in the overall level of performance (say for example the level of the sustainable operating profit margin)? There are arguments both for and against so think carefully!2. What would you as an investor be most happy about: (1) a company that has a constant operating margin and market share in a growing market, (2) a company that has a constant operating margin, but gains market shares in a market that is not growing, or (3) a company that increases its operating margin in a market that is not growing?

PreparationThis chapter is more of a summary of what we have done so far. It provides a link between the valuation chapters in Damodaran (i.e., chapter 13-16) and the financial analysis in the compendium. Hand-out distributed at the lecture.

Lecture 9: Peer valuation and multiplesContentThis lecture discusses the use of multiples and key ratios, and discuss their usefulness as valuation tools. We also show a buttom up valuation using multiples.

Things to think of3. Both P/E ratios and other key ratios, such as Ebitda/sales, are very common in describing a firms performance. What are the drawbacks using key ratios for valuation purpose 4. A ratio must be theoretically consistent. The P/E ratio measures the price for a share in relation to the earnings you receive owning the share, the measure and the purpose of the valuation are therefore aligned as the numerator and the denominator are both eqiuty value. This is not so if we look at the price to EBITDA ratios.

PreparationRead chapters 17 and 18 in Damodaran

Lecture 10: Mergers & Acquisitions (Synergies)ContentThis lecture examines M&A activities with special emphasis on the acquisition process and the various motives that different parties concerned may have for initiating and carrying though an M&A. The importance and use of different forms of payment for the target firm is also elaborated upon.Things to think of1. What are the relevant cash flow effects to consider when evaluating the performance of an M&A?2. What time horizon is relevant in such an evaluation?3. How does M&As impact on the acquiring companys overall risk?PreparationRead chapter 25 in Damodaran.

Lecture 11: Value enhancementContentThis lecture examines actions to increase firm value and the impact of different financial performance measurements on managerial incentives. We compare two widely used value enhancement and performance measurements; Economic Value Added (EVA) and Return on Investment (ROI), and show when these measures are consistent with traditional Net Present Value (NPV) calculations and when they are not.PreparationRead chapters 31 and 32 in Damodaran.

LiteratureGeneral commentsThere are, quite obviously, a number of standard textbooks on the topic of valuation. We have selected one of them; Investment Valuation by Aswath Damodaran. The strength of this book is that the on-line support for student and researchers are very useful, and that the book cover a wide area from a financial perspective. You can buy the book in paperback or hardback and we certainly suggest that you get the paperback. There are several alternatives that are worth mentioning. Stephen Penman has written a much appreciated textbook that has a clear-cut accounting orientation. Its title is Financial Statement Analysis and Security Valuation. Another book that is often used in valuation classes is Valuation: Measuring and managing the value of companies by Koller, Goedheart and Wessels. It is now out in its fifth edition (2005) and focuses on free cash flow models. Investment Valuation (Aswath Damodaran (2002). John Wiley & Sons, 2nd ed.)The book by Damodaran is nearly 1000 pages long and contains 35 chapters. We require course participants to read 16 chapters intensively and suggest that you read another 6 chapters extensively. The following chapters are part of the required readings:

NoTitle

2Approaches to valuation

3Understanding financial statements

4The basics of risk

7Riskless rates and risk premiums

8Estimating risk parameters and cost of financing

9Measuring earnings

10From earnings to cash flows

11Estimating growth

12Closure in valuation: Estimating terminal value

13Dividend discount models

14Free cash flow to equity models

15Firm valuation: Cost of capital and adjusted present value approaches

161718Estimating equity value per shareFundamental principles of relative valuationEarnings multiples

25Acquisition and takeovers

31Value enhancement: A discounted cash flow valuation framework

32Value enhancement: EVA, CFROI and other tools

Extensive reading:

1

5

6

19

Appendix A

All teams have to sign up for a company that they want to analyze (by writing your names next to the company on the seminar list). The companies are allocated on a first come, first serve basis.

Seminar Group 1: Heavy manufacturing, large capAtlas CopcoSandvikSKFAlfa Laval

Alternatives: Volvo, Scania, Assa Abloy, Saab

Seminar Group 2: Heavy manufacturing, mid capVBGHaldexBeijer AlmaTrelleborg

Alternatives: Nederman, Seco Tools

Seminar Group 3: ConstructionSkanskaNCCJM ByggPeab

Alternatives: Lindab, Systemair

Seminar Group 4: Forestry & PaperSCAHolmenStoraEnsoUPM Kymmene

Alternatives: Billerud, Norske Skog, Rottneros

Seminar One Historical analysis of the company

Date: Friday the 9th of October

Structure and organization of seminar oneThere will be four 2-hour seminars and at a seminar there will be 4 teams presenting. Each team attends one 2-hour seminar. Appendix A contains a list of companies your team may choose among. You choose a company by signing up on the seminar list. The intention is to have all teams within a seminar to analyze a company in the same industry.One team analyses one of the companies in the industry and to do this they need at least the latest three annual reports of their company. You need to get a copy of these from the companys webpage (or order them from the company!). It is also highly beneficial if you search the Internet for analyses of your company, and particularly analyses where its performance is compared to other companies. Remember to make a reference to such analyses that you find and use.

Overall purposeThe overall purpose with seminar one is to get a good understanding of the companys current financial position and its development over the last years. We focus primarily on the financial analysis, but do not forget that when extrapolating past performance into the future (i.e., the task for seminar two) one needs to understand the competitive environment of the past relative to the future. This means doing a strategic analysis. We divide the task into three components.

Task One: Creating common-size financial statementsYou only need to perform this task for the latest year (=2008). Rearrange the assets and liabilities so that it is possible to identify risk bearing capital, interest bearing debt, non-interest bearing debt, capital employed and financial/operating assets. Create common-size financial statements for your company. All balance sheet items that make up more than 10% of total assets/liabilities should be separately noted.Do the same thing with the income statement. (Sales revenue is then equal to 100%)

Task Two: Measuring financial performanceCalculate the following financial ratios for your company and for the years 2006-08:Sustainable operating profit margin Net profit marginReturn on net operating assets Return on capital employedReturn on risk bearing capital Debt ratioInterest cover margin Operating cash flow to sales

Specify the definitions that you use. If you have problems with interpreting certain accounting items this should be specified in notes.

Task Three: Analysis of the financial performanceMake a brief analysis of your company. This analysis should comprise 3-4 pages. You may bring up anything you want but the following questions are interesting (Do NOT attempt to answer all of them!). Remember: this seminar paper must comprise an analysis. This is of course the most important part of the paper, but it builds on solid work in the previous parts.

* Have there been any changes over time (2005 to 2008)? -Comment on observable trends.* Does your company state any financial goals in the annual report? -How does the company perform in relation to these goals?* Have there been any substantial gains/losses in the years you analyzed? -How have they affected the measures?* Decompose the RNOA into asset turnover and profit margin. -Which factor affects RNOA the most?* Try to find any financial analyses on the Internet of the industry your company is in. How does your company perform in comparison to other companies?

Hand-in of materialThe seminar paper shall be handed in (using e-mail) to Mattias Hamberg no later than 18.00 the day before the presentation. It shall be in a Word-format or pdf-format. We do not want any attached Excel-files (=create tables of the important information). All team members must participate in the work. The length of the paper shall be no longer than nine (9) well-written pages (excluding the front page)! Because half of the teams have one day more to prepare for the presentation it is not possible to make any changes to the paper after the due date. This is only to ensure reasonable fairness between teams!

PresentationA presentation of your company has to be prepared. This presentation has to be short however and you do not have to present details of the financial situation. Maximum 15 minutes and 10 slides. After this we will continue to analyze the companies. Send a PowerPoint file with your presentation no later than 18.00 the day before the presentation.. All seminar participants need their own copies of the annual reports. It is not good enough with a pdf-file on the laptop.

Seminar Two Valuation of the company

Date: The 21th of October

Background and tasksThe second seminar is a direct continuation of seminar one. Your task is to conduct a company valuation of the same company as before. This involves particularly the creation of pro forma financial statements for a foreseeable time period. Each team will therefore base their analysis on the financial statement analysis from the first seminar. It is encouraged that students use the analyses from the other teams (at their seminar) when determining how well their own firm performs. 1. Make a comment on the financial statements from the past years. Make them usable for a forecast of the future (Income statements, Balance sheets and Net investments)2. State the assumptions on which your valuation is based.3. Make forecasts of financial statements for a foreseeable time-period (pro forma statements)4. Estimation cost of capital, continuing value, etc.5. Determine the company value, applying discounted cash flow methods. and discuss it briefly (scenarios and sensitivity)

PresentationThe presentation shall be 20 minutes per group including 8 minutes seminar discussion. You are asked to present the background for your analysis, assumptions and the actual results. After the presentations there will be time to discuss the questions listed below. All students should have considered these and be prepared to discuss them (you should not address them in your paper though).1. What are the main difficulties when creating pro forma statements for your company?2. What portion of your companys current value is, according to your estimates, created during the foreseeable future?

Send a PowerPoint file with your presentation before 18.00 the day before the presentation.Hand-in of materialThe analysis has to be handed in to Stefan Sjgren before 18.00 the day before the presentation. It shall be in a Word-format or pdf-format. We do not want any attached Excel-files (=make tables of the important information). The length of the paper shall be no longer than nine (9) well-written pages (excluding the front page)! ~ 14 ~