valncaps2
DESCRIPTION
types of valuationTRANSCRIPT
Valuation methodsDiscounted Cash Flow (DCF)
WACC method
APV method
Valuation: P/E multiple
If valuation is being done for an IPO or a takeover,
Value of firm = Average Transaction P/E multiple EPS of firm
Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when
firms in the industry are profitable (have positive earnings)
firms in the industry have similar growth (more likely for “mature” industries)
firms in the industry have similar capital structure
FIN
Valuation: Price to book multiple
The application of this method is similar to that of the P/E multiple method.
Since the book value of equity is essentially the amount of equity capital invested in the firm, this method measures the market value of each dollar of equity invested.
This method can be used for
companies in the manufacturing sector which have significant capital requirements.
companies which are not in technical default (negative book value of equity)
FIN
Valuation: Value to EBITDA multiple
This multiple measures the enterprise value, that is the value of the business operations (as opposed to the value of the equity).
In calculating enterprise value, only the operational value of the business is included.
Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded.
The following economic value balance sheet clarifies the notion of enterprise value.
FIN
$1500
Cash
$200
Debt
$650
Value to EBITDA multiple: Example
Suppose you wish to value a target company using the following data:
Enterprise Value to EBITDA (business operations only) multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3.
Recent EBITDA of target company = $20 million
Cash in hand of target company = $5 million
Marketable securities held by target company = $45 million
Interest rate received on marketable securities = 6%.
Sum of long-term and short-term debt held by target = $75 million
FIN
Average (Value/ EBITDA) of recent transactions
(10.1+9.8+9.2+10.5+10.3)/5 = 9.98
Interest income from marketable securities
0.06 45 = $2.7 million
20 – 2.7 = $17.3 million
9.98 17.3 = $172.65 million
Subtract debt to find equity value: 222.65 – 75 = $147.65 million.
FIN
Since this method measures enterprise value it accounts for different
capital structures
cash and security holdings
By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value.
Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive.
Gives a measure of cash flows that can be used to support debt payments in leveraged companies.
FIN
Heuristic methods: drawbacks
While heuristic methods are simple, all of them share several common disadvantages:
they do not accurately reflect the synergies that may be generated in a takeover.
they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm under consideration.
They assume that the firm being valued is similar to the median or average firm in the industry.
They require that firms use uniform accounting practices.
FIN
Valuation: DCF method
Here we follow the discounted cash flow (DCF) technique we used in capital budgeting:
Estimate expected cash flows considering the synergy in a takeover
Discount it at the appropriate cost of capital
FIN
Cost of debt of firm
Cost of equity of firm
Target debt ratio (debt to total value) of the firm.
FIN
“Income Statement”
Template for Free Cash Flow
The goal of the template is to estimate cash flows, not profits.
Template is made up of three parts.
An “Income Statement”
Adjustments for non-cash items included in the “Income statement” to calculate taxes
Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc.
The “Income Statement” portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting.
Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.
FIN
Template for Free Cash Flow
There are four categories of items in our “Income Statement”. While the first three items occur most of the time, the last one is likely to be less frequent.
Revenue items
Cost items
Depreciation items
Profit from asset sales
Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e.g. depreciation) and subtract all non-cash items added earlier (e.g. gain from salvage).
There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E))
Working capital
Template for Free Cash Flow
It is important to recover both at the end of a finite-lived project.
Salvage the market value property plant and equipment
Recover the working capital left in the project (assume full recovery)
FIN
FIN
Estimating Horizon
For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it.
Since a company is assumed to have infinite life:
Estimate FCF on a yearly basis for about 5 10 years.
After that, calculate a “Terminal Value”, which is the ongoing value of the firm.
Terminal value is calculated one of two ways:
Estimate a long-term growth and use the constant growth perpetuity model.
Use a Enterprise value to EBIT multiple, or some such multiple
FIN
Costs of debt and equity
Cost of debt can be approximated by the yield to maturity of the debt.
If it is not directly available, check the bond rating of the company and find the YTM of similar rated bonds.
Cost of equity
Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.
FIN
Value from investments
- Value of debt and other liabilities
Working capital
Depreciation
operations
$1500
Cash
$200
Debt
$650
NOPAT = Taxable income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
WACC method
APV method
Valuation: P/E multiple
If valuation is being done for an IPO or a takeover,
Value of firm = Average Transaction P/E multiple EPS of firm
Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when
firms in the industry are profitable (have positive earnings)
firms in the industry have similar growth (more likely for “mature” industries)
firms in the industry have similar capital structure
FIN
Valuation: Price to book multiple
The application of this method is similar to that of the P/E multiple method.
Since the book value of equity is essentially the amount of equity capital invested in the firm, this method measures the market value of each dollar of equity invested.
This method can be used for
companies in the manufacturing sector which have significant capital requirements.
companies which are not in technical default (negative book value of equity)
FIN
Valuation: Value to EBITDA multiple
This multiple measures the enterprise value, that is the value of the business operations (as opposed to the value of the equity).
In calculating enterprise value, only the operational value of the business is included.
Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded.
The following economic value balance sheet clarifies the notion of enterprise value.
FIN
$1500
Cash
$200
Debt
$650
Value to EBITDA multiple: Example
Suppose you wish to value a target company using the following data:
Enterprise Value to EBITDA (business operations only) multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3.
Recent EBITDA of target company = $20 million
Cash in hand of target company = $5 million
Marketable securities held by target company = $45 million
Interest rate received on marketable securities = 6%.
Sum of long-term and short-term debt held by target = $75 million
FIN
Average (Value/ EBITDA) of recent transactions
(10.1+9.8+9.2+10.5+10.3)/5 = 9.98
Interest income from marketable securities
0.06 45 = $2.7 million
20 – 2.7 = $17.3 million
9.98 17.3 = $172.65 million
Subtract debt to find equity value: 222.65 – 75 = $147.65 million.
FIN
Since this method measures enterprise value it accounts for different
capital structures
cash and security holdings
By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value.
Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive.
Gives a measure of cash flows that can be used to support debt payments in leveraged companies.
FIN
Heuristic methods: drawbacks
While heuristic methods are simple, all of them share several common disadvantages:
they do not accurately reflect the synergies that may be generated in a takeover.
they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm under consideration.
They assume that the firm being valued is similar to the median or average firm in the industry.
They require that firms use uniform accounting practices.
FIN
Valuation: DCF method
Here we follow the discounted cash flow (DCF) technique we used in capital budgeting:
Estimate expected cash flows considering the synergy in a takeover
Discount it at the appropriate cost of capital
FIN
Cost of debt of firm
Cost of equity of firm
Target debt ratio (debt to total value) of the firm.
FIN
“Income Statement”
Template for Free Cash Flow
The goal of the template is to estimate cash flows, not profits.
Template is made up of three parts.
An “Income Statement”
Adjustments for non-cash items included in the “Income statement” to calculate taxes
Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc.
The “Income Statement” portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting.
Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.
FIN
Template for Free Cash Flow
There are four categories of items in our “Income Statement”. While the first three items occur most of the time, the last one is likely to be less frequent.
Revenue items
Cost items
Depreciation items
Profit from asset sales
Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e.g. depreciation) and subtract all non-cash items added earlier (e.g. gain from salvage).
There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E))
Working capital
Template for Free Cash Flow
It is important to recover both at the end of a finite-lived project.
Salvage the market value property plant and equipment
Recover the working capital left in the project (assume full recovery)
FIN
FIN
Estimating Horizon
For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it.
Since a company is assumed to have infinite life:
Estimate FCF on a yearly basis for about 5 10 years.
After that, calculate a “Terminal Value”, which is the ongoing value of the firm.
Terminal value is calculated one of two ways:
Estimate a long-term growth and use the constant growth perpetuity model.
Use a Enterprise value to EBIT multiple, or some such multiple
FIN
Costs of debt and equity
Cost of debt can be approximated by the yield to maturity of the debt.
If it is not directly available, check the bond rating of the company and find the YTM of similar rated bonds.
Cost of equity
Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.
FIN
Value from investments
- Value of debt and other liabilities
Working capital
Depreciation
operations
$1500
Cash
$200
Debt
$650
NOPAT = Taxable income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items: