VALUATION: Valuation, discount rate, discount rate, growth rate and project selection

LECTURE 3

2

$45?

$35?

$55?

Business Valuations

1

We know the cost of

everything but the value of

nothing.

Learning Goal

Lecture outline

Introduction Value creation Valuation models Discount rates Growth rates Project selection

Value creation

Firms make various value-increasing decisions New venture New project

Product innovation Process innovation

Need to value those projects/ventures well for better management

Lecture 5 looks at valuation of Technologies/IP

Valuation Framework

1. Gather latest information/data

2. Estimate expected revenue growth (past rates, mkt. rates, other factors )

3. Sustainable operating margin (CVP analysis)

4. Reinvestment (plough-back rate = g/ROC)

5. Risk parameters (discount rates)

6. Start-up valuation (EPS)

7. Project selection

Valuation Measures

Approach DescriptionSubjective/Personal

Accounting Book

Replacement

Deprival

Market

Breakup Liquidation

Fair Value

Intrinsic/Economic

Enterprise Value

Many different valuation methods…….

5

Valuation Measures

Approach Description

Subjective/Personal Based on unique individual preferences

Accounting Book Historical cost from the financial reporting model

Replacement Cost to buy asset in the purchase market

Deprival Cost to compensate for the loss of an asset

Market Equilibrium price amongst actively traded parties

Breakup Liquidation Net realizable value in the sales market

Fair Value A “reasonable” value given information at hand

Intrinsic/Economic A estimate of value basing on earning potential

Enterprise Value The intrinsic value of a firm’s operating assets

Many different valuation methods…….

5

In general

Cost approach (accounting book) Income approach (Present value or

discounted cash flow (DCF); Market approach

Example: Valuing a second hand car

Accounting valuation vs. DCF valuation

1. Cost Approach

measures the future benefits of ownership by quantifying the amount that would be required to replace the future service capability of the asset

assumes that the cost of replacement commensurate with the value of the service that the asset can provide during its productive life

1. Cost Approach

1. Research and Development Expenditures: involves the capitalisation of R&D or product launch

expenses has the double effect of reducing expenses in the

income statement and building up the asset side of the balance sheet

capitalisation of R&D expenditure is to recognise its future benefit and therefore should be amortised against future sales

1. Cost Approach

Research and Development Expenditures:

empirical evidence has failed to ‘find significant correlation between research and development expenditures and increased future benefits as measured by subsequent sales, earnings, or share of industry sales’.

1. Cost Approach

Research and Development Expenditures:

The professional practice is to take a conservative approach to R&D expenses and to remove intangible assets unless there is a history of profits and sales as justification (i.e. brand names)

1. Cost Approach

2. Tobin’s q combines the market value and the replacement

cost methods for valuing assets in a way very similar to the market-to-book (M/B) value ratio

expectations of future profits are the basic determinant of investment activity and these expectations are supposed to be reflected in a firm’s market value

1. Cost Approach

2. Tobin’s q

Compare Tobin’s Q with 1.

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assetsMV

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1. Cost Approach

Tobin’s q market value of the firm exceeds the value of its

existing capital when investors’ perceive its expected earnings as high or increasing

firm can be worth less than its existing capital when its prospects are considered uncertain or low

investment in new real capital is profitable if q exceeds one

1. Cost Approach

Tobin’s q Firms with high q ratios are normally those with

attractive investment opportunities or a significant competitive edge, as would the case with most technology start-ups

Tobin’s q ratio differs from the M/B ratio q ratio utilises market value of the debt plus equity It also uses the replacement value of all assets

instead of the historical cost value

3. Adjusted Net Assets Method - One of the Cost Approaches

i. The balance sheet is restated from historical cost to market valueii. A valuation analysis is performed for the fixed, financial, other

assets, and liabilitiesiii. The aggregate value of the assets is “netted” against the estimated

value of existing and potential liabilities to estimate the value of the equity

iv. This value represents the minimum, or “floor,” value the company at liquidation

1. Cost Approach

Income Approach: Discounted cash flows method

Focuses on the income-producing potential of the asset

The value of the asset can be estimated from the present worth of the net economic benefit generated over the life of the asset

The DCF approach captures the essence of the time value of money and risk.

N

tt

t

i

CFValue

1 1

The present value of all future cash flows discounted at a rate that reflects the time value of money and the certainty of cash flows.

=

Discounted cash flows method

Discounted cash flows method

Value of firm =

t

t WACC

CFf

1 1

Who knows what future cash flow &

discounts rate to use?

The complexity of modeling an enterprise

is daunting!

Nice Idea But…

Step 1: Estimate Cash flows Cash flows are pre-financing, i.e.,

independent of the capital structure of the firm. Do not take out interest expense from cash flows

Estimating Cash flows

CFt = EBITt*(1 - T) + DEPRt – CAPEX - WKt + othert

 Where CF = Cash flow; EBIT = Earnings before interest and taxes; T = Corporate tax rate; DEPR = Depreciation; CAPEX = Capital Expenditure; WK = Increase in working capital, and other = Increases in taxes payable, wages, payable, etc.

Industry based understandingCash flow

Time

Cash flow diagram for an airline company

Cash flow

Time

Cash flow diagram for a newsletter company

Multiple cash flow curvesCash flow

Invest

Harvest

Growth option

Time

This occurs when after the first project, the firm has options to introduce related products/services to the market.

This presents new growth opportunity to the company.

Projection vs. reality

Reality

Cash flow

projection

Time

Cash flow

Scenario 1 original projection

Time

Scenario 2 More time & money, succeeded

Scenario 3: More time & money, failed

Need to understand the industry Group discussion exercise

The following common sized Financial statements were taken from 4 companies in 4 different industries. Could you please match the numbers to the companies? Utility Banking Grocery Pharmaceutical

Step 2: Estimate growth rate and discount rate Using CAPM to work out the cost of equity

Need risk free rate (note the matching principle) Firm beta (leveraged vs. unlevered) Market risk premium Note on beta. Use this as the discount rate for all equity firm

)(* fmfa rrrr

Estimating accounting beta The private firm’s accounting earnings can be used to regressagainst changes in earnings for a market equity index such asthe S&P/ASX 200 to estimate an accounting beta.

Earningsf = + S&P/ASX200 +

 where

Earningsf = the change in earnings of the firm; = the intercept or constant; = the beta of the market equity index;S&P/ASX200 = the market equity index, and = the random error term.

Bottom-up Betas This method involves breaking down betas into their business risk and financial leverage components to enable us to estimate betas without having to rely on past prices on a technology start-up

Unlevered Betas (u): The systematic risk of a firm assuming that it is 100% equity financed and has no debt.

  L

U = [1 + (D/E)]

Bottom-up Betas

Levered Betas (u): Where the firm’s capital structure

consists of both equity and debt financing.

L = U [1 + (D/E)]

The use of operating income (i.e. EBIT) would yield an unlevered beta while using the net income would yield the equity or levered beta.

The limitations with this type of beta are the distortion of data caused by accounting adjustments and the lack of a long time series for earnings given the short history of most technology start-ups

Cost of Debt

The best practices for estimating the cost of debt are to use the marginal borrowing rate and a marginal tax rate or the current average borrowing rate and the effective tax rate.

The after-tax cost of debt, Kd(1 – T), is used

to calculate the weighted average cost of capital.

WACC as the discount rate

DDL

EEWACC rwrwr *)1(**

Note:

Weight of Debt and Weight of Equity are based on Market value

Venture Capital Rates of Return The required rates of return for venture capital

at different development stages are illustratedbelow (Smith and Parr 2000): Venture Capital Rates of Return

Stage of Development Required Rate of Return (%)Start-up 50First Stage 40Second Stage 30Third Stage 25

Venture Capital Rates of ReturnThe pharmaceutical industry provides aspecific industry example, Hambrecht & Quist(Smith and Parr 2000)Development Stage Required Rate of Return (%)Discovery 80Pre-Clinical 60Clinical Trials – Phase I 50 – Phase II 40 – Phase III 25New Drug Application 20Product Launch 17.5 – 15

Growth Rates

Damodaran (2002) suggests three ways of

estimating growth for any firm as follows:

 

        Historical growth rate

        Market analysts’ estimates

        Firm’s fundamentals

Valuing cash flows with the CCF method All equity (unlevered firm)

Ta

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TVCF

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CF

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Valuing cash flows with the CCF method (cont.) Leveraged firm

Tax shield advantage when debt is taken as interest payment are tax deductible.

Value of tax shield, TS (time period t)

DrTS dt **

Valuing cash flows with the CCF method (cont)

The tax shields are discounted to PV to get PVTS

Assuming D stays constant for simplicity WACC can be used as a discount rate

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d

a

d

r

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Valuing cash flows with the CCF method (cont)

InvestmentPVNPV

PVTSPVPV

CCF

UCCF

Practice with NSK case

Please work out the value of NSK company basing on the information of NSK and comparable companies provided in the case.

Next class

Valuation with market based approach. Case: Tutor Time (A) (p. 131)