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Valuation

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Approaches to Valuation

Question: What is the value of firm?

Relative Valuation

Discounted Cash Flows Contingent Claim Valuation, Real Options

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Valuation

Valuation critical in M&As Aids evaluation of acquisition candidates Helps to set goals and benchmarks

Framework essential to discipline valuation

estimates Comparables (Companies, Transactions) Discounted Cash Flow (Spreadsheet, Formula) Use of multiple methods offers differing

perspectives Valuation should be guided by a business

economics analysis of the firm and itsenvironment

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I. Relative Valuation

Relative Valuation:

Use companies (or transactions) comparable in:

Size and products

Recent trends and future prospects

Key ratios calculated for each company

Key ratios are averaged for group

Average ratios applied to absolute data for

company of interest Applying ratios yields indicated market values

Valuation judgments are made

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Relative Approaches

Advantages of relatives Common sense approach Marketplace transactions are used Widely used in legal cases, fairness evaluation,

etc. Allows valuation of private firms

Limitations May be difficult to find companies comparable

by key criteria Ratios may differ widely for comparables Different ratios may give widely different

results

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II. DCF Spreadsheet Methodology

Procedure Historical data for elements of financial

statements are presented for 5 to 10 years Financial analysis is performed to determine

ratios and patters Analysis of business economics of industry Based on analysis, relevant cash flows are

forecast

Cash flows are then discounted to obtainpresent values

These present values are summed to arrive at anNet Present Value (NPV)

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Discounted Cash Flows (DCF)

Determine cash flows of the asset and

take discounted by the appropriate

discount factor:

tperiodinoutlaysinvestment

periodsofnumbercapitalofcost

periodinflowscash

:erewh)1()1(1 1

t

t

n

t

n

tt

t

t

t

o

I

n =k =

tCF

k

I

k

CFNPV

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DCF Spreadsheet Methodology

Advantages Spreadsheets allow great flexibility in

projections Expresses calculations in recognizable financial

statements Disadvantages

Projectednumbers may create the illusion thatthey are actual numbers

May have a disconnect between business logicand projections

Complexity of spreadsheets may obscureimportant driving factors

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III. Contingent Valuation: Real Options Analysis

Critical point: uncertainty

Payoffs are contingent on future

conditions

Equity holders are compensated afterdebt payments, residual claims

Equity can be seen as an option,

if the firm covers debt payments thenequitys payoff is positive

Otherwise, it is zero

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NPV may not recognize flexibility ofpostponement, abandoning, etc.

Value of flexibility may make some negativeNPV project positive

Example: Negative NPV projectPostpone $ 50 million investment until Year 2

PV of incremental cash flows = $40 million

Cost of capital = 10%

million322.1$

322.41$40

)8264.0(50$40$

21.150$40$

)10.1(50$40$ 2

NPV

NPV

III. Contingent Valuation: Real Options Analysis

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Real Options Analysis

Example: View as a call option

Real Option Variable Call Option Value

Present Value of Incemental Cash Flows S Current Stock Price $40 million

Investment to Create the Option X Exercise Price $50 million

Volatility of Cash Inflows Stock-Price Volatility 20%

Life of Option T Life of Option 2 years

Risk-Free Rate of Return rF Risk-Free Rate of Return 3.70%

million3.1$

)()( 21

C

dNXedNSCTrF