fina241 handout valuationanddcf

©2001 M. P. Narayanan

University of Michigan

FIN Valuation methodsValuation methods

An overview


University of Michigan 2

FIN MethodologiesMethodologies

Comparable multiples P/E multiple Market to Book multiple Price to Revenue multiple Enterprise value to EBIT multiple

Discounted Cash Flow (DCF) NPV, IRR, or EVA based Methods

WACC method APV method CF to Equity method



FIN Valuation: P/E multipleValuation: 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 multipleValuation: 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 Valuation: Value to EBITDA multiplemultiple

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 Enterprise ValueEnterprise Value

Economic Value Balance Sheet

PV of future cash from businessoperations

$1500

Cash $200 Debt $650

Marketable securities $150 Equity $1200

$1850 $1850

Enterprise Value



FIN Value to EBITDA multiple: Value to EBITDA multiple: ExampleExample

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 Value to EBITDA multiple: Value to EBITDA multiple: ExampleExample

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

EBITDA – Interest income from marketable securities 20 – 2.7 = $17.3 million

Estimated enterprise value of the target 9.98 17.3 = $172.65 million

Add cash plus marketable securities 172.65 + 5 + 45 = $222.65 million

Subtract debt to find equity value: 222.65 – 75 = $147.65 million.



FIN Valuation: Value to EBITDA Valuation: Value to EBITDA multiplemultiple

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: drawbacksHeuristic 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 methodValuation: 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 DCF methods: Starting dataDCF methods: Starting data

Free Cash Flow (FCF) of the firm Cost of debt of firm Cost of equity of firm Target debt ratio (debt to total value) of the firm.



FIN Template for Free Cash FlowTemplate for Free Cash Flow“I

nco

me

Sta

tem

en

t”

Working capital

Year 0 1 2RevenueCostsDepreciation of equipment Noncash item

Profit/Loss from asset sales Noncash item

Taxable incomeTaxNet oper proft after tax (NOPAT)Depreciation Adjustment for

Profit/Loss from asset sales for non-cash

Operating cash flowChange in working capitalCapital Expenditure Capital items

Salvage of assetsFree cash flow



FIN Template for Free Cash FlowTemplate 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.




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




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)




Taxable income = Revenue - Costs - Depreciation + Profit from asset sales

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:

Add the noncash items you subtracted earlier and subtract the noncash items you added earlier.



FIN Estimating HorizonEstimating 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 equityCosts 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 CAPM

Find e 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 Model of a FirmModel of a Firm

Value from Operations

FIRM

DEBT and other

liabilitiesEQUITY

Value generated

Value to Equity

Equal if debt is fairly priced

Value from investments

Enterprise value



FIN Value of equityValue of equity

Value of equity

= Enterprise value

+ Value of cash and investments

- Value of debt and other liabilities

fina241 handout valuationanddcf

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