Valuing BusinessValuing Business

Methods of valuationMethods of valuation DCF valuation (e.g. using WACC)DCF valuation (e.g. using WACC) Relative valuation (comparables)Relative valuation (comparables) Cost-based valuationCost-based valuation

Ideko CorporationIdeko CorporationLine of business: designing and manufacturing sports Line of business: designing and manufacturing sports eyeweareyewear

Estimated 2006 Income Statement and Balance Sheet:Estimated 2006 Income Statement and Balance Sheet:

Sales = 75,000Sales = 75,000EBITDA = 16,250EBITDA = 16,250Net Income = 6,939Net Income = 6,939Debt = 4,500Debt = 4,500

You want to acquire this company at a price of $150 mln. You want to acquire this company at a price of $150 mln. Is it a fair price?Is it a fair price?At this price:At this price:

P/E = 21.6P/E = 21.6 EV = E + D – cash. Assume you estimate that Ideko holds $6.5 EV = E + D – cash. Assume you estimate that Ideko holds $6.5

mln in cash in excess of its working capital needs (i.e. invested mln in cash in excess of its working capital needs (i.e. invested at a market rate of return)at a market rate of return)

EV = 150 + 4.5 – 6.5 = EV = 150 + 4.5 – 6.5 = $148 mln$148 mln EV/Sales = 2EV/Sales = 2 EV/EBITDA = 9.1EV/EBITDA = 9.1

Ideko Financial Ratios ComparisonIdeko Financial Ratios Comparison

150 looks like a reasonable price150 looks like a reasonable price

Valuing Ideko using DCFValuing Ideko using DCF

So, assume you are buying it for 150 mln. So, assume you are buying it for 150 mln. What’s the NPV of this transaction? (how much What’s the NPV of this transaction? (how much will you gain)will you gain)Multiples give a rough idea. After you acquire Multiples give a rough idea. After you acquire the firm you will change it. Hence, you need to the firm you will change it. Hence, you need to forecast future (after acquisition) FCF and use forecast future (after acquisition) FCF and use DCF techniquesDCF techniques Business planBusiness plan Financial model (to forecast FCF and terminal value)Financial model (to forecast FCF and terminal value) Estimating cost of capitalEstimating cost of capital Valuation using DCFValuation using DCF

Estimated 2005 Income Statement and Balance Estimated 2005 Income Statement and Balance Sheet Data for Ideko Corporation (Spreadsheet)Sheet Data for Ideko Corporation (Spreadsheet)

The Business PlanThe Business PlanExpected market growth: 5% per yearExpected market growth: 5% per yearCut administrative expenses and increase Cut administrative expenses and increase expenditures on product development, sales and expenditures on product development, sales and marketing marketing expected raise in the firm’s market expected raise in the firm’s market share from 10% to 15% over 5 yearsshare from 10% to 15% over 5 yearsOnce cumulative sales growth reaches 50% Once cumulative sales growth reaches 50% expansion neededexpansion neededInflation Inflation Selling price will rise at 2% per yearSelling price will rise at 2% per year Raw materials price will rise at 1% per yearRaw materials price will rise at 1% per year Labor costs will rise at 4% per year (inflation + Labor costs will rise at 4% per year (inflation +

additional overtime)additional overtime)

Ideko Sales and Operating Cost AssumptionsIdeko Sales and Operating Cost Assumptions

Capital expenditure assumptionsCapital expenditure assumptions

Capital structure changes: levering upCapital structure changes: levering upPlanned debt and interest payments (after Planned debt and interest payments (after 2010 all is repaid)2010 all is repaid) Indeko is underleveraged (book value of debt = Indeko is underleveraged (book value of debt =

4,500 while total assets = 86,822)4,500 while total assets = 86,822) Hence, plan to increase debt: 100 mln now (put in Hence, plan to increase debt: 100 mln now (put in

our pocket) and some more in 2008 and 2009, our pocket) and some more in 2008 and 2009, interest rate = 6.8%interest rate = 6.8%

Sources and uses of fundsSources and uses of fundsYou buy the company for 150 mln, get an You buy the company for 150 mln, get an excess cash of 6.5 mln and repay the debt of 4.5 excess cash of 6.5 mln and repay the debt of 4.5 mln. Hence, essentially you spend 148… + 5 mln. Hence, essentially you spend 148… + 5 mln in fees = 153 mlnmln in fees = 153 mln

But you raise 100 mln in debt – this allows you But you raise 100 mln in debt – this allows you to pay essentially only 53 mln for the companyto pay essentially only 53 mln for the company

Building the financial modelBuilding the financial model

Forecasting earningsForecasting earnings

Working capital forecast (for details Working capital forecast (for details see BD, ch. 19)see BD, ch. 19)

Forecasting free cash flowForecasting free cash flow

Estimating the cost of capitalEstimating the cost of capital

Estimating betaEstimating beta

We have to unlever betas first:We have to unlever betas first:

Let our unlevered beta = 1.20 (based on Let our unlevered beta = 1.20 (based on comparables)comparables)

Let market risk premium = 5%Let market risk premium = 5%

Hence, rHence, rUU = r = rff + + ββUU(E[R(E[Rmktmkt] – r] – rff) = 4% + 1.20*5% = ) = 4% + 1.20*5% =

10%10%

Valuing the investmentValuing the investment

First, we need to estimate continuation value in First, we need to estimate continuation value in year 2010.year 2010.

Multiples approach (but DCF can also be used):Multiples approach (but DCF can also be used):

Now we can value Ideko. Let’s use APVNow we can value Ideko. Let’s use APV

VVLLtt = V = VUU

tt + T + Ttt

So, we obtain Equity Value = 113 mlnSo, we obtain Equity Value = 113 mln

We have spent only 53 mlnWe have spent only 53 mln

Hence, NPV = 113 mln – 53 mln = $60 mln – good deal!Hence, NPV = 113 mln – 53 mln = $60 mln – good deal!

Our estimate of EV based on comparables, $148mln, was Our estimate of EV based on comparables, $148mln, was an underestimation (now we obtain $213 mln)an underestimation (now we obtain $213 mln)

Why? Because previously we did not take into account the Why? Because previously we did not take into account the changes that we are going to implement in the firmchanges that we are going to implement in the firm