recommend an alternative method.

If the treatment of hybrid securities will make a

material difference in valuation results,51 we recommend using adjusted present value
(APV). In the APV, enterprise value is determined by discounting free cash ow at the
industry-based unlevered cost of equity. The value of incremental cash ows
relatedtonancing,suchasinteresttaxshields,isthencomputedseparately.To
determinethecompanysunleveredcostofequity,usetheunleveredindustry beta. This avoids
the need to compute company-specic components, such as the debt-to-equity ratio, a
required input in the unlevering equation. In some situations, you may still desire an
accurate representation of the cost of capital. In these cases, split hybrid securities into
their individual components. For instance, you can replicate a convertible bond by
combining a traditional bond with a call option on the companys stock. You can further
disaggregate a call option into a portfolio consisting of a risk-free bond and
thecompanysstock.Byconvertingacomplexsecurityintoaportfolioofdebt and equity, you
once again have the components required for the traditional
costofcapital.Theprocessofcreatingreplicatingportfoliostovalueoptionsis discussed in
Chapter 32.
REVIEW QUESTIONS
1. Sao Paolo Foods is a Brazilian producer of breads and other baked goods.
Overthepastyear,protabilityhasbeenstrongandthesharepricehasrisen from R$15 per share
to R$25 per share. The company has 20 million shares outstanding. The companys
borrowing is conservative; the company has only R$100 million in debt. The debt trades
at a yield to maturity 50 basis points above Brazilian

This chapter lays out the process for converting core operating value (via
discountedcashow)intoenterprisevalueandsubsequentlyintoequityvalue.
Exhibit12.1detailsthevaluationbuildupforacomplexhypotheticalcompany to demonstrate a
comprehensive analysis of nonoperating items. For many
companies,nonoperatingassetscompriseonlyexcesscash,andnancialclaims comprise only
traditional debt.
Asnotedalreadyinthischapter,convertingcoreoperatingvalueintoenterprisevalueentailsaddi
ngtothevalueofoperationsthevalueofnonoperating assets whose income is not included in
EBITA and consequently excludedv from free cash ow. The most common nonoperating
assets are excess cash,
nonconsolidatedsubsidiaries(alsoknownasequityinvestments),andnancial
subsidiaries.Tocompleteenterprisevalue,addthevalueofothernonoperating
assetssuchastaxlosscarry-forwards,excesspensionassets,excessrealestate,
anddiscontinuedoperations.Theresultingenterprisevaluerepresentsthetotal value of the
company that can be allocated among the various claim holders. Converting enterprise
value to equity value entails deducting nonequity claims. Similar to nonoperating assets,
nonequity claims are nancial claims against enterprise value whose expenses are not
included in EBITA and consequently excluded from free cash ow. Double-counting an
expense and its associated liability would bias your valuation downward. The most
typical nonequity claimsbank loans and corporate bondsare reported on the balance
sheet; but off-balance-sheet debt, such as operating leases, securitized receivables, and
contingent claims, are not and must be estimated separately. Hybrid securities, such as
preferred stock, convertible debt, and employee
options,havecharacteristicsofbothdebtandequity.Suchhybridsrequirespecial care, as their
valuations are highly dependent on enterprise value, so you shouldvaluethemusingoptionpricingmodelsratherthanbookvalue.Finally,
ifminorityshareholdershaveclaimsagainstcertainconsolidatedsubsidiaries, deduct the value
of minority interest. Using the valuation buildup as our framework, we will go step-bystep through how to value nonoperating assets, debt and debt equivalents, hybrid
securities, and minority interests, ending with the nal step in valuation, estimating the
intrinsic value per share.

wnedstakesinafewunconsolidatedsubsidiaries.2Onesignicantinvestment was LG Display,

a South Korean manufacturer of TFT-LCD panels for use in
televisions,notebookcomputers,andotherapplications.AlthoughLGDisplay is publicly
traded, Philips used subsidiary accounting for LG Display because the company was
represented on the board of directors and continues to
exerciseinuence.Underthisaccountingclassication,thebookvaluereported on the
balance sheet will not represent the investments current value. To estimate Philipss stake
in LG Display, start with LG Displays market capitalization (10,433 billion won), and
divide by the exchange rate of South Korean won to euros (1,680). This converts LG
Displays local market capitalization into euros. To determine the value of Philipss
partial ownership, multiply the resulting market capitalization in euros by Philipss
ownership stake (19.9 percent). Repeat this process for each of Philipss holdings to nd
each subsidiarys contribution to Philipss enterprise value.
Privately held subsidiaries Ifthesubsidiaryisnotlistedbutyouhaveaccess to its nancial
statements, perform a separate DCF valuation of the equity stake. Discount the cash ows
at the appropriate cost of capital (which, as
before,isnotnecessarilytheparentcompanysWACC).Also,whencompleting the parent
valuation, include only the value of the parents equity stake and not the subsidiarys
entire enterprise value or equity value. If the parent companys accounts are the only
source of nancial information for the subsidiary, we suggest the following alternatives to
DCF:
Simplied cash-ow-to-equity valuation: This is a feasible approach when the parent
has a 20 to 50 percent equity stake, because the subsidiarys net income and book equity
are disclosed in the parents