Project valuation: firms acquire productive capacity by assembling necessary assets.

Enterprise valuation: acquisitions of entire businesses - acquiring the productive assets of an existing firm Investment evaluation report consists of: - Proposal - Justification - Risks - Timeline In Valuations firms must consider: - Cash flow estimation - Risk assessment - Financing opportunities - The effects on earnings - Staged investments - Follow-on investments ******************************************************************************************************* Discounted Cash Flow Valuation (DCF) The value of an investment is determined by the magnitude and the timing of the cash flows it is expected to generate. The 3-Step DCF Process: 1) Forecast the FCF (i.e. the amount and timing of future cash flows) 2) Determine the WACC (i.e. do the weighted average cost of capital by combining the debt and equity discount rate) 3) Discount the FCF using WACC (to estimate the value of the project as a whole) Investment cash flow is the sum of the cash inflows and outflows from the project Equity free cash flow (EFCF): cash flow available for distribution to the firms common shareholders Values the equity claim in the project Includes cash dividends and share repurchases Free cash flow (FCF): amount of cash produced (by a project or a firm) during a particular time that is available for distribution to both the firms creditors and equity holders Values the project or firm as a whole (both equity and debt claims) Calculation of FCF FCF = (Revenues COGS OPEX DA)*(1-T) + DA CAPEX - NWC or stated differently: FCF = EBIT(1-T) + DA CAPEX - NWC Sales Less: COGS Gross Profit Less: Operating expenses (including depreciation expense) EBIT Less: Taxes Equals: NOPAT (i.e. after tax operating income EBIT(1-T) ) Plus: Depreciation expense Less: CAPEX (i.e. Capital Expenditures for Property, Plant, and Equipment) Less: Increases in NWC FCF Net PPE (property, plant, and equipment) = gross PPE (accumulated cost of all property, plant, and equipment) - accumulated depreciation for those assets. NWC = NWCt NWCt-1 (Operating) NWC = (Current Assets Cash and Marketable securities) (Current Liabilities Current portion of InterestBearing Debt/Notes)

CAPEX2010 = Net PPE2010 - Net PPE2009 + Depr.2010 Net PPE2010 = Net PPE2009 - Depr.2010 + CAPEX2010 Operating NWC = Current Assets Accounts Payable Current Assets = Cash and Marketable securities+AR+Inventories, etc. We should not expect CAPEX to equal the firms depreciation expense. When a firm anticipates growth, it spends more on long-lived assets than the amount it depreciates on older assets. Revenues = Total units sold * Market share * Market price per unit COGS + Cash OPEX = Variable cost per unit * Unit sales + Fixed Operating Costs Contribution margin = (price per unit variable cost per unit)/price per unit Internal rate of return (IRR): Compound rate of return earned on the investment. IRR should be > than discount rate for an investment to be considered profitable Investment Outlay0 =
( )

******************************************************************************************************* Evaluating new investment opportunities: 2 Phases Phase I Analyst prepares estimates and forecast - forms the basis for estimating an expected value for the investment along with NPV, IRR, and other measures of investment worth Phase II Analyst details underlying sources of risk (Identify value drivers and uncertainty) and seeks ways to mitigate risks and monitors throughout the life of the project Scenario Analysis: Sensitivity of an investments value under different situations (best, expected, worse). Breakeven Sensitivity Analysis: The critical value of a particular value driver that pushes NPV to zero. Limitations to Breakeven Sensitivity Analysis: - Considers only one value driver at a time, while holding all others equal to their expected values. This can produce misleading results if two or more of the critical value drivers are correlated with one another. - We dont have any idea about the probabilities associated with exceeding or dropping below the breakeven value drivers. - No formal way of incorporating consideration for interrelationships among the variables. Simulation Analysis. Monte Carlo simulation can help the analyst evaluate what can happen to an investments future cash flows and summarize the possibilities in a probability Decision Trees: Valuing Project Flexibility ******************************************************************************************************* WACC is the weighted average of the estimated required rates of return for the firms interest-bearing debt (kd), preferred stock (kp), and common equity (ke). The cost of debt financing is adjusted downward to reflect the interest tax-shield. It is the discount rate that should be used to discount the firms expected free cash flows to estimate firm value. It can be viewed as its opportunity cost of capital. Steps in a WACC: 1. Estimate capital structure and determine the weights: wd, wp, we. 2. Estimate the opportunity cost of debt (kd), preferred stock (kp), and common equity (ke), and adjust for the effects of taxes where appropriate. cost of debt (kd). Use yield to maturity (YTM) on publicly-traded bonds or the risk-free rate plus a default spread given actual (or projected) debt rating. If debt is not publicly-traded, use the YTM on a portfolio of bonds with similar credit ratings and maturity (i.e. use the YTM when the firm issues investment-grade debt (estimated using current market

prices and promised interest and principal payments). if YTM for such bonds is 8.25%, we adjust for tax: 0.825*(10.25) = 6.19% and use this as kd). For debt with default risk, the expected cash flows must reflect the probability of default (Pb) and the recovery rate (Re) on the debt in the event of default. Cost of Debt Capital is after-tax: kd (1-t) Bond price = Interest + Principal/(1+YTM) or = (Interest + Principal)*(1 Pb) + (Interest + Principal)*Pb*Re/(1+kd) preferred stock (kp). Generally pays a constant dividend every period (perpetuity), so we take the perpetuity formula, rearrange and solve for kp Preferred stock price (Pps) = Preferred Dividend (Divps)/Required Return (kps) and (kps) = Divps/Pps common equity (ke). Use CAPM methods or DCF approach. ke is the rate of return investors expect from investing in the firms stock. Returns are based on cash distributions (i.e., dividends and cash proceeds from the sale of the stock). If we use CAPM: it is subject to Systematic (nondiversifiable) and Nonsystematic (diversifiable) risk Traditional CAPM: ke - krf = + e(km - krf) + e or ke= Rf + e(Rm - Rf) Beta is = Cov(Ri,RM)/Var(RM) Beta: the sensitivity of the firms equity returns to variations in the rates of return on the overall market portfolio Beta estimate based on e of comparable firms: Involves unlevering the betas for each of the sample firms to remove the influence of capital structure. The average Unlevered are relevered to reflect the capital structure of the target firm: firm = equity + debt L = 1 +(
( )

3) Discount the Estimated FCF (using the above Firm Value formula. Using the same formula can give you Firms equity by formula. subtracting out the debt from the Firm value value) DCF models estimate the intrinsic value of a firm The DCF method takes observed values and estimated cash flows and firm. estimates the internal rate of return, or the implied cost of eq equity capital. Single-stage DCF growth model: Stock price0 = stage Divt/(1 + ke)t Reduces down to: Stock price0 = ke = +g =

)*BU here we use the firms D/E

U =

) /

here we use the average industrys D/E

( ( ) )

Unlever the Beta (i.e. the equity): Average unlevered Beta (U) =

Model Strengths: growth, dividend-paying companies - Good for valuing stable-growth, dividend - Good for valuing indexes - Simplicity and clarity, also helps understanding of relationships between V, r, g, and D - Can be used as a component in more complex models Model Weaknesses: - Calculated values are very sensitive to assumed values of g and r - Is not applicable to non-dividend-paying stocks paying - Is not applicable to unstable-growth, dividend paying stocks growth, There are three basic methods for forecasting growth rates (g), using: here 1. equity analyst forecasts 2. historical rates (use historical dividend growth rate or a statistical forecasting model based on historical data) statistical 3. company and industry fundamentals Over-optimism in estimating the anticipated rate of growth in the firms earnings and dividends will lead to an upward bias in the cost of equity and, consequently, the cost of capital estimat ost estimate. Arbitrage Pricing Theory (APT). Fama-French three French three-factor model: , where SMB (small minus big): a size risk premium (return on small cap portfolio minus return on large cap portfolio return portfolio) HML (high minus low): a risk premium related to the relative value of the firm when compared to its book value (historical cost-based value) Rm - Rf , the excess return on the market, is the value weighted return on all NYSE, AMEX, and NASDAQ stocks (from CRSP) value-weighted minus the one-month Treasury bill rate (from Ibbotson Associates). th RS - RB is the average return on three small portfolios minus the average return on three big portfolios, RS - RB = 1/3 (Small Value + Small Neutral + Small Growth) - 1/3 (Big Value + Big Neutral + Big Growth) Grow RH - RL is the average return on two value portfolios minus the average return on two growth portfolios, RH - RL = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth) Three sources of error in using CAPM or APT models: 1. Model uncertainty Is the model correct? 2. Input uncertainty Are the equity risk premium or factor risk premiums and risk free rate correct? risk-free 3. Uncertainty about current values of stock beta or factor sensitivities ******************************************************************************************************* ******************************************************************************************************* Forecasting Future Financial Performance 1. Perform an Analysis of Historical Financial Statements 2. Prepare Pro Forma Financial Statements for the Planning Period 3. Convert Pro Forma Statements into Cash Flow Fo Forecasts 4. Estimate the Terminal Value of Firm Free Cash Flows NI = Revenues Expenses Revenue recognition principle: revenue is recognized in the period in which products (goods or services), merchandise, or other assets are exchanged for cash or claims on cash. ms The matching principle and expenses: The expenses reported in the firms income statement are those that were incurred in the process of generating the reported revenue nues. Change in cash balance for the period = Cash fro (Operating + Investing + Financing activities) h from

then relever that average unlevered equity to reflect the target firms D/E capitalization ratio and corporate tax rate: equity = U(1 + ) debt ( ) Beta coefficients vary not only by industry (or with business risk) but also by the firms capital structure. Firms that use more financial leverage have higher betas. Problems with CAPM: - Insufficient proof that of relation between the beta estimates of stock and their future rates of return - Market capitalization and book-to-market ratios provide much better predictions of future returns than do betas - Proposed modifications of CAPM i.e. size premium 3. Calculate WACC Use market weights Use market-based opportunity costs (Costs should reflect the current required rates of return, rather than historical rates) Use forward-looking weights and opportunity costs WACC assumes constant capital structure, if this does not exist, apply APV model

Summary for WACC. WACC is a weighted average of the after-tax costs of the various sources of invested capital raised by the firm to finance its operations and investments. Firms use their own WACCs to calculate whether they are under- or overvalued. The estimation of a firms WACC involves: 1) evaluating the composition of the firms capital structure 2) estimating the opportunity cost of each source of capital 3) calculating a weighted average of the after-tax cost of each source of capital Invested capital of a firm: capital raised through the issuance of interest-bearing debt and equity (both preferred and common). Opportunity cost of capital: the expected rate of return that its investors forgo from alternative investment opportunities with equivalent risk. Using DCF to Value an Acquisition 1) Forecast FCF 2) Estimate Appropriate Discount Rate (i.e. find a WACC)

Firm Free Cash Flow Computations: Direct method: focuses directly on the cash flows generated by the firms operations FCF = EBIT(1-T) + DA CAPEX - NWC (EBIT(1-T) is NOPAT) Indirect method: focuses on the distribution of cash to the firms shareholders through the payment of cash dividends or share repurchases net of any new equity financing the firm might have obtained from the sale of shares. Forecast the firms accounts receivable balance: use an estimate of the average collection period: Average Collection Period (ACP) = Accounts Receivable/Sales + 365 days Accounts Receivable = (ACP/365 days)*Sales Percent of Sales = ACP/365 days Enterprise Value = PV of firm FCF from Operations + PV of Nonoperating Cash Flows and because we divide up the period to forecast period and a terminal value: Enterprise Value = (PV of firm FCF from Operations for 2011-2015 + PV of Nonoperating CFs for 2011-2015) + (PV of Terminal Value for firm FCF from Operations + PV of Terminal Value for Nonoperating Income) Difference between the DCF and the price multiple methods: DCF models estimate the intrinsic value of a firm. Price multiples value a firm relative to how similar firms are valued by the market at the moment. Steps in Relative Valuation 1. Identify similar or comparable investments and recent market prices for each. 2. Calculate a valuation metric for use in valuing the asset. 3. Calculate an initial estimate of value. 4. Refine or tailor your initial valuation estimate to the specific characteristics of the investment. Capitalization rate: the reciprocal of the multiple used to value the property. Value =
( )

Disadvantage: measures only the earnings of the firms assets already in place, it ignores the value of the firms new investments Summary EBITDA multiples: provide a good valuation tool for businesses in which most of the value comes from a firms existing assets. used primarily for the valuation of stable, mature businesses. less useful for evaluating businesses whose values come mainly from future growth opportunities. FCF will be equal to EBITDA if: we assume that the firm will not be paying taxes and will not be investing and growing and it will not experience any changes in working capital. FCF is frequently negative, since capital expenditures often exceed internally generated capital. FCF is too volatile since it reflects discretionary expenditures for capital investments and working capital that can change dramatically from year to year. FCF multiples are unlikely to be as reliable as multiples based on EBITDA, and are not used as often in practice. EBITDA multiples should be adjusted for: Variations in operating leverage; differences in profit margins Differences between fixed and variable operating costs Differences in expected growth rates Idiosyncratic effects Nonrecurring special events (Onetime transaction with a customer that contributed to EBITDA but is unlikely to happen again - make a downward adjustment to EBITDA; Extraordinary write-offs - make an upward adjustment) e.g. if EBITDA is $10M: an upward adjustment by $500,000 will give us $10,500,000 Possible Nonrecurring Items: Asset write-downs Gain (loss) from discontinued operations Restructuring charges Strikes Start-up costs expensed LIFO liquidations Profits & losses from asset sales Catastrophes such as natural disasters or accidents Change in accounting estimates or principles Product recalls Equity Value of a firm = * EPS for the firm being valued or = P/E multiple * EPS

where the multiple is

e.g. $100 x

= $100

5 = $500 => 5 is multiple and cap rate is

= 0.20

Market capitalization = Price per share * shares outstanding P/E = P/E Ratios for High-Growth Firms (2-stage GGM): P0 = =
( )( )

The cap rate is < the discount rate when cash flows are expected to grow, and it is > the discount rate when cash flows are expected to shrink or decline over time. As the rate of growth increases, the divergence between the cap rate and discount rate widens. When we have growth, we use the GGM: Gordon Growth Model: Value =
( ) )

where the valuation multiple is

( ( ) )

( (

) )

and cap rate is the reciprocal:

( (

) )

1 1
( (

( ( ) )

) )

+ +
( )(

) (

)(

) (

Therefore, capitalization is: with no growth = k ; with growth =

A firm that has more operating leverage is riskier and has a higher capitalization rate. Enterprise value: the sum of the values of the firms equity and its interest-bearing debt minus the firms cash balance on the date of the valuation. Because Owners Equity = Enterprise Value (Interest-Bearing Debt Cash) = EV Net Debt, we have EV = OE + Interest-Bearing Debt Cash or rearranged: EV = OE + Net Debt Enterprise ValueAirgas 2005 = EBITDAAirgas 2005 * EBITDA multiple Therefore EBITDA multiple = For privately owned companies, use similar firms that are publicly traded to infer a value by using the appropriate EBITDA valuation ratio. EBITDA: is a before-tax measure and does not include expenditures for new capital equipment (CAPEX) and does not account for changes in working capital (NWC). FFCF is often more volatile than EBITDA because it includes consideration for new investments in CAPEX and NWC. In years when large capital investments are being made, EBITDA significantly overstates the firms free cash flow, and vice versa i.e. EBITDA will overestimate cash flow from operations if working capital is growing. Advantage: EBITDA provides a good measure of the before-tax CFs that are generated by the firms existing assets.

Drawbacks to the P/E ratio: EPS can be negative. The P/E ratio does not make economic sense with a negative denominator. Earnings often have volatile, transient components, making application of this method difficult. Management can manage earnings and distort earnings per share. Use higher multiples: when the cash flows of an investment are likely to grow faster than those of the comparable investments Use lower multiples: when the risk of the investment is higher
Equity Valuation Ratios Ratio Definition Price per Share P/E EPS per Share Price is mkt price EPS =

Measurement Issues If current price is very volatile, an average of the beginning and ending price might be used

When to use Firms with positive earnings that do not have significant noncash expenditures

Valuation Model Estimated Stock Price = EPSfirm * P/E ratioindustry

PEG

Price per Share EPS/Growth rate in EPS Growth rate in EPS is the expected rate of growth in EPS over the next year

Estimates of growth rate can be based on historical rates or on analysts estimates

Firms with stable future growth in EPS and similar capital structure & industry risk

Estimated Stock Price = ir * PEG ratioindustry

Mkt to Book Value of Equity

Mkt Value of Equity Book Value of Equity Mkt Value of Equity = Price per Share * hares outstanding Book Value of Equity = Total Assets Total Liabilities

Book Value of Equity issues leading to variations across firms: differences in the ages of the firms assets & differences in how various assets are accounted for (fair mkt, mkt to mkt, or cost) Problems in determining which price to use (most recent vs normalized) EBITDA Cyclical variations in earnings & unusual variations in firm revenues may require normalization to better reflect the firms future earnings potential FCF adjusts EBITDA to consider taxes & additional investment required in CAPEX. Sales may not be reflective of the firms earnings potential if they are abnormally large or depressed due to nonrecurring factors

Firms whose balance sheets are reasonable reflections of the mkt value of their assets

Estimated Equity Value = Book Value of Equityfim * Mkt-to-book ratioindustry

- Forecast assumptions - Risk assessment - Relative attractiveness of the company and industry Specific industry factors to consider include: - Competitive environment - Trends in demand, new and alternative products - Legislative concerns - Technological developments - Industry profitability P/E, DCF after interest expense = equity MVIC/EBITDA, debt-free cash flow = MVIC Fair Market Value: The amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts Investment Value: The specific value of goods or services to a particular investor (or class of investors) for individual investment reasons . The value to a particular investor, based on that investors requirements and expectations, including alue based potential synergies. Can include psychological factors, the joy of ownership or the value of a long tradition of family ownership ownership Liquidation Value: The net amount the owner can realize if the business is terminated and the assets sold off piecemeal. The time frame is either immediate ( (forced liquidation) or with adequate exposure to the market ( (orderly liquidation), Considers the costs incurred to sell the assets and shut down operations, such as brokerage commissions and ), severance. Going concern value: is premise which implies an operating, viable business and the related intangible value. related Methods of calculating terminal value include: Gordon Model (assumes continued ownership of business assumes business). Formula: CF in the 1 st yr of the terminal period/k - g Assumed Sale (based on a multiple of a measure of financial performance appl at the end of the based applied forecast period). Often used by buyout funds ften

Enterprise-Valuation Ratios EV EV to EBITDA EBITDA EV = (Price per Share* Shares Outstanding) + Interest-Bearing Debt Cash EBITDA = Earnings before Interest, Taxes, Depr. & Amortization

Firms that have significant noncash expenses (i.e. Depr.& Amortization). Firms with large investments in fixed assets: oil & gas, telecom., health care

Estimated Enterprise Value = EBITDAfirm * EV/EBITDA ratioindustry

EV to CF

EV Cash Flow per Share Cash Flow is FCF

EV to Sales

EV Sales

Firms with stable growth and thus predictable CAPEX: chemicals, forestry, industrial metals Young firms and start-ups that do not have an established history of earnings

Estimated Enterprise Value = FCFfirm * EV/FCF ratioindustry

Estimated Enterprise Value = Salesfirm * EV/Sales ratioindustry

Discount for Lack of Control: Minority interests in a privately held company are worth less on a per share basis than control interest DLOC = 1-[1/(1+Control Premium)] Discount for Lack of Marketability: Marketability relates to the liquidity of an investment. Impairment of liquidity reduces value because it increases an investors required rate of return. Factors affecting liquidity -number of investors; size of the number interest being valued; restrictions on its sale by agreement or law; absence of registration; anticipated cash flows attributable ed; to the investment

3 approaches to measuring Value: 1) Income. The two methods within the income approach: the DCF (Forecast of the CF available to investors is discounted to PV using an appropriate rate of return) - capitalized earnings methods(An estimate of normalized expected earnings is capitalized based on the required rate of return and growth prospects) 2) Asset (Value is based on fair market value of assets less fair market value of liabilities. Primarily used for holding companies or if liquidation is a consideration) 3) Market (Valuation multiples. Valuation multiples are adjusted for differences between the subject and guideline companies: a)Risk factors - size, volatility of financial performance, product and customer diversification & b) Growth prospects). Multiples: P/E, MVIC/EBITDA (Mkt Value of Invested Capital to EBITDA), etc. Excess cash should be excluded from calculation of multiple and added back as an adjustment. Advantage: it is based on actual transactions. Disadvantage: difficulty in finding similar public companies and M&A transactions The industry analysis impacts the following valuation variables: