Business valuation

What we will cover?

Basic valuation concepts
Purpose of valuation
Methods of valuation Trading
comparables, Transaction comparables
and DCF method of valuation using MS
excel financial model
Valuation: Meaning, Concept
Meaning: ascertaining value real,
intangible and financial assets
Value Price
Value differs with time
 Merger/Acquisition

Buyback of shares Demerger

Why
Valuation ?
Test impairment IPO/FPO

Private placement Sale/Disinvestment

Valuation of Business Vs. Value of
Equity

Value of
Value of the =
- debt (less Value of
operational
cash) Equity
business i.e
Enterprise Bondholder value
Value
Shareholder value

Enterprise value
(Value of Business)
EV & Balance Sheet - a
comprehensive picture
Cash Debt (MV)
Financial
+
Cash Preference
Invest- - Shares
Ments, Invt equivalents
in associates + Minority
Non interest
controlled
Investment =
s+
Land Non-core Ordinary Equity
banks value
assets +
Enterprise
value (net
operating
assets: EV)
 Valuation
Methods

Asset based Earning based Market price

based

DDM

Market
Net Asset DCF Price/Price
multiples
Replacement Economic
value profit Market
Comparables /
Liquidation value EV transaction
Multiples multiple
Asset based Net assets Method
Net Asset = Total Assets (other than
miscellaneous expenses and losses)
Total External Liabilities

Net assets = Shareholders funds(other

than revaluation reserve) Miscellaneous
expenses and losses
Asset based method Replacement
value, Liquidation value

Replacement value = Replacement cost of

assets - External liabilities

Liquidation value = Sale value of assets

External liabilities.
Earning based Approach
Dividend Discount models Walter and
Gorden models, One stage, two stage
models single period and perpetuity
models.
Future expected dividends are discounted
at opportunity cost of capital to investors
to arrive a value of equity.
Earnings based approach - DCF
Earning capacity of operating assets - Free
cash flow to firm or Free cash flow to
equity is ascertained. The same is
discounted at CC to arrive at value of
operating assets
Earning capacity of operating assets is
arrived at using Economic profit or concept
of EVA and the same is discounted to arrive
at value of operating assets
 Free Cash Flow
Free Cash Flow to the
Free Cash Flow to Equity
Firm

= Cash flow available to = Cash flow available to

Common stockholders Common stockholders

Debtholders

Preferred stockholders
FCFF vs. FCFE Approaches to
Equity Valuation

Equity Value

FCFE Discounted FCFF Discounted

at Required at WACC Debt
Equity Return Value
 FCFF vs. FCFE Approaches to
Equity Valuation

FCFFt
Firm value t
t 1 1 WACC

Equity value Firm value Debt value

FCFEt
Equity value t
t 1 1 r
Single-Stage Free Cash Flow Models
FCFF1
Firm value
WACC g
Equity value Firm value Debt value

FCFE1
Equity value
rg
Example: Single-Stage FCFF Model

Current FCFF $6,000,000

Target debt to capital 0.25
Market value of debt $30,000,000
Shares outstanding 2,900,000
Required return on equity 12%
Cost of debt 7%
Long-term growth in FCFF 5%
Tax rate 30%
 Example: Single-Stage FCFF
Model
MV(Debt) MV(Equity)
WACC
dr (1 Tax rate) r
MV(Equity) MV(Debt) MV(Equity) MV(Debt)

WACC 0.25 7% (1 0.30) 0.75 12% 10.23%

 Example: Single-Stage FCFF
Model

FCFF1
Firm value
WACC g
$6, 000, 000(1.05)
Firm value $120.5 million
0.0123 0.05
Equity value $120.5 million $30 million $90.5 million

Equity value per share $90.5 million 2.9 million $31.21

 Using Net Income to Determine
FCFF

FCFF NI NCC Int 1 Tax rate FCInv WCInv

 Other Noncash Adjustments
Amortization Added back
Restructuring Expense Added back
Restructuring Income Subtracted out
Capital Gains Subtracted out
Capital Losses Added back
Employee Option Exercise Added back
Deferred Taxes Added back?
Tax Asset Subtracted out?
 Using EBIT and EBITDA to
Determine FCFF

FCFF EBIT 1 Tax rate Dep FCInv WCInv

FCFF EBITDA 1 Tax rate Dep Tax rate FCInv WCInv

 Using Cash Flow from Operations
to Determine FCFF

FCFF CFO Int 1 Tax rate FCInv

 Calculating FCFE from
FCFF, Net Income, & CFO
FCFE FCFF Int 1 Tax rate Net borrowing

FCFE from net income (NI) and FCFF:

FCFF NI NCC Int 1 Tax rate FCInv WCInv
FCFE NI NCC FCInv WCInv Net borrowing
FCFE from CFO and FCFF:
FCFF CFO Int 1 Tax rate FCInv
FCFE CFO FCInv Net borrowing
 Example: Calculating FCFF

EBITDA $1,000
Depreciation expense $400
Interest expense $150
Tax rate 30%
Purchases of fixed assets $500
Change in working capital $50
Net borrowing $80
Common dividends $200
 Example: Calculating FCFF from
Net Income
NI EBITDA Dep Int 1 Tax rate

NI $1000 $400 $150 1 0.30 $315

FCFF NI NCC Int 1 Tax rate FCInv WCInv

FCFF $315 $400 $150 1 0.30 $500 $50 $270

 Example: Calculating FCFF from
EBIT and EBITDA

EBIT EBITDA Dep $1000 $400 $600

FCFF EBIT 1 Tax rate Dep FCInv WCInv

FCFF $600 1 0.30 $400 $500 $50 $270

FCFF EBITDA 1 Tax rate Dep Tax rate FCInv WCInv

FCFF $1000 1 0.30 $400 0.30 $500 $50 $270
Example: Calculating FCFF from
CFO
CFO NI Dep WCinv
CFO $315 $400 $50 $665

FCFF CFO Int 1 Tax rate FCInv

FCFF $665 $150 1 0.30 $500 $270
 Example: Calculating FCFE from
FCFF, Net Income, & CFO
FCFE FCFF Int 1 Tax rate Net borrowing
FCFE $270 $150 1 0.30 $80 $245

FCFE NI NCC FCInv WCInv Net borrowing

FCFE $315 $400 $500 $50 $80 $245

FCFE CFO FCInv Net borrowing

FCFE $665 $500 $80 $245
 Forecasting FCFF & FCFE
FCFF EBIT(1 Tax rate)Capital
expenditures WCInv

FCFE NI 1 DR FCInv Dep 1 DR WCInv

Example: Forecasting FCFF & FCFE
Sales $4,000
Sales growth $200
EBIT $600
Tax rate 30%
Purchases of fixed assets $800
Depreciation expense $700
Change in working capital $50
Net income margin 10%
Debt ratio 40%
 Example: Forecasting FCFF &
FCFE
Sales growth $200/$4000 5%

EBIT margin $600 / $4000 15%

$800 $700
Incremental FC/Sales growth 50%
$200
$50
Incremental WC/Sales growth 25%
$200
 Example: Forecasting FCFF
Sales $200 $4000 $4200
EBIT $4200 15% $630
EBIT(1 ax rate) $630 (1 30%) $441

Incremental FC $200 50% $100

Incremental WC $200 25% $50
FCFF EBIT(1 Tax rate)Capital
expenditures WCInv
FCFF $441 $100 $50 $291
 Example: Forecasting FCFE
Sales $200 $4000 $4200

Net income $4200 10% $420

Incremental FC $200 50% $100

Incremental WC $200 25% $50

FCFE NI 1 DR FCInv Dep 1 DR WCInv

FCFE $420 1 0.40 $100 1 0.40 $50 $330

 Issues in FCF Analysis
Financial Statement Discrepancies

Dividends vs. FCFE

Effect of Shareholder Cash Flows & Leverage

FCFF & FCFE vs. EBITDA & Net Income

Country Adjustments

Sensitivity Analysis

Nonoperating Assets
 Simple Two-Stage FCF Models
n
FCFFt FCFFn 1 1
Firm value +
t 1 1 WACC t
WACC g (1 WACC) n

n
FCFE t FCFE n 1 1
Equity value +
(1 r )
t =1 1 r t
r g n

Illustration
 Example: Three-Stage FCF Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for years 1 to 3 30%
FCFF growth for year 4 24%
FCFF growth for year 5 12%
FCFF growth for year 6 and thereafter 5%
WACC 10%
 Example: Three-Stage FCF Models

Year
1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 12% 5%

FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4
PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5
Example: Three-Stage FCF Models

FCFFn 1 1
Terminal value
WACC g (1 WACC)n

$320.4 1
Terminal value $3979
0.10 0.05 (1 0.10) 5
 Example: Three-Stage FCF Models
n
FCFFt FCFFn 1 1
Firm value +
WACC g (1 WACC)n
t =1 1 WACC t

Firm value $118.2 $139.7 $165.1 $186.1 $189.5 $3979 $4777

Equity value Firm value Debt value

Equity value $4777 $400 $4377

Equity value per share $4377/300 $14.59

 Multiple based method
Based on linking VALUE/PRICE with its DRIVERS.
Multiple ratio of what you pay/what you get.

EBIT
Earnings
EBITDA

Enterprise
value or Sales
Price of Revenue
Sales growth
equity

Employees
Non Production
Financial quantity etc.
Most popular multiples
Price earnings (PE) : Ratio of price per share
and earnings per share.
Price to book value (PBV): ratio of price per
share to book value per share
Price to Sales(PS): ratio of price per share to
sales value per share.
By replacing price by enterprise value we
can get 3 more ratios, where
EV = Market value of equity + market value
of debt - cash
Understanding the multiples
Define understand its calculation
Describe cross section distribution
Analyse drivers of the multiples
Apply easily said than done
 Understanding multiples an example
Mean multiples of the pharmaceutical sector for the period 200503-201003

PE, EV_PBIT AND EV_PBITDA fall within a range of 13-25 for the sector.
However, PBV, Mcap_sales and EV_sales are distributed in a range of
3.25-4.97. In the last four quarters from 2009-03 to 2010-03 the entire
sectors mean multiples have shown consistently increasing trend
 Steps in relative valuation
Arrive at comparable companies
Peer Group (Size, nature, growth, margin, risk)

Annual reports, direct discussion with the company

Financial and
non financial Share price data, market and industry data
data

Choice of multiple PE, PBV, P-sales, EV/EBIT,

Arrive at
benchmark
EV/EBITDA, EV/Sales, EV/tonne, EV/subscriber etc.
multiple and Mean, median and harmonic mean, or regressions.
value
Relative valuation an example Basic facts
Relative valuation an example Basic facts
Relative valuation - projections

Lupin Market data as on 31 March 2011

Open 417, H- 422, L- 409, C - 405

Lupin Market data as on 13 Jan, 2012:

Lupin NSE: 52 week high Rs.494, 52 week low Rs.393
Issues & Challenges
How to arrive at comparable companies?
Which multiple to use for valuation
company specific.
How to arrive at the benchmark multiple
for the next period?
Dynamic nature of drivers.
Weak market efficiency
Adjusted Present Value
Illustsration