FIN Valuation methods

An overview

©2001 M. P. Narayanan University of Michigan

FIN Methodologies

✦ 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

©2001 M. P.
University of Michigan 2
Narayanan
FIN Valuation: 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

©2001 M. P.
University of Michigan 3
Narayanan
FIN Valuation: 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)

©2001 M. P.
University of Michigan 4
Narayanan
FIN
Valuation: Value to EBITDA
multiple
✦ 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.

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University of Michigan 5
Narayanan
FIN Enterprise Value

Economic Value Balance Sheet

PV of future cash from business
$1500
operations

Cash $200 Debt $650

Marketable securities $150 Equity $1200

$1850 $1850

Enterprise Value

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University of Michigan 6
Narayanan
FIN
Value to EBITDA multiple:
Example
✦ 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

©2001 M. P.
University of Michigan 7
Narayanan
FIN
Value to EBITDA multiple:
Example
✦ 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.

©2001 M. P.
University of Michigan 8
Narayanan
FIN
Valuation: Value to EBITDA
multiple
✦ 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.
©2001 M. P.
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Narayanan
FIN Heuristic 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.

©2001 M. P.
University of Michigan 10
Narayanan
FIN Valuation: 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

©2001 M. P.
University of Michigan 11
Narayanan
FIN DCF 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.

©2001 M. P.
University of Michigan 12
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FIN Template for Free Cash Flow

Working capital

Year 0 1 2
Revenue
“Income Statement”

Costs
Depreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flow
Change in working capital
Capital Expenditure Capital items
Salvage of assets
Free cash flow

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University of Michigan 13
Narayanan
FIN Template 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.

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University of Michigan 14
Narayanan
FIN Template for Free Cash Flow

✦ 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
©2001 M. P.
University of Michigan 15
Narayanan
FIN Template for Free Cash Flow

✦ 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)

©2001 M. P.
University of Michigan 16
Narayanan
FIN Template for Free Cash Flow

Taxab le income = Revenue - Costs - Depreciation + Profit from asset sales

NOPAT = Taxab le 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 sub tracted earlier and sub tract the noncash items you added earlier.

©2001 M. P.
University of Michigan 17
Narayanan
FIN Estimating 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

©2001 M. P.
University of Michigan 18
Narayanan
FIN Costs 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 β 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.

©2001 M. P.
University of Michigan 19
Narayanan
FIN Model of a Firm

Value from Value from

Operations investments
Value generated Equal if debt
Enterprise value is fairly priced
FIRM
Value to Equity

DEBT and
other EQUITY
liabilities
©2001 M. P.
University of Michigan 20
Narayanan
FIN Value of equity

✦ Value of equity
= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities

©2001 M. P.
University of Michigan 21
Narayanan