Valuation

Alexander Groh 1
 Structure
• Introduction
• Fundamentals of Valuation
• Tax Shields and Cost of Capital
• Multiples and Hurdle Rates
• Free Cash Flow Valuation and the LBO Model
• Modelling a Company‘s Free Cash Flows
• Summary

• Recommended Literature:
– Koller/Goedhart/Wessels: Valuation, New Jersey, Wiley, 2005
– Arzac: Valuation for Mergers, Buyouts, and Restructuring, New Jersey, Wiley,
2005

Alexander Groh 2
 Meaning of Valuation for
Financial Investors
• Finding a Bidding-Range in transaction processes
– It is not the point to find „the fair value“
– If the bid is too low „you are out!“
– If the bid is too high you´ll have problems with built expectations and
with your own company´s governance
• Finding a price for expected Exit

Alexander Groh 3
 Meaning of Valuation for
Financial Investors
Essentials of Deal-Making:

Luck Valuation

Atmosphere Deal Negotiation

Reputation Deal Structure

Tax-Modell

Alexander Groh 4
 Valuation Methods

Real Options-
Approach
Comparing Market Values
Discounting expected of quoted companies
Cash Flows Value
Comparing similar
Net Asset Value recent M&A-Transactions
Liquidation Value

Alexander Groh 5
Fundamental Valuation Principle
for a Financial Investor
Calculate Present Value of future Cash Flows !!!
Example:

V0 = 1€
V1 = 1€ ∗ (1 + r )
V2 = V1 ∗ (1 + r ) = 1€ ∗ (1 + r ) ∗ (1 + r ) = 1€ ∗ (1 + r )
2


Vn = Vn−1 ∗ (1 + r ) = 1€ ∗ (1 + r ) ∗ (1 + r )  = 1€ ∗ (1 + r )
n

Alexander Groh 6
 Example
What is the Present Value of 100 mn € to be received
by redemption of a Zero-Bond in five years?
V5 = 100 mn € = V0 ∗ (1 + r )
5


100 mn €
V0 =
(1 + r ) 5

r = 5% r = 10% r = 15%

V0 = 78,35 mn € V0 = 62,09 mn € V0 = 49,72 mn €

Alexander Groh 7
 Valuing Perpetuities
A Perpetuity is a Cash Flow that is payed (annually) in
equal amounts until infinity

CF1 CF2 CF3 CF∞

V0 = + + ++
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) ∞
results in

CF
V0 =
r

Alexander Groh 8
 Perpetuities and Multiples

The valuation of a Perpetuity can be transferred into a

Multiple-Valuation
CF 1
V0 = = CF ∗
r r

1
= Multiple
r

V0 = CF ∗ Multiple

Alexander Groh 9
 Example
Calculate the Net Present Value of a 10 mn € Perpetuity !!!

CF 10 mn €
V0 = = = 10 mn € ∗ Multiple
r r

Multiple = 20 Multiple = 10 Multiple = 6,7

r = 5% r = 10% r = 15%

V0 = 200 mn € V0 = 100 mn € V0 = 67 mn €

Alexander Groh 10
 Growing Perpetuities
Imagine a Perpetuity that grows every year at a constant
growth rate g
CF1 CF2 CF3 CF∞
V0 = + + +  +
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) ∞
CF1 = CF0 ∗ (1 + g)
CF2 = CF1 ∗ (1 + g) = CF0 ∗ (1 + g) 2


CF0 ∗ (1 + g) CF0 ∗ (1 + g) CF0 ∗ (1 + g) CF0 ∗ (1 + g)

2 3 ∞
V0 = + + ++
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) ∞

Alexander Groh 11
 Growing Perpetuities

CF0 ∗ (1 + g) CF0 ∗ (1 + g) CF0 ∗ (1 + g) CF0 ∗ (1 + g)

2 3 ∞

V0 = + + ++
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) ∞

1+ g Multiple of a
V0 = CF ∗
r −g Growing Perpetuity

Alexander Groh 12
 Growing Perpetuity Multiples

1+ g
Multiple of a Growing Perpetuity =
r−g
r = 15%

g = 5% g = 7% g = 10%

Multiple = 10,5 Multiple = 13,8 Multiple = 22

Be realistic: What can grow forever at a rate of 5% ???

Alexander Groh 13
 The Principle Valuation Tasks

1. Estimating future Cash Flows (Modelling)

2. Determining Discount Rates (Comparables

and Structuring)

Alexander Groh 14
 Discount Rates

• Discount Rates are also referred to as the Cost of

Capital and have to reflect the uncertainty of the
Cash Flow Stream.
Discount Rates are the Cost of Capital for foregone
Investments of equal Risk!!!
– Economic risk
• Subject to changes
– Leverage risk
• Definitely changes through debt redemption in Buyout
Transactions
– Cost of Capital change !!!

Alexander Groh 15
 Cost of Capital
Remind the Interest
C-Class Tax Shield

B-Class Cost
Entity Debt of Weighted
Value, Debt Average
Paid to Senior Cost
Seller of
Pref. Cost Capital
Equity of (WACC)
Common Equity

Alexander Groh 16
 Cost of Debt

The base is the Zero Cupon Yield Curve of riskfree debt:

r
inverse Yield-Structure

flat Yield-Structure

„normal“ Yield-Structure

Maturity T

Alexander Groh 17
Credit Spread-Term Structure

10,00%

1,00%
Added
Spreads
0,10%

0,01%
17 19
11 13 15 B Rating
5 7 9
1 3 A
Maturity AAA

Alexander Groh 18
 Tax Shield of Debt

Company Newco
all Equity
financed Assets Equity

Tax
(on PBT)

PBT = EBIT
PAT

Alexander Groh 19
 Tax Shield of Debt
Newco
Debt finance included
Equity
Assets
Debt

Interest

Tax Savings =
Tax
(on PBT)
EBIT Interest X Corporate Tax Rate
PBT
PAT

Alexander Groh 20
 Leverage and Tax Shield

Newco Newco

Equity
Assets Equity Assets
Debt

PAT Equity
PAT Equity

Alexander Groh 21
 Cost of Equity
• Academics estimate Cost of Equity with Capital Market Models
– CAPM (Capital Asset Pricing Model)
– APT (Arbitrage Pricing Theory)
• Models can surely help to find benchmarks !
• To use the models correctly you will need many information, calculations and
experience !
– Betas
– Return of Market Portfolio
• Models are sensitive to time horizon and basis-effects !
• We are valuing non quoted companies generally !
• It is questionable to find Equity Costs for Private Equity Investments by
models that assume fully diversified portfolios and perfect markets !

Alexander Groh 22
 Multiples and Hurdle Rates
• We often use Multiples and Hurdle Rates
Operating
Costs

Depre-
ciations

Sales Interest Banks

Core
Activities
EBITDA
EBIT Tax State

PAT PE Investor

Alexander Groh 23
 Multiples and Hurdle Rates
• P/E Ratio

Interest Banks

Tax State

PAT PE Investor X P/E Multiple = 1/Hurdle Rate

results in Equity Value !!!

Alexander Groh 24
 Multiples and Hurdle Rates
• EBIT Multiple

Interest Banks

EBIT Tax State X EBIT Multiple

Results in
PAT PE Investor “Entity Value”

But what about Taxes ???

Alexander Groh 25
 Multiples and Hurdle Rates
• EBITDA Multiple

Depre-
ciations

Interest Banks
EBITDA X EBITDA Multiple
EBIT Tax State
Results in
PAT PE Investor “Entity Value”

This “Entity Value” is hard to justify !!!

Alexander Groh 26
 A “Correct Multiple”

Tax State

EBIT Interest Banks

X PBIAT Multiple
PAT PE Investor

Alexander Groh 27
Cash Flow Definition and
Investments for Growth
Operating
Costs

Depre-
ciations

Net

Sales Investments
+
„Corrections“
Core
Activities
EBITDA
EBIT Cash
Flow
(generated by
the Company)

Alexander Groh 28
 Free Cash Flow Definition

Tax
(as if the
company
had no
Cash debt)

Flow
(generated by
the Company) Free
Could flow to the Investors
Cash
if the company had no debt!!!
Flow

Sets all companies equal disregarding

different Degrees of Leverage!!!

Alexander Groh 29
Entity vs. Equity Valuation

Equity-
Value

Entity-
=
Value Value
of
Net Debt

Intellectual foundation: 1963 by Franco Modigliani and Merton Miller

Alexander Groh 30
 Cash Flow Definitions
Tax Tax Tax
(as if the (real (real
company
payment) payment)
had no
Cash debt) Cash Cash
Flow Flow Cash Flow Interest
(generated by (generated by (generated by
the Company) Free the Company) Flow for the Company)
Cash Debt
Flow Service Cash
Flow for
Redemption

Typical Buyout Model Cash Flows

Alexander Groh
 Linking FCF and
PE Cost of Capital

Flows to banks but the cost are less

Interest than the nominal interest rate
due to the tax savings!!!
Free
Cash The residual can flow to
Cash
Flow the equity investors at their
Flow
to Cost of Equity
Equity resp. Hurdle Rate

Alexander Groh 32
 PE Cost of Capital

D E E
Newco WACC = (1 − τ) ∗ r ∗ + r ∗ D

V V
Equity
Hurdle Cost
Rate Debt/ of
(constant) Equity Tax Rate Debt WACC
Assets 30% 1 40% 8% 17%
Debt 30% 2 40% 8% 13%
30% 3 40% 9% 12%
30% 4 40% 10% 11%
30% 5 40% 11% 11%
30% 6 40% 12% 10%
30% 7 40% 13% 11%
30% 8 40% 14% 11%

Alexander Groh 33
 Return Determinants of Private
Equity Investments
Market Value Added

Debt
Debt
Debt
Entity Debt
Debt
Value,

Deleverage
Paid to Equity
Equity
Seller Equity
Equity Equity

Year 0 Transaction 1 2 3 4
Structure
Alexander Groh 34
 Changing Cost of Capital

WACC0 WACC1 WACC2

Debt
Entity Debt
Debt WACC
Value, is not
Paid to Constant!!!
Seller Equity
Equity Equity

Year 0 Transaction 1 2
Structure

Alexander Groh 35
 Changing Cost of Capital

• Should we use different Discount Rates then in our

transaction model ???
– Pros and cons
• „To be precise we should!“
• „It is not necessary because bandwidth of expected Cash Flows is
very broad anyway!“

Alexander Groh 36
Debt Capacity

Alexander Groh 37
Equivalent Multiples

Alexander Groh 38
Modelling a Corporation´s
Free Cash Flows
16
14

mn €
12
10
8 12
15 15 15 15 ...
6 10
4
2
0
2009 2010 2011 2012 2013 2014
Year

Variable Cash Flows Perpetuity

Growth rates could be considered !!!

Alexander Groh 39
 Duplicating a Corporation´s
Free Cash Flows
Present Value = Present Value of Variable Cash Flows +
Present Value of Perpetuity

10 mn € 12 mn € 1 15 mn €
V0 = + + ∗
(1 + r ) (1 + r ) 2
(1 + r ) 2
r

r = 5% r = 10% r = 15%
NPV(Perp.) = 272 mn € NPV(Perp.) = 124 mn € NPV(Perp.) = 76 mn €

V0 = 293 mn € V0 = 143 mn € V0 = 93 mn €

Alexander Groh 40
 Using an Average of
Free Cash Flows ???
10 mn € + 12 mn € + 15 mn €
3 12,33 mn €
V0Average = = = 123,3 mn €
r 0,1

V0Average 123,3
= = 86%
V0 143

• No satisfying results !!!

Alexander Groh 41
 Modelling Free Cash Flows
• Modelling the Free Cash Flows is the only way to come to a
fair bid:
– Analyze historical performance first !!!
– Calculate Key Value Drivers
– Understand strategic position
– Develop performance scenarios
– Forecast individual line items
– Check overall forecast for reasonableness

Alexander Groh 42
 Calculate Key Value Drivers
• Use (part of the) ROIC-tree for example:

Operating Margin
= (EBIT/Revenues)

= 1- (...)
Depreciation Selling, General and
Cost of Goods Sold/
Revenues + Expenses/
Revenues
+ Administrative
Expenses/Revenues

Key Value Drivers can be further broken down to operational

levels !!!

Alexander Groh 43
 Develop Performance Scenarios
• Get as many research reports as possible !
• Read the businessplan critically !
• Get information from consultants, market researchers,
competitors and professionals !
• Perform best-, worst- and most likely scenarios !
– Perform sensitivity analysis !
– Interpret the result of different scenarios and sensitivity analysis
carefully !
• Discuss possible scenarios in your management team !

Alexander Groh 44
 Get Help by
Mathematical Tools
2005 2006 2007 2008 2009
Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate
Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues
SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)
Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)
EBIT 14,00 14,89 15,34 15,80 16,28

Monte Carlo Simulation with Crystal Ball ©

Alexander Groh 45
 Get Help by
Mathematical Tools
Play with the assumptions
for sensitivity analysis !!!

Alexander Groh 46
 Simulation of Possible Scenarios
Forecast: Revenues 2004
1.000 Trials Frequency Chart 4 Outliers
,030 30

,023 22,5

,015 15

,008 7,5

Mean = 112,65
,000 0
100,00 106,25 112,50 118,75 125,00
Euro

Forecast: COGS 2004

1.000 Trials Frequency Chart 3 Outliers
,030 30

,023 22,5

,015 15

,008 7,5

Mean = 60,31
,000 0
52,50 56,25 60,00 63,75 67,50
Euro

Alexander Groh 47
 Simulated EBIT
Forecast: Ebit 2001
1.000 Trials Frequency ChartEbit 2002
Forecast: 0 Outliers
,029 29
1.000 Trials Frequency Chart
Forecast: Ebit 2003 0 Outliers
,025 25
1.000 Trials Frequency Chart 0 Outliers
,022 21,75 Forecast: EBIT 2004
,025 25
,019 18,75
,015 1.000 Trials 14,5 Frequency Chart 0 Outliers
,019 18,75
,013 ,021 12,5 21
,007 7,25
,013 12,5
,006 6,25
,000 0
,006 6,25
12,00
,000
13,25 ,016 14,50 15,75 17,00
0 15,75
Euro
12,00 13,50 15,00 16,50 18,00
,000 0
Euro
12,00 13,75 15,50 17,25 19,00
Euro
,011 10,5

,005 5,25

Mean = 16,29
,000 0
12,00 14,00 16,00 18,00 20,00
Certainty is 80,80% from 15,01 to +Infinity Euro

Alexander Groh 48
 Calculating FCFs
and Entity Values
2005 2006 2007 2008 2009
Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate
Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues
SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)
Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)
EBIT 14,00 14,89 15,34 15,80 16,28

Taxes on EBIT 5,60 5,96 6,14 6,32 6,51 40% assumed marginal Tax Rate
Operating Cash Flow 8,40 8,93 9,20 9,48 9,77
Net Investments 2,00 2,06 2,12 2,19 2,25 3% est. Growth Rate
Free Cash Flow 6,40 6,87 7,08 7,30 7,51

Net Present Values 5,98 5,35 4,80 32,94 15% Discount Rate

Entity Value 49,1

Alexander Groh 49
 Possible Bidding Range
Forecast: Entity Value
1.000 Trials Frequency Chart 0 Outliers
,084 84

,063 63

,042 42

,021 21

Mean = 49,10
,000 0
35,00 41,88 48,75 55,63 62,50
Certainty is 50,40% from 44,84 to 52,48 Euro

Alexander Groh 50
 Putting All Together !!!
Formulate your bid !!!
Use your Valuation-Spreadsheet

Compare IRRs with Forecast future Earnings

Hurdle Rates of each investor and Free Cash Flows

Calculate IRRs for

financing layers Adjust leverage Perform Scenario-Planning
(reversed DCF- and Sensitivity Analysis
Valuation)

Build a transaction Find company market value

structure
(Taxes!)

Alexander Groh 51