Basic Financial Modelling
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Transcript of Basic Financial Modelling
Financial Modelling and Company ValuationA Sharing Session by Tan Heng Leng29th August 2014
Agenda
Valuation Approaches
Free-Cash Flow Models
Weighted average cost of capital
Application: Derive Enterprise Value of Pura
Limited
What is valuation
How much money something is worth?
Why valuation?
Valuation Approaches
Determined by a stream of
forecasted cash flows
Benchmark against other comparable companies
Based on book values in
balance sheet
Income based approach
▪ Value both business acquisitions and disposals
▪ Understanding the value of a business and then pricing in synergies
Applicability
▪ Most complex technique
▪ Large range of assumptions
▪ Prone to forecasting error
Weakness
▪ Based on discounted future cash flows
▪ Most technically robust approach
▪ Focus on true economic drivers of value
Strength
Market based approach
▪ To compare and contrast the relative values of investments within a portfolio
▪ Provide a ‘sense check’ for business acquisition / disposal decisions
Applicability▪ Relies wholly on
available data of comparable companies
▪ Broad assumptions made
▪ No detailed analysis of intrinsic drivers of value
▪ Difficult to apply to privately owned entity
Weakness▪ Straightforward
technique
▪ Readily available data
▪ Benchmarking the relative value of organisations against each other
▪ Uses market based factors instead of analyst own estimate
Strength
Market based approach
Three (3) Steps Approach
2 Convert these to a standardised statistic (Price / Earnings) which becomes the valuation multiplier
Apply the valuation multiplier to the assets being valued3
1 Identify comparable assets and their market value
Example:
Value of Turquoise Ltd : RM 1,500 mil (market capitalisation)
Current year earnings : RM 100 mil
Earnings multiple : 1500 ÷ 100 = 15 times
Cost based approach
▪ Obtain preliminary view of the base value of a business especially in a divestment exercise
▪ Liquidation value used where all assets are sold and liabilities are repaid
▪ Used to value excess assets within a business
Applicability▪ Book value does not
reflect current fair values
▪ May significantly undervalue a business (intangibles value are often ignored)
Weakness▪ Simple and quick
▪ Data readily available in balance sheet
▪ Has an element of certainty - based on assets that are owned
Strength
Enterprise Value vs Equity Value
Question:
Should this WACC be the
Acquirer WACC or Target’s
WACC?
What is Free Cash Flow?
Definition:Cash flow available to suppliers of capital (i.e. debt holders and equity holders) after:
All operating expenses have been paid in cash Necessary investments in working capital; and Fixed capital have been made
EBIT / Operating Income 100+ Depreciation and Amortisation 5EBITDA 105- Income Tax (25)- Change in Net Working Capital (10)Operating Cash Flow 70- Capital Expenditure (20)FCF in forecast period 50
What is Free Cash Flow to Equity (“FCFE”)?
FCF in forecast period 50.0- Interest expense (10.0)- Debt repayment (20.0)+ Tax benefit on interest 2.5FCF to Equity Holders 22.5
Example:
Free Cash Flow Valuation Framework
Step-by-Step Guide
•Step 1: Value the business/ operating assets
•Step 2: Value the company
•Step 3: Value the company’s equity
•Step 4: Find the fair value per share
Main idea !Fair value of a stock = the present value of all the cash that can be
potentially be distributed
Corporate Valuation vs Project Valuation
What is the difference between:
valuing TNB as a company
VS
valuing an IPP project?
Terminal Value
Y0 Y1 Y2 Y3 Y4 Y5
Explicit forecast period
Firm in steady state
Step 1: Calculate terminal value
Step 2: Derive present value of terminal value to Year 0
Step 3: Add Present Value of Terminal Value to Present value of FCFs to arrive at final enterprise value
Weighted Average Cost of Capital
Definition:Discount rate used to find the Present Value of the FCFs.
The return an investor would require for owning all the capital issued / raised
WACC = wdkd(1-t) + wprp + weke
Where:
wd,wp,we = proportion of debt, preference shares and ordinary
shares
t = corporate tax rate
kd, kp, ke= cost of debt, cost of preference shares, cost of equity
Cost of Equity
Definition: cost of equity (ke)
= rate of return that shareholders require on their investment in an organisation
Application: Financial Modelling Basics Steps
Big Step Baby Steps
1. Project income statement
i. Understand income statement mechanics by keying in historical data
ii. Document assumptionsiii. Project income statements
2. Project balance sheet
i. Understand balance sheet mechanics by keying in historical data
ii. Document assumptionsiii. Project balance sheet items
3. Project cash flow statement
i. Link income statement and balance sheet items to cash flow statement
ii. Dividends and share repurchasesiii. Wrap up the cash flow statement
4. Balancing i. Deal with the PLUG that make the financial statements balance!
Case Study: Pura Limited
IMD is investigating the acquisition of Pura Limited, a biscuit-manufacturing company based in Sungai Petani, Kedah.
FCF drivers
1.Current level of sales = RM 22.1 mil per annum
2.Sales growth rate during the forecast period = 4.5% per annum
3.Operating expenses (net of interest and depreciation): remain constant at 88.8% of sales per annum
4.Income tax rate = 30% of EBITDA
5.Fixed capital and working capital
Incremental fixed capital rate = 15.0%
Working capital investment rate = 10.0%
6.WACC = 10.0%
7.Terminal value growth rate = 1.5%
8.Market value of debt = RM10 mil
Case Study: Pura Limited
Step 1: Calculate FCF in the forecast period by applying FCF drivers
Step 2: Calculate the terminal value using a growth rate of 1.5%
Step 3: Calculate the enterprise and equity values
Thank you