Determining Value

• Buying or selling a firm• Planned merger• Evaluation/analysis of corporate strategy• Prospect for market notation• Management Buyout• Financing

Stock valuation and corporate valuation

Total value: do not equal valueof equity plus value ofliabilities

Valuation of private and public companies

Public: • Over- or undervaluedin relation to market price• Return not only due to the firm• Moral hazard

Private: • Reference point?• Assets establish value• Risk!• Idiosyncratic value

Fundamental analysis

Strategic analysis

Accountinganalysis

Financial analysis

Prognoses(proformas)

Valuation

Strategic analysis

• Identify factors that has major impact on business profit (profit drivers & KPI’s)• Identify key business risks• Qualitative• Includes an industry perspective• Provides a focus for the remaining analysis• Usually ends with an estimated turnover and market share

• Industry growth rate• Concentration and balance between competing firms• Product differentiation• Economies of scale• Over-capacity & exit barriers• Treats from entrants

• economies of scale• first-mover advantage• legal barriers

• Substitutes• Bargaining power of customers• Bargaining power of suppliers

Competition strategies (Porter, 1980):• Cost superiority• Differentiation• Focus

Accountinganalysis

Qualitative aspects of FinancialReporting

* Predictability* Feedbackminimum: understandability and timeline-iness

Validity- neutrality- substance over form- completeness vs essential

Verificationassymmetry requirement:pre-caution

Purpose of Financial Reporting: provide relevant information regardingthe economic consequences of the business activity of a legal entity fora given time period. Measure and report. Problem(s)? What about conformity?

Reliability

Comparabiltyover time & between firms

Correctness

Reliable

Steps in Accounting analysis

1. Identification of main accounting principles

Source: www3.sandvik.com/pdf/ar_2006_eng/ar_2006_eng.pdf

Steps in Accounting analysis (cont.)

2. Assessment of degree of flexibility in the financial reporting of the firm

• Impairment tests of Goodwill• Impairment of other non-current assets• Pension assumptions• Income tax

3. Evaluation of the Accounting Polices adopted by the firm4. Evaluation of Supplementary information

Steps in Accounting analysis (cont.)

5. Identification of potential warning signals

• Unexplained changes in accounting principles (especially following unusual earning levels). Note: IFRS

• Single transactions with major influence on profits (not explained in the reports). E.g sell of important assets to pump-up the profit.

• An unusual growth in accounts receivable in relation to growth in sales. Indicating what?!!!

• An unusual growth in inventories in relation to growth in sales. Indicating what?!!!

• Large write-downs on non-current assets. Indicating what?!!!

Financial analysis • Uses financial information (reports)• Is based on what has happened• Aims to assess future performance• Has to be systematic (select appropriate measures)• As well as effective (limiting the number of measures in focus)• Ratio analysis and cash flow reports

Return to Equity

Internally Generated Cash Flow

An important relationship: Permanent growth in profits (g)

ATR

OPM

Financialleverage

(rA-rD)D/E

Return onEquity

Dividendshare(Ds)

g

g = [OPM * ATR + ((rA-rD)D/E ) ]*(1-t) * (1 – Ds)

g = [OPM * ATR + ((rA-rD)D/E ) ]*(1-t) * (1 – Ds)

Prognoses(proformas)

• Summarizes the first three parts• Based on fundamental accounting principles: construct estimated income- and balance statements• Used foremost in discounted cash flow models• Of use also in credit rating, financial management, evaluation of strategic decisions, etc.• No fixed style• Major input: turnover!

Valuation

• Two major approaches• Asset (or substance)• Return based

• Asset based: starts with current assets & liabilities. No proformas are necessary

• Return based approaches are forward looking. Discounting of future cash flows/dividends/residual profits

Overview of valuation models

1. Present value models1. based on dividends2. based on cash flows3. based on residual profits

2. Return valuation based on sustained (permanent) income

3. Reference valuation (multipliers)

4. Valuation based on asset structure

Example:We are to value a company that (at t = 0) has, as the sole asset, a machineacquired for 3000. The firm is financed only by equity. The required rate of return is 7%. The remaining life-time of the machine (firm) is three years.

Year 1 Year 2 Year 3

Asset value 3000 2000 1000

Income before depreciation 1300 1200 1100

Depreciation -1000 -1000 -1000

Income net of depreciation 300 200 100

Cash flow 1300 1200 1100

Dividends 1300 1200 1100

Calculations:

Cash flow & Dividend valuation:

Residual profits valuation:

161,3

11001200

07.1

1300

07.107.1 32V

BVBERP

rRP

ttt

ttt

r

BVV

1

1 1

161,3

3060

07.1

903000

30100007.0100

60200007.0200

90300007.0300

07.107.1 32

3

2

1

V

RPRPRP

Simplified methods for valuation

Permanent income (foremost in use for small private firms)“The perpetual value added..” V = E / rwhere E is permanent income

Suppose that the profits of Persistent Inc for the last five years is:2007 = 1602006 = 2202005 = 1802004 = 2402003 = 200

Permanent income = 200 =

Estimated value = 200 / = 2000

An alternative would be to weight the time-series in some way. Perhapsgive more weight to more recent (or usual) periods (or levels).

Simplified methods for valuation (cont.)

Multipliers

A multiplier is a scalar indicating the relation between firm profit and market value of shares.

Example: P/E ratio (= 5) is used as the multiplier, Firm profit is 1M.

The estimated value of the firm is then = 5 * 1M = 5M.

Common multipliers are:• P/E ratio• P/CF ratio• P/S ratio (S = sales per share; taken from most previous IS)• P/BV ratio (BV = Book Value of Equity)

Simplified methods for valuation (cont.)

Example:A firm within the software industry is to be valued. We use averagemultiplers for other firms in the same industry as comparison

avP/E = 25avP/BV = 3

The profit of the software firm is expected to be 150 M for the upcoming year. Book value of equity (from the latest IS) is 950M.

Valuation:a) 25 * = 3750Mb) 3 * = 2850M

Pro’s and Con’s with comparable (relative) valuation

• Comparable models vs models based on discounting: The former is more reflecting market expectations. Think of a firm to be marketed in a time of high P/BV-ratios (like IT in the late 90’s). What would you have done?

• Comparable methods do not need as much information as discounting models do. Cost of information – Investor behavior!

• A definitive disadvantage for comparable valuation: Suppose that firms that uses comparable valuations are over-valued. An ‘under-valued’ firm in such an industry can still be ‘over-valued’.

• Short-time horizon. To much emphasis on current conditions.

• A comparable approach do not explicitly recognize other factors influencing firm values such as risk and capital structure.

• Relies on publicly disclosed information. Financial information.

Valuation based on asset structure (Substance)

The substance value = Value of Assets – Value of debt = Value of Equity

A problem: Book values are rarely equal to ‘true’ values.

This approach starts in the public Balance statement. Note that what willfollows may include tax consequenses.

‘True value’: the definition depends on the purpose of the valuationa) Market value/Re-purchase valueb) Liquidation value

Example: Valuation by substance

Assets Equity and Liabilities

Non-current assets Equity

Machinery and inventories 24,000 Shares 30,000

Buildings 64,800 Reserves 6,000

Property 8,100 Free reserves 91,460

Shares 400 Untaxed reserves 10,100

Non-current liabilities

Current assets Collateralized Debt 31,000

Cash and equivalents 10,800 Current liabilities

Accounts receivables 58,800 Account payables 40,900

Other receivables 23,300 Check account 2,000

Inventories 43,200

Factoring 940

Other liabilities 21,000

Total assets 233,400 Total Equity & Liabilities 233,400

Value of equity = 139,360

Available information:

1. Accounts receivables; 15% of the receivables are more than twomonths overdue. Only 50% of them can be expected to be recovered.

2. Inventories; The re-purchase value is 40,0003. Machinery; Acquisition value is 113,300 but the current salvage value

is 37,260.4. The market value of the property is: Land = 16,000; Buildings =84,000;5. Other liabilities: the firm is by an agreement forced to pay royalty

of 200. This agreement is not recognized in the balance sheet. Anassessment gives this agreement a present value of 2,000.

6. The income statement includes paid retirement of 250 for two formersenior executives. A valuation of these payments gives a capitalvalue of 1,600.

What is the substance value? Assume a tax rate of 28%

Adjustments:

Equity: 30,000+6,000+91,460+(10,1*0,72) = 134,732

Accounts receivables: -58,800*0.15*0.5*0.72 = -3,175Inventory: (40,000 – 43,200)*0.72 = - 3,200Shares: (1,000 – 600)*0.72 = 432Machinery: (37,200 – 24,000)*0.72 = 9,547Property: (100,000 – 72,900)*0.72 = 19,512

Liabilities:Royalty: 2,000*0.72 = 1,440Pensions: 1600*0.72 = 1,152

24,012

2,592

Adjusted Substance value = 134,732 + 24,012 – 2,592 = 156,152