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©2001 M. P. Narayanan
University of Michigan
FIN Valuation methodsValuation methods
An overview
©2001 M. P. Narayanan
University of Michigan 2
FIN MethodologiesMethodologies
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. Narayanan
University of Michigan 3
FIN Valuation: P/E multipleValuation: 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. Narayanan
University of Michigan 4
FIN Valuation: Price to book multipleValuation: 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. Narayanan
University of Michigan 5
FIN Valuation: Value to EBITDA Valuation: Value to EBITDA multiplemultiple
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.
©2001 M. P. Narayanan
University of Michigan 6
FIN Enterprise ValueEnterprise Value
Economic Value Balance Sheet
PV of future cash from businessoperations
$1500
Cash $200 Debt $650
Marketable securities $150 Equity $1200
$1850 $1850
Enterprise Value
©2001 M. P. Narayanan
University of Michigan 7
FIN Value to EBITDA multiple: Value to EBITDA multiple: ExampleExample
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. Narayanan
University of Michigan 8
FIN Value to EBITDA multiple: Value to EBITDA multiple: ExampleExample
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. Narayanan
University of Michigan 9
FIN Valuation: Value to EBITDA Valuation: Value to EBITDA multiplemultiple
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. Narayanan
University of Michigan 10
FIN Heuristic methods: drawbacksHeuristic 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. Narayanan
University of Michigan 11
FIN Valuation: DCF methodValuation: 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. Narayanan
University of Michigan 12
FIN DCF methods: Starting dataDCF 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. Narayanan
University of Michigan 13
FIN Template for Free Cash FlowTemplate for Free Cash Flow“I
nco
me
Sta
tem
en
t”
Working capital
Year 0 1 2RevenueCostsDepreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable incomeTaxNet oper proft after tax (NOPAT)Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flowChange in working capitalCapital Expenditure Capital items
Salvage of assetsFree cash flow
©2001 M. P. Narayanan
University of Michigan 14
FIN Template for Free Cash FlowTemplate 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.
©2001 M. P. Narayanan
University of Michigan 15
FIN Template for Free Cash FlowTemplate 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. Narayanan
University of Michigan 16
FIN Template for Free Cash FlowTemplate 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. Narayanan
University of Michigan 17
FIN Template for Free Cash FlowTemplate for Free Cash Flow
Taxable income = Revenue - Costs - Depreciation + Profit from asset sales
NOPAT = Taxable 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 subtracted earlier and subtract the noncash items you added earlier.
©2001 M. P. Narayanan
University of Michigan 18
FIN Estimating HorizonEstimating 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. Narayanan
University of Michigan 19
FIN Costs of debt and equityCosts 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 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. Narayanan
University of Michigan 20
FIN Model of a FirmModel of a Firm
Value from Operations
FIRM
DEBT and other
liabilitiesEQUITY
Value generated
Value to Equity
Equal if debt is fairly priced
Value from investments
Enterprise value
©2001 M. P. Narayanan
University of Michigan 21
FIN Value of equityValue of equity
Value of equity
= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities