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Business Valuation Methods Prepared by Professor Kirby D. Cochran and Eric E. Anderson, PhD January 2014.

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Presentation on theme: "Business Valuation Methods Prepared by Professor Kirby D. Cochran and Eric E. Anderson, PhD January 2014."— Presentation transcript:

1 Business Valuation Methods Prepared by Professor Kirby D. Cochran and Eric E. Anderson, PhD January 2014

2 Exercise 1 – Performing DCF Analysis Compute DCF valuations for the cash flow series below Assume discount rate, r = 36% Assume growth rate, g = 10%, for the period beyond Yr 5 NPV of cash from Yr 1 to 5 = $16.7M Terminal Value, T 0 = Y5 cash flow*(1+g)/(d-g) = $465.4M Present value of T 0 = T 0 /(1+r)^5 = $100.0M DCF valuation = $116.7M Company Valuation Exercises – Income Approach 2 ? Y1Y1 Y2Y2 Y3Y3 Y4Y4 Y5Y5 T0T GrowthTerminal NPV PV(T 0,5) DCF Value DCF Analysis of Free Cash Flow ($M) Development

3 Exercise 2 – Calculating the IRR Compute IRR of the cash flow series below with terminal value beyond year 5 of $465.4M as computed in the previous example. Assume discount rate, r = 36% and the growth rate, g = 10%, for the period beyond year 5. Using the Excel formula IRR(values, [guess]), calculate the IRR = 82.52% Check the answer by calculating the NPV of the cash flow series using r = IRR calculated above and verify that NPV = 0. If your company’s Cost of Capital is 30%, would you invest in this company? Company Valuation Exercises – Income Approach 3 ? Y1Y1 Y2Y2 Y3Y3 Y4Y4 Y5Y5 T0T GrowthTerminal NPV PV(T 0,5) DCF Value DCF Analysis of Free Cash Flow ($M) Development Because the terminal value changes with the discount rate, using an iterative approach, the IRR converges on % with terminal value, T0 = $ M

4 Exercise Solution – Calculating DCF and IRR 4 Iteratively replacing the IRR estimate into the discount rate, and using the resulting new T0. Assuming T0 = , the IRR is computed as follows:Computing the DCF value with r=36%, and g=10%,

5 Agenda  The Asset Approach  Book Value and Common BV Ratios  Intangible Assets and Goodwill  Valuing Distressed or Declining Companies  Replacement Cost Analysis  Valuation Adjustments 5

6 Asset Approach to Business Valuation

7 7

8 The Asset Approach to Business Valuation The Asset Approach estimates a company’s value using the company's adjusted net book value, or the fair-market value of its total assets minus its total liabilities “How much is left over after I settle all my debts and obligations and sell all the assets.” Net Book Value - the total assets minus liabilities (minus preference shares) on the Balance Sheet as of the last reporting period. Adjusted Net Book Value – the net book value adjusted to the fair value as of the end of the financial period, i.e., the current value of the net assets. Often used for Mature or Declining growth cycle businesses Used for Strong Asset Base companies Good indicator of barriers to entry for asset intensive businesses Serves as sanity check on business value Liquidation Valuation Replacement Cost Analysis Asset based values are often lower than fair- market-value because the method doesn’t consider ongoing business concerns and growth, nor the current market for a company’s products. Book value is quite relevant for some sectors such as the to real estate and financial sectors where book value multiples are routinely used to value companies. 8

9 Book Value and Shareholder Equity Book Value of an asset= the value is based on the original cost of the asset less any depreciation, amortization, depletion or impairment costs made against the asset. Book value of a Company= Shareholder Equity = Assets – Liabilities, a measure of the liquidation value Tangible Book Value= The net asset value of a company, = Assets – Liabilities – Intangible Assets (patents, goodwill) – value of Share Preferences. Comparing Book Value to Market Value can indicate whether a stock is under- or over-priced Common Book Value Ratios: Book Value per share = Shareholder Equity / #of shares outstanding Price-to-Book value = Price/Share / Book Value per share Return on Equity = Annual earnings / Shareholder Equity 9

10 Issues with Net Book Value Book value of assets may not reflect current market value Companies have significant latitude in valuing their inventory, real estate and other assets. Often times companies will discount appreciation in order to avoid tax consequences. Book Value does not consider a company’s ongoing interests and growth and hence often serves as a lower bound to a company’s intrinsic value. Valuable of certain assets may depressed by value of overall firm Companies can be worth a lot more divided up than sold in one piece Value of intangible assets and goodwill often mask true market value Net Book value is only an estimate of liquidation value. The actual liquidation value depends on the current market for a companies assets. Price-to-Book ratio depends on earnings per dollar of assets employed – Shares of capital intensive industries typically trade at lower price/book ratios because they generate lower earnings per dollar of assets. – Business depending on human capital will generate higher earnings per dollar of assets, so will trade at higher price/book ratios 10

11 Intangible Assets Intangible Assets (IA) are one contributor to the disparity between company value as per their accounting records, and company value as per their market capitalization 1 – Intangibles are difficult to quantify, but can have a tremendous effect on market value. – Section 197 of the IRC refers to certain Intangible Assets acquired in connection with the purchase of a business including computer software, intellectual property, designs and patterns, franchises, goodwill, going concern value, information base (e.g., customer lists, etc.) Many new types of intangible assets are discussed in FASB 141. – Goodwill is an IA arising as a result of the acquisition of one company by another for a premium value. (Goodwill is an “unidentifiable asset”) – Brand equity an IA to a Company, and often a primary factor in determining future earnings Some disregard Intangible Assets and use Tangible Book Value Tangible Common Equity (TCE) is found by subtracting intangible assets, goodwill and preferred equity from the company's book value Accounting and Tax Treatment: – Accounting treatment: Write identifiable assets up at FMV. Excess over FMV is Goodwill. Intangible assets are typically expensed according to their respective life expectancy. 2 Goodwill is not amortized since it has an indefinite life, but subject to impairment tests. – Tax Treatment: Treasury regulations generally require capitalization of costs associated with acquiring, creating, or enhancing intangible assets Prof. Ian H. Giddy, Methods of Corporate Valuation, New York University, some material adapted from fool.com and growco.com 2 IAS 38". International Accounting Standards Board. Retrieved 19 December IAS 38" 3 Treas. Reg. § 1.263(a)-4.

12 AOL Time Warner Goodwill and Intangible Assets 12 AOL paid $147 billion in stock for Time Warner when AOL and Time Warner merged in 2000 $128 billion of goodwill and other intangible assets was booked. In early 2002, AOL Time Warner was trading for $66.27 per share. $209 billion of assets on its balance sheet. 1,2 Did merger create the value that was expected? AOL Time Warner had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors drove the stock price down to $ or nearly a 60% loss. Note: Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. Goodwill subjected to an annual impairment test whereby the market value of the lingering goodwill is determined, and in the event that market is lower than book value, the goodwill must be written down to reflect this reality. 1 “ 2 Positive Signs for McDonald's” by Rex Moore, The Motley Fool Sep 13th 2011.“ 2 Positive Signs for McDonald's 2 Business Week, “AOL Time Warner's ‘Goodwill’ Games,” January 10, 2002.AOL Time Warner's ‘Goodwill’ Games

13 Goodwill and Intangible Assets for Selected Companies Company Market Cap ($ B) Price/ Book Shareholder Equity ($B) Goodwill ($B) Intangible Assets ($B) Apple (AAPL) McDonalds (MCD) Coca Cola (KO) General Mills (GIS) Source: finance.yahoo.com, January 15, 2014 and MRQ filings

14 10 Global Companies with the Most Valuable Brands Brand Valuation Google$48.2B 2.Apple$39.3B 3.Microsoft$39.0B 4.IBM$34.9B 5.Walmart $34.9B 6.Vodaphone$30.7B 7.General Electric$29.0B 8.Toyota$28.8B 9.AT&T$28.4B 10.HSBC$27.1B The Economic crisis caused companies to lose 25% ($6.3T) of intangible assets value in the first 9 months of 2011, (according to Brand Finance plc.) However, only a 2.4% drop in combined value of top 100. The Economic crisis caused companies to lose 25% ($6.3T) of intangible assets value in the first 9 months of 2011, (according to Brand Finance plc.) However, only a 2.4% drop in combined value of top Note: GOOG Market Cap was $374B as of January Ref: according to Brand-Finance Global 100:

15 Google (GOOG) Balance Sheet – Quarter Ending - Sep 30,

16 General Mills (GIS) Balance Sheet – Quarter Ending – Nov 24,

17 Symptoms of Declining or Distressed Companies A Declining or Distressed Company may exhibit one or more of the following symptoms: Whereas for mature companies most value is from existing assets with less from growth assets, declining or distressed companies have little or no value comes from Growth assets Value may even be lost from growth investments if reinvestments are at rates below their cost of capital More value may come from liquidating or divesting assets than from continuing operations Stagnant or declining revenues Declining or negative margins Depressed stock price / stock buy backs Low Current Ratio (negative Working Capital) Negative Cash Flow Potentially over-levered High cost of capital Occasional profits generated from asset divestures Unable to refinance debt with attractive terms Large fraction intangible assets to total assets 17

18 Valuing Declining or Distressed Companies Difficult to use DCF methods because low margins and high debt leave little if any cash flow. – Firm’s earnings are less than the cost of capital – Assets that generate sub-par earnings the destroy value of the Company – Divestures make projecting future earnings based on past results difficult and skew beta values. – Must identify past divestures and estimate future divestures and their likely sales price to properly forecast cash flow. Asset-based valuation methods are commonly used to value declining or distressed firms. Problems with Estimating Discount Rates Distress significantly increases the cost of equity and debt.. The cost of debt will increase as default risk increases and ratings will drop to junk status - BB, B or lower. If operating earnings drop below interest expenses, the tax benefits of debt will also dissipate, leading to further pressure upwards on the after-tax cost of debt. As debt-to-equity ratios climb, the cost of equity should also increase further, as equity investors will see much more volatility in earnings and increased default risk. Problems with Computing Terminal Value Estimating sustainable growth rate is impossible with the likelihood that a distressed company have negative growth or cease operations Declining or even negative earnings earned at a rate less than cost of capital Extremely high cost of equity and debt 18

19 Degrees of Corporate Distress 19 Source: Corporate Renewal Solutions,

20 Decline of the Sears Empire The Situation (February 2008) Customers jumping ship for Target & Walmart FY 2008 revs = $50.7B (3.2% > in 2006) Op Inc of $1.54B (17.7% < than in 2006) Op Margin of 3.05% Reduction in number of stores Bought back $2.9B in stock ROC = 4.99% Cost of Cap = 7.5% on retail operations Cash = $1.6B Debt = $7.7 B Number of Shares = M Stock value = $76.25/sh (from High of $195/sh in April 2007) “Optimistic” Analyst Rev Growth remains at 6% Op Margin grows from 3.05% to prior 5% level in 5 years Reinvestment of 50% of FCF Cost of capital will return to industry average of 7.13% Stable 4% growth long term Return on Capital will return to 12% in perpetuity => DCF Value per Share = $223.90/share Sears/Kmart announced closing up to 120 stores in Dec 2011 on slow holiday sales Currently trading at about $38-$39 for the past couple years 20 Ref: USA Today, “ Sears, Kmart to close up to 120 stores,” December 30, Sears, Kmart to close up to 120 stores

21 XYZ Genetics – Income Statement 21

22 XYZ Genetics – Balance Sheet 22 Note: DCF analysis yielded a valuation of about $130 million (for conservative Case 1 growth model)

23 XYZ Genetics – Cash Flow Statement 23

24 Replacement Cost Analysis Replacement Cost Analysis determines the amount of capital required to reach the present state of the Company at the current time. Replacement Cost includes the costs associated with the development of technologies, systems, sales channels, customer base, organization as well as overhead at current prices. The results are independent of any forward-looking assumptions (e.g., growth) but includes capital costs for growth assets for which associated revenues have not reached steady state. Costs are based on estimated man hours for engineering software and related activities, using appropriate hourly rates and overheads. Replacement Cost Analysis is not indicative of true value for a profitable company in the growth stage because it does not take into account the future earnings potential of the Company. It also does not take into account the current market for a companies products and services. It can serve as a useful benchmark and often lower bound (in the case of a growing market) on the true value. 24

25 XYX Genetics – Replacement Cost Analysis The four major cost centers in the development of the Company’s technology were analyzed to determine the amount of capital required to reach the technology status at the present state of the Company. As the analysis evaluates the cost to bring the company to its current state, the results are independent of the Case assumptions described above. The following table summarizes the Replacement Cost valuation. Replacement Cost for Current State of Company ComponentsCost Research & Development$117,039,000 Manufacturing2,887,000 Sales & Marketing1,376,400 Overhead & Administration5,569,500 Total Replacement Cost$126,861,900 These numbers are based on estimated man hours for engineering software and related activities, using hourly rates and overheads associated with a venture company. Replacement cost for an established corporation would be higher. 25

26 XYZ Genetics - Cost Replacement Summary 26

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28 Selected Valuation Adjustments Fair Value of Assets – adjust asset values to reflect current market value Fair Value of Debt - a Company’s Short Term, Long Term and Off-Balance Sheet Debt – Current value needed to pay off debt and all satisfy creditor claims – Example: As of its FY 2012, AT&T had an adjusted total debt of $101 billion. Their balance sheet only shows $72 billion of debt, for which the fair value was disclosed as $84 billion in the financial footnotes. Adding $19 billion in operating lease obligations gives a far more accurate $101 billion liability for total adjusted debtdisclosed as $84 billion in the financial footnotes Intangible Asset Valuation – Allocation of Purchase Price for Acquisitions – Goodwill Impairments (annual tests) Remove Discontinued Operations – Assets and Liabilities Valuation of Contingencies (Enabling Assets) – Earn-outs, other forms of contingent consideration, and certain acquired contingencies (assets and liabilities) are recorded at fair value as of the acquisition date – DCF analysis can be used to determine the current value of an earn outs and contingencies 28

29 Economic Book Value and the Price-to-EBV ratio Economic Book Value (EBV) measures the no- growth value of the company based on the current Net Operating Profit After Tax (NOPAT) of the business. 1,2 Also known as the “pre-strategy value” of the company because it focuses only on the perpetuity value of the current NOPAT or cash flows. Price-to-economic book value (“Price-to-EBV”) ratio measures the difference between the market’s expectations for future profits and the no- growth value of the stock. When market prices are much higher than EBV, the market predicts economic profitability will increase. When market prices are much lower than EBV, the market predicts economic profitability will decrease. EBV = (NOPAT / WACC) with the following adjustments: - Adjusted total debt (including off-balance sheet debt) + Excess cash + Unconsolidated Subsidiary Assets + Net Assets from Discontinued operations - Value of Outstanding Employee stock option liabilities - Under (Over) funded Pensions - Preferred stock - Minority interests + Net deferred compensation assets + Net deferred tax assets EBV per share = EBV / shares outstanding. 29 Sources: 1 “Definition: Price-To-EBV, or Price to Economic Book Value ratio,” David Trainer, Diligence Institute, June 18, 2012.Definition: Price-To-EBV, or Price to Economic Book Value ratio 2 “Blue-Light Special: Wal-Mart Stock” David Trainer, Diligence Institute, June 28, 2011.Blue-Light Special: Wal-Mart Stock

30 Sources: 1 “Definition: Price-To-EBV, or Price to Economic Book Value ratio,” David Trainer, Diligence Institute, June 18, 2012.Definition: Price-To-EBV, or Price to Economic Book Value ratio 2 “Blue-Light Special: Wal-Mart Stock” David Trainer, Diligence Institute, June 28, 2011.Blue-Light Special: Wal-Mart Stock WMT Increasingly Attractive through WMT stock price traded relatively flat from 2000 to mid-2012 WMT price jumped to $70-80 range in the last year.

31 Which Valuation Method is Most Appropriate? Valuation ApproachTypical UsageProsCons Market Approach Value based on Comparing Business with its Peers (Industry & Specific Companies) Most valuations in stock markets are market based. Also known as Relative Valuation Approach or Comparable Approach Simpler to compute Takes into account both supply and demand factors and current market climate Many businesses are unique Difficulty in finding comparable businesses Growth only implicitly considered Asset Approach Value based on adjusted net book value (Assets less Liabilities) Often used for Mature or Declining growth cycle businesses Used for Strong Asset Base companies Liquidation Valuation Easier to support valuation Good indicator of barriers to entry for asset intensive businesses Serves as Sanity Check on business value Results are often lower than fair-market-value because the method doesn’t consider ongoing business concerns and growth Income Approach Current value is function of Future value that an investor can expect to receive from purchasing some or all of business Use Discounted cash flow analysis to determine present value of future returns from a business (NPV, IRR) Used for valuing profitable businesses expected to continue operating for the foreseeable future (a going concern) Most accurately represents the economic value of a particular business Accurately models future growth Doesn’t require identification of comparable companies More difficult to compute Requires detailed financial model Early stage companies require forecast with no track record Must determine appropriate discount rate 31

32 IBM Balance Sheet – Quarter Ending – Sep 30,

33 33


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