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

2. Stock valuation and corporate valuation Total value: do not equal value of equity plus value of liabilities

3. Valuation of private and public companies Public: Over- or undervalued in relation to market price Return not only due to the firm Moral hazard Private: Reference point? Assets establish value Risk! Idiosyncratic value

4. Fundamental analysis Strategic analysis Accounting analysis Financial analysis Prognoses (proformas) Valuation

5. 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

6. Accounting analysis Qualitative aspects of Financial Reporting * Predictability * Feedback minimum: understandability and timeline-iness Validity - neutrality - substance over form - completeness vs essential Verification assymmetry requirement: pre-caution Purpose of Financial Reporting: provide relevant information regarding the economic consequences of the business activity of a legal entity for a given time period. Measure and report. Problem(s)? What about conformity? Reliability Comparabilty over time & between firms Correctness Reliable

7. Steps in Accounting analysis 1.Identification of main accounting principles Source: www3.sandvik.com/pdf/ar_2006_eng/ar_2006_eng.pdf

8. 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 firm 4. Evaluation of Supplementary information

9. 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?!!!

10. 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

11. An important relationship: Permanent growth in profits (g) ATR OPM Financial leverage (r A -r D )D/E Return on Equity Dividend share (D s ) g g = [OPM * ATR + ((r A -r D )D/E ) ]*(1-t) * (1 – D s )

13. 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!

14. 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

15. Overview of valuation models 1.Present value models 1.based on dividends 2.based on cash flows 3.based on residual profits 2.Return valuation based on sustained (permanent) income 3.Reference valuation (multipliers) 4.Valuation based on asset structure

16. Example: We are to value a company that (at t = 0) has, as the sole asset, a machine acquired 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 1Year 2Year 3 Asset value300020001000 Income before depreciation130012001100 Depreciation-1000 Income net of depreciation300200100 Cash flow130012001100 Dividends130012001100

17. Calculations: Cash flow & Dividend valuation: Residual profits valuation:

18. Simplified methods for valuation Permanent income (foremost in use for small private firms) “The perpetual value added..” V = E / r where E is permanent income Suppose that the profits of Persistent Inc for the last five years is: 2007 = 160 2006 = 220 2005 = 180 2004 = 240 2003 = 200 Permanent income = 200 = Estimated value = 200 / = 2000 An alternative would be to weight the time-series in some way. Perhaps give more weight to more recent (or usual) periods (or levels).

19. 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)

20. Simplified methods for valuation (cont.) Example: A firm within the software industry is to be valued. We use average multiplers for other firms in the same industry as comparison avP/E = 25 avP/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 * = 3750M b)3 * = 2850M

21. 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.

22. 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 will follows may include tax consequenses. ‘True value’: the definition depends on the purpose of the valuation a)Market value/Re-purchase value b)Liquidation value

23. Example: Valuation by substance AssetsEquity and Liabilities Non-current assetsEquity Machinery and inventories 24,000Shares 30,000 Buildings 64,800Reserves 6,000 Property 8,100Free reserves 91,460 Shares 400Untaxed reserves 10,100 Non-current liabilities Current assetsCollateralized Debt 31,000 Cash and equivalents 10,800Current liabilities Accounts receivables 58,800Account payables 40,900 Other receivables 23,300Check account 2,000 Inventories 43,200Factoring 940 Other liabilities 21,000 Total assets 233,400Total Equity & Liabilities 233,400 Value of equity = 139,360

24. Available information: 1.Accounts receivables; 15% of the receivables are more than two months overdue. Only 50% of them can be expected to be recovered. 2.Inventories; The re-purchase value is 40,000 3.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. An assessment gives this agreement a present value of 2,000. 6.The income statement includes paid retirement of 250 for two former senior executives. A valuation of these payments gives a capital value of 1,600. What is the substance value? Assume a tax rate of 28%

25. Adjustments: Equity: 30,000+6,000+91,460+(10,1*0,72) = 134,732 Accounts receivables: -58,800*0.15*0.5*0.72 = -3,175 Inventory: (40,000 – 43,200)*0.72 = - 3,200 Shares: (1,000 – 600)*0.72 = 432 Machinery: (37,200 – 24,000)*0.72 = 9,547 Property: (100,000 – 72,900)*0.72 = 19,512 Liabilities: Royalty: 2,000*0.72 = 1,440 Pensions: 1600*0.72 = 1,152 24,012 2,592 Adjusted Substance value = 134,732 + 24,012 – 2,592 = 156,152