1. Valuation methods An overview
For details, see “Finance for Strategic Decision Making,”
by M. P. Narayanan & Vikram Nanda,
Published by Jossey-Bass
©2006 M. P. Narayanan

2. Methodologies Comparable multiples Discounted Cash Flow (DCF)
P/E multiple
Market to Book multiple
Price to Revenue multiple
Enterprise value to EBITDA multiple
Discounted Cash Flow (DCF)
NPV, IRR, or EVA based methods
WACC method
CF to Equity method
©2006 M. P. Narayanan

3. Understanding Value
In the context of valuing companies, it is important to understand what we mean by value.
From an economic perspective, value is the present value of future free cash flows (FCF) expected to be produced by the company, discounted at the weighted average cost of capital (WACC) that reflects the risk of the cash flows.
For a definition of free cash flow, see cash flow template later
For an understanding of the WACC, see conceptual diagram later
©2006 M. P. Narayanan

4. Understanding Value
This value, is often called the “Economic Value” or “Market Value” of the company.
Let us first clearly understand the differences between
Economic value of the company
Accounting or book value of the company
©2006 M. P. Narayanan

5. Understanding Value: Book Value
Consider a company whose balance sheet is shown on the next page.
The important points to note are:
Fixed assets represent the investment in property, plant and equipment, minus the depreciation
Cash is cash on hand
Accounts receivable is the amount due from customers. It is an interest free loan to customers.
Accounts payable is the amount owed to suppliers. It is an interest free loan from suppliers.
Accrued expenses are amounts owed to employees, government, etc. It is also an interest free loan.
Financial investments include holdings in other companies.
©2006 M. P. Narayanan

6. Understanding Value: Book Value
©2006 M. P. Narayanan

7. Understanding Value: Book Value
Finally the Shareholder funds in an accounting balance sheet (called the book value of equity) is the amount of equity capital invested in the company. This includes
The original equity capital invested when the company was started.
Additional equity invested in the company through subsequent external equity financings minus any equity repurchases.
Profits reinvested in the company.
It is important to understand that the value of equity in the accounting balance sheet is NOT what the shareholders can obtain if they sold the company and paid off all the debt.
©2006 M. P. Narayanan

8. Understanding Value: Book Value
Before we relate the accounting balance sheet to economic values, we slightly reconfigure the accounting balance sheet.
The cash on hand is decomposed into “operating cash” and “excess cash”.
Operating cash is the cash required for working capital purposes.
It is determined by the company’s cash budgeting process.
“Excess cash” is cash that is not required for working capital purposes.
It is presumably kept for strategic reasons
In this example, we assume that $25 cash is required for operating purposes.
Remaining cash ($175) is “Excess cash.”
©2006 M. P. Narayanan

9. Understanding Value: Book Value
Marketable securities and financial investments are taken out of current assets which is now re-labeled as “current operating assets.”
If there are any interest-bearing current liabilities, they are left on the sources side of the balance sheet.
Remaining items are re-labeled as “current operating liabilities.”
©2006 M. P. Narayanan

10. Understanding Value: Book Value
Working capital
©2006 M. P. Narayanan

11. Understanding Value: Book Value
The total capital (on which a return must be provided) raised by the company is $2200:
Short-term debt = $150
Long-term debt = $1000
Equity = $1050
Note that accounts payable and accrued expenses are not included as they are not interest-bearing liabilities.
©2006 M. P. Narayanan

12. Understanding Value: Book Value
This capital is used to
Acquire fixed assets = $1500
Invest in working capital = $375
Acquire financial holdings in other companies and invest in excess cash and marketable securities (possibly for future investment needs) = $325
Note that working capital is the difference between current operating assets and current operating liabilities.
©2006 M. P. Narayanan

13. Understanding Value: Economic Value
Using the reconfigured accounting balance sheet as a model, we can now create an economic balance sheet.
The main difference is that
Values in the accounting balance sheet represent what has been invested.
Values in the economic balance sheet represent the current value of what has been invested.
The goal of companies is to ensure that the economic value exceeds the accounting value!!
©2006 M. P. Narayanan

14. Understanding Value: Economic Value
Enterprise value
©2006 M. P. Narayanan

15. Understanding Value: Economic Value
Fixed assets and working capital in the accounting balance sheet have been replaced by the present value of the free cash flow they are expected to generate in the future ($2500).
This figure is just an assumed number.
This is the economic value of the operations of the company and is often called Enterprise Value.
Excess cash and marketable securities are usually valued the same as in the accounting balance sheet as their values are unlikely to be different.
Financial investments should be valued at market
It is assumed in this example that the market and book values are the same.
©2006 M. P. Narayanan

16. Understanding Value: Economic Value
The total value of the company is:
Enterprise Value + Excess cash + Marketable securities + Financial investments
In this example it is assumed the economic value of the debt is the same as in the accounting balance sheet.
This is more likely to be true for short-term debt.
The value of the long-term debt is more sensitive to changes in interest rates.
If the interest rates had increases since their issue, their value would decrease from the face value.
©2006 M. P. Narayanan

17. Understanding Value: Economic Value
In general, liabilities also include, in addition to debt, obligations to other parties such as
Legal and environmental liabilities
Liabilities to employees such as pension
The value of equity is the difference between the total value of the company and all its liabilities.
It is also called the market capitalization and is equal to the share price times the number of shares outstanding.
This is the current value of the equity, i.e., what the shareholder will receive if they were to sell the company off at its current value and payoff all the liabilities.
©2006 M. P. Narayanan

18. Constructing Economic Value Balance Sheet
If a company is publicly traded, it is easy to construct the right side of the balance sheet:
Debt values can be obtained from the accounting balance sheet
Equity value can be calculated by multiplying the share price by the number of outstanding shares.
Value of items such as excess cash, marketable securities, and financial investments can be obtained from the accounting balance sheet and market prices of these items.
The enterprise value can then be calculated as the residual.
©2006 M. P. Narayanan

19. Multiples: P/E 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
See next page
©2006 M. P. Narayanan

20. P/E and leverage Gordon growth model: P0 = D1/(re − g)
P0 = Stock price today
D1 = Expected next-year dividend per share
re = Cost of equity
g = Expected dividend growth rate
Assume constant payout ratio
K = Payout ratio = D1/ EPS1
P0 = K × EPS1/(re − g)
Simple algebra yields P0/EPS1 = K /(re − g)
As leverage increases, re increases, decreasing P/E multiple
©2006 M. P. Narayanan

21. Multiples: Price to book
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)
©2006 M. P. Narayanan

22. Multiples: Enterprise Value to EBITDA
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.
©2006 M. P. Narayanan

23. Value to EBITDA multiple: Example
Suppose you wish to value a target company using the following data:
Revenue = $800 million
COGS = $500 million
SG&A = $150 million
All from continuing operations only
Excludes any non-operating income such as interest and dividend income
Excludes interest expenses
Depreciation (from CF statement) = $50 million
Cash in hand = $25 million
Marketable securities = $45 million
Sum of long-term and short-term debt held by target = $750 million
©2006 M. P. Narayanan

24. Value to EBITDA multiple: Example
You collect the following data about a recent takeover in the same industry
Selling price = $40 a share (40 shares)
Cash on hand = $50 million (all assumed “Excess Cash”)
Marketable securities = $200 million
Market value of financial investments = $120 million
Short-term debt = $200 million
Long-term debt = $1100 million
From continuing operations
Revenue = $1000 million
COGS = $650 million
SG&A = $120 million
Depreciation = $70 million
©2006 M. P. Narayanan

25. Value to EBITDA multiple: Example
First compute enterprise value at which this comparable company sold.
Equity value = 40 × 40 = $1600 million
Enterprise value = − 250 − 120 = $2530 million
©2006 M. P. Narayanan

26. Value to EBITDA multiple: Example
Next compute the EBITDA of the comparable company from continuing operations
EBITDA = Revenue − COGS − SG&A + Depreciation
EBITDA = 1000 − 650 − = $300 million
Compute the Enterprise value/EBITDA multiple at which the comparable firm sold
Enterprise value/EBITDA = 2530/300 = 8.43
Compute EBITDA of your target company
EBITDA of target = 800 − 500 − = $200 million
Compute enterprise value of the target
Enterprise value of target = 200 × 8.43 = $1686 million
©2006 M. P. Narayanan

27. Value to EBITDA multiple: Example
Compute equity value of target company
Equity value = − 750 = $1006 million
Finally, if there are acquisition costs (Investment banking, legal) and financing costs (bank fees, transaction costs) subtract from equity value (not done in this example).
©2006 M. P. Narayanan

28. Valuation: Value to EBITDA multiple
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.
©2006 M. P. Narayanan

29. Mutiples methods: drawbacks
While Multiples 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.
©2006 M. P. Narayanan

30. Valuation: DCF method
This is similar to the technique we used in capital budgeting:
Estimate expected free cash flows of the target including any synergies resulting from the takeover
Discount it at the appropriate cost of capital
This yields enterprise value
After calculating enterprise value, equity value of target is calculated using the same process as before.
©2006 M. P. Narayanan

31. Valuation: DCF method
DCF methods impose stricter discipline on the acquiring company
They need to specify the value drivers of the takeover
They need to provide estimates of the value created and their sources
Allows for post-audit of the takeover based on these benchmarks
©2006 M. P. Narayanan

32. DCF methods: Starting data
Free Cash Flow (FCF) of the firm
WACC
©2006 M. P. Narayanan

33. Template for Free Cash Flow
Revenue
Less Costs
Less Depreciation
Profits from asset sale
Taxable income
Less Tax
NOPAT
Add back Depreciation
Less Profits from asset sale
Operating cash flow
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
Operating Income Statement
©2006 M. P. Narayanan

34. Template for Free Cash Flow
The goal of the template is to estimate cash flows, not profits.
Template is made up of three parts.
An Operating Income Statement
Adjustments for non-cash items included in the Operating Income Statement to calculate taxes
Capital items, such as capital expenditures, working capital, cash from asset sales, etc.
The Operating 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.
©2006 M. P. Narayanan

35. Template for Free Cash Flow
There are four categories of items in our Operating 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
Cash from asset sale − Book value of asset
Book value of asset = Initial investment − Accumulated depreciation
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. Profit from asset sale).
©2006 M. P. Narayanan

36. Template for Free Cash Flow
There are two type of capital items
Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E))
Working capital
We need to include only additions to capital (both fixed and working) since the capital originally invested is still employed in the project.
It is important to recover both types of capital at the end of a finite-lived project.
Recover the market value property plant and equipment
Cash from asset sale
Recover the working capital left in the project (assume full recovery)
©2006 M. P. Narayanan

37. Template for Free Cash Flow
What is the FCF template actually doing?
See table on the right
The template is longer because of tax calculations
Items on the right are the value drivers
You may view this as a conceptual template
Revenue
Less Costs
Less Tax
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
©2006 M. P. Narayanan

38. Estimating 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 years.
After that, calculate a “Terminal Value”, which is the ongoing value of the firm.
©2006 M. P. Narayanan

39. Terminal Value Terminal value can be calculated several ways:
Use the constant growth perpetuity model with a long-term growth closer to economy growth rates.
Works for mature industries
Estimate a two- or three-stage model,
Higher growth rate(s) in the initial stage(s) (for about 10 years)
A lower long-term growth for the final stage
Use a Enterprise value to EBITDA multiple based on industry averages to estimate terminal value
©2006 M. P. Narayanan

40. WACC
One of the issues in the valuation of companies for acquisition is what WACC to use.
Should we use the target company’s WACC or the acquirer’s WACC? Or something else?
As always, the answer is “it depends.”
If a conglomerate is buying a target company, it is appropriate to use the target company’s WACC.
There is likely to be very little interaction between the target company’s operations and that of the acquirer.
If it is a horizontal merger, the WACC of acquirer and target are likely to be close.
A weighted average WACC may be appropriate (weights based on the enterprise values of the two parties)
©2006 M. P. Narayanan

41. WACC
The idea is that if the integration of the target with the acquirer is minimal, the target’s WACC is appropriate.
If there is substantial integration, but companies are not in the same industry, it becomes more difficult to figure out a precise WACC to value the target.
The issue has to be dealt on a case by case basis.
©2006 M. P. Narayanan

42. Valuation of private companies
Private company stocks are very illiquid
Similar to small firms with less liquid stocks, private company stocks also will sell at a discount. The liquidity issue much more severe with private companies.
Private company owners are likely to be less diversified. Therefore, they bear both the market risk and the company-specific risk, increasing their cost of capital and decreasing the value of the firm to them.
If you own only GM stock you are bearing the risk of the auto industry as well risk that is GM-specific (a strike at GM).
If you own all the auto company stocks (GM, Ford, Toyota, Nissan, Volkswagen, Diamler-Chrysler), you bear only the auto industry risk.
©2006 M. P. Narayanan

43. Valuation of private companies
The typical method of valuing a private company is to value it as if it is a public company and then apply a discount for the reasons stated earlier.
Find a pure-play and use its WACC to discount the cash flows of the private company
Pure-play is a public company that has the same business risk as the private company
Or, use the multiples of a public company
The trick is to compute this discount. There are ways to get some handle on this discount.
The discounts are in the 20-40% range
©2006 M. P. Narayanan

44. Weighted average cost of capital: Overview
Lenders
Required rate = 8%
Stockholders
Required rate = 12%
Debt capital $40
Annual return
$3.20
Annual return
$7.20
Equity capital $60
Annual tax saving from interest deduction = $1.12 (35% of 3.20)
Total return = $10.40
Total capital $100
Annual return
$9.28
Rate of return on capital required to payoff the debt and minimally satisfy stockholders, i.e., WACC
Operations
Required rate = 9.28%
©2006 M. P. Narayanan

45. Costs of debt and equity
Cost of debt can be approximated by the yield to maturity of the debt.
If the yield is not directly available, check the bond rating of the company and find the YTM of similar rated bonds.
Cost of equity
CAPM
Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.
You need an estimate of future dividend growth rate to do this.
Therefore, works better for firms with a history of dividend payments
©2006 M. P. Narayanan

46. Valuation: CF to Equity method
In the WACC method, we compute
Enterprise value by discounting the free cash flows at WACC
Add value of any financial investments
Subtract value of debt to obtain equity value
In CF to Equity method, we
Compute CF that are available to equity-holders
This is Free Cash Flow less principal and after-tax interest payments
Discount this at cost of equity and directly compute equity value
©2006 M. P. Narayanan

47. Equity value: WACC method
Value from Operations
Value from investments
Enterprise value
Value generated
Value of Debt
Equity value
All are values: CF discounted at appropriate cost of capital
©2006 M. P. Narayanan

48. Equity value: CF to Equity method
FCF from Operations
CF from investments
Total CF generated
CF to Debt
(Principal, after-tax interest)
CF to Equity
All are CF
Equity value = CF to re
©2006 M. P. Narayanan