1. Scholl Professor of Finance
Corporate Valuation
Keith M. Howe
Scholl Professor of Finance
DePaul University
Summer 2009

2. Valuation Approaches Discounted cash flow (DCF) analysis
Relative valuation analysis
comparable companies analysis
equity valuation using P/E multiples
enterprise valuation using EBITDA multiples

3. Discounted cash flow (DCF) analysis
Basic idea: find the present value of the expected future cash
flows over the asset’s life and discount at cost of capital
(required rate).
Where:
CFt =Cash flow in period t
r = discount rate
Notes:
Discount rate is an opportunity cost.
CF = Rev - Costs - Taxes - Investment
= (Rev - Costs) (1 - Tc) + (Tc * Dep) - Investment

4. Discounted cash flow (DCF) analysis
A DCF model has three parts:
Explicit forecast period
Cash flows are after-tax incremental cash flows
Continuing value or terminal period
Perpetuity
FCF, NOPLAT, NOPAT
Constant growth
Multiples
Discount rate
Discount rates can be determined a number of different ways (e.g., CAPM, Gordon growth model, APT, etc), but the expected free cash flows are discounted at the rate that reflects the risk of the cash flows. 4 4

5. Discounted cash flow (DCF) analysis
Continuing Value
PV of forecasted CFs
Continuing Value (CV)

6. Discounted cash flow (DCF) analysis
Two general approaches are taken:
For the continuing value (or terminal value) component, simplifying assumptions are made about future CFs (e.g., g=3% in perpetuity) or future valuation alignment based on market multiples.
Two general approaches:
1) Constant growth rate of CFs.
2) Market-based multiples

7. Forecasting Continuing Value CFs
Discounted cash flow (DCF) analysis
Forecasting Continuing Value CFs
Forecasted Cash Flows
g = ?
Time 1 2 3 4 5
Explicit forecast
Assumed growth path

8. Discounted cash flow (DCF) analysis
1) Constant growth approach:
FCFt+1
WACC - g
CVt =
Over what period will the firm earn abnormal returns?
What is the relation between the period of competitive advantage and the continuing value formula?

9. Discounted cash flow (DCF) analysis
2) Multiples Approach:
EVt
EBITDA Peers
CVt =
EBITDA *
Where:
EV = enterprise value
EBITDA = earning before interest, tax, depreciation and amortization
Aligns DCF value with market pricing for the industry

10. Example: Discounted Free Cash flow
Discounted cash flow (DCF) analysis
Example: Discounted Free Cash flow
Free Discount Present
Year Cash flow Factor (10%) Value
Terminal Value , ,049.00
Value of Operations ,906.40
Less: Value of Debt (600.00)
Equity Value $2,306.40
Price per share $4.16

11. Required Rates for DCF Method
Discounted cash flow (DCF) analysis
Required Rates for DCF Method
r =D1/P0 + g Gordon’s Model
r = rf + β (rm - rf) CAPM
r = rf + β1 (r1 - rf) + β2 (r2 - rf) +…
Arbitrage Pricing Theory
Fama-French model (size, BV/MV)

12. Weighted average cost of capital (WACC)
Discounted cash flow (DCF) analysis
Weighted average cost of capital (WACC)
WACC = RD(1-T) * D/V + RE * E/V
Where:
RD(1-T) = after-tax cost of debt (current)
RE = cost of equity (CAPM)
D/V, E/V = debt and equity proportions (market-value based)

13. Discounted cash flow (DCF) analysis
Market
Forces
Value Drivers
Competitive
Nature
Required
Investment
Market
Demand
Profitability
Corporate
Value
Investment
Growth
Competitive
Position
Cost
Advantage
Product
Differentiation
Risk

14. Forecasting CF Performance
Discounted cash flow (DCF) analysis
Forecasting CF Performance
1. Develop the forecast period
How long will it take to reach an mature, equilibrium stage? (often 10 years is used)
2. Define strategic perspective
Tell the story - give the context
(For example, demand will peak in 4-5 years and then decline as
competitors enter the market. Margins will decline following
the period.)

15. Forecasting CF Performance
Discounted cash flow (DCF) analysis
Forecasting CF Performance
3. Period of competitive advantage
(ROIC > WACC)
Providing superior value to consumers thru better service, a differentiated product.
Low cost provider
Barriers to entry - patents, government policy
4. Develop financial forecast based on the strategic perspective
Begin with revenue forecast.
Develop the income and balance sheet forecasts.
Then calculate CFs and key value drivers.

16. Forecasting CF Performance
Discounted cash flow (DCF) analysis
Forecasting CF Performance
5. Develop performance scenarios
(best and worst cases)
Sets of plausible assumptions.
6. Check consistency and alignment with industry structure
Entry barriers, technology, strategic issues

17. How to Display a DCF- Based Model Assumptions Example:
Here we develop a base case model from Wall Street Research and CSFB projections 17

18. Discounted Cash Flow Valuation
($ in millions)
(1) 2004E not included in calculating NPV of cash flows.
($ in millions) 18 18

19. critically review your assumptions on the following variables
Scenario analysis
critically review your assumptions on the following variables
Broad economic conditions: How sensitive is the forecast to the economic conditions?
Competitive structure of the industry: How competitive and concentrated is the industry? What impact will this have?
Internal capabilities of the company : Can the company develop its products on time and manufacture them within the expected range of costs?
Financing capabilities of the company: Can the company finance the changes in its plan? How?

20. Discounted cash flow (DCF) analysis
Pros
Widely accepted
Provides a generally reliable and sophisticated approach to valuation by accounting for:
Profitability
Growth
Capital investment/intensity
Capital structure
Risk and opportunity cost
Cons
Generally not easy to calculate
Grounded by assumptions
Gives only an absolute valuation, which in isolation is not telling
Loaded with assumptions 20 20

21. Note on Cash Flow Analysis
We can use free cash flows to find:
a) Enterprise Value
b) Value of Equity 21 21

22. Project or Firm Valuation (Debt Plus Equity Claim)
Note on Cash Flow Analysis
Matching CFs and discount rates in DCF analysis
Project or Firm Valuation
Steps
(Debt Plus Equity Claim)
Equity Valuation
Step 1: Estimate the amount and timing of future cash flows
Project (firm) free cash flow (i.e., PFCF = FFCF)
Equity free cash flow (EFCF)
Step 2: Estimate a risk appropriate discount rate
Combine debt and equity discount rate (weighted average cost of capital - WACC)
Equity required rate of returm (cost of equity)
Step 3: Discount the cash flows
Calculate the PV(FCF) using the WACC to estimate V(Firm)
Calculate the PV(EFCF) using the equity discount rate to estimate V(Equity)
Note that we have the same value of equity and the value of project
(firm) from using project and equity valuation methods 22 22

23. Definitions: Project (firm) free cash flow
Sales
#####
Less:
Cost
EBITDA
Depreciation
EBIT
40%
Unlevered Net Income
Add:
CAPEX
NWC Increase
Free Cash Flows to the firm

24. Definitions: Equity free cash flow
Sales
#####
Less:
Cost
EBITDA
Depreciation
EBIT
Interest expense
Levered net income before taxes
40%
Levered net income or Net Income*
Add:
CAPEX
NWC Increase
Cash Flows to equity
*Note that Net Income + Interest (1-t) = EBIT (1-t)

25. Equity Valuation Method
Cash Flow Outline
Firm Valuation Method
Equity Valuation Method
EBIT
Subtract taxes
(tax rate X EBIT)
Subtract Interest
Expense
Unlevered Net Income
Net Income before Taxes
Subtract taxes
(Tax rate X Net income
before taxes)
Plus Depreciation, Less
Capital Expenditure, Less
Working Capital Change
Plus Depreciation, Less
Capital Expenditure,
Less Working Capital Change
Firm Free Cash Flow
Equity Free Cash Flow
Discount at WACC
Discount at
Cost of Equity

26. Example: Sample data Using free cash flows to find: Enterprise Value
Cost of Equity (Rs) = 12%
Cost of Debt (Rd) = 8%
Tax rate = 40%
Earnings before Interest and taxes (EBIT) = $40 million
Depreciation = $15 million
Capital Expenditures = $15 million
The EBIT is perpetual (mature firm)
Target debt-to-value ratio (D/V) = 40%
Current value of debt is $ million
Using free cash flows to find:
Enterprise Value
Value of Equity

27. Firm Free Cash Flow WACC Enterprise Value (EV) Value of Equity
Firm Valuation Method
Firm Free Cash Flow
- Change in NWC
WACC
Enterprise Value (EV)
Value of Equity

28. Equity Valuation Method
Interest Payments
Cash Flows to Equity
Equity Value
Enterprise Value

29. General thoughts on relative valuations
Relative valuation analysis
General thoughts on relative valuations
Most valuations on Wall Street use multiples
Multiples reflect current market perceptions
Relative valuations require fewer explicit assumptions and are easier to use
Relative valuations often find a more receptive audience (easier to understand as there are fewer assumptions) 29 29

30. Although widely accepted, P/E has serious drawbacks.
Relative valuation analysis
Equity valuation using P/E multiples
Pros
Most commonly used and accepted multiple with sell side research
Easy to calculate (simply need to ensure you match time periods, trailing, current, future)
Takes into account profitability
Cons
Cannot use if companies do not have accounting earnings
Are GAAP earnings a good measure of cash flow?
Adjustments for normalized earnings?
Ignores Economic Profitability
A company could be buying earnings
Completely ignores capital structure
Debt not included in the value of the firm
Interest costs and tax shield are ignored
Ignores future growth opportunities
Ignores capital intensity and investment
Although widely accepted, P/E has serious drawbacks.

31. Example: P/E multiples
Multiple of comparable firms
Price of subject firm

32. Relative valuation analysis
Equity valuation using P/E multiples
Example
Comparable firm example (Automotive):
P/E Ratio
Toyota Motor Corp
DaimlerChrysler AG
General Motors Corp
Ford Motor Company
Average

33. Relative valuation analysis
Equity valuation using P/E multiples
Example (con’t)
Private Company:
EPS = $2.50
P = 2.50 x = $28.94 Estimate
Traded Company: GM P/E=6.6
What can we say about GM? Price too low?
Need to look at accounting methods, risk, growth rates, and payout to see if comparable.

34. Display Example: A Valuation Perspective
P/E 2004E
From our analysis what can you tell me about our company? 34 34

35. Relative Valuation - Correct Time Periods
Display Example:
Relative Valuation - Correct Time Periods
P/E E
2003 P/E
2004E P/E
Source: I/B/E/S Estimate.
EV / 2004E EBITDA
PX’s trading multiples are consistent with the market’s expectations for future performance. 35 35

36. Relative valuation analysis
Enterprise valuation using EBITDA multiples
Pros
Second most commonly used and accepted multiple on Wall Street
Easy to calculate (but need to ensure you match time periods, trailing, current, future)
Takes into account profitability
EBITDA generally a good proxy for cash
Takes into account capital structure
Includes debt in the value of the firm (should use net debt)
Includes Interest as part of cash flow
Cons
Ignores Economic Profitability
Ignores capital intensity and investment
The EBITDA multiple is a “cleaner” multiple, however it still misses the hurdle rate and investment required into the business.

37. Implementing a Multiples Approach
Define the multiple
There are different definitions for the same multiple (current, trailing, forward).
It is integral to look at the entire distribution of the multiple
Understand the differences between the mean, median and standard deviation
Understand why the outlier are outliers (question relevance of the multiple and the companies inclusion in the peer group)
Understand the fundamentals of the multiple
What are the strengths and weaknesses of the multiple?
Choosing a peer group for Relative Valuation Methods
Why are you trying to determine value? 37