1. FIN ©2001 M. P. NarayananUniversity of Michigan Valuation methods An overview

2. FIN ©2001 M. P. NarayananUniversity of Michigan2 Methodologies F Comparable multiples n P/E multiple n Market to Book multiple n Price to Revenue multiple n Enterprise value to EBIT multiple F Discounted Cash Flow (DCF) n NPV, IRR, or EVA based Methods u WACC method u APV method u CF to Equity method

3. FIN ©2001 M. P. NarayananUniversity of Michigan3 Valuation: P/E multiple F If valuation is being done for an IPO or a takeover, n Value of firm = Average Transaction P/E multiple  EPS of firm n Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be) F If valuation is being done to estimate firm value n Value of firm = Average P/E multiple in industry  EPS of firm F This method can be used when n firms in the industry are profitable (have positive earnings) n firms in the industry have similar growth (more likely for “mature” industries) n firms in the industry have similar capital structure

4. FIN ©2001 M. P. NarayananUniversity of Michigan4 Valuation: Price to book multiple F The application of this method is similar to that of the P/E multiple method. F 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. F This method can be used for n companies in the manufacturing sector which have significant capital requirements. n companies which are not in technical default (negative book value of equity)

5. FIN ©2001 M. P. NarayananUniversity of Michigan5 Valuation: Value to EBITDA multiple F This multiple measures the enterprise value, that is the value of the business operations (as opposed to the value of the equity). F In calculating enterprise value, only the operational value of the business is included. F Value from investment activities, such as investment in treasury bills or bonds, or investment in stocks of other companies, is excluded. F The following economic value balance sheet clarifies the notion of enterprise value.

6. FIN ©2001 M. P. NarayananUniversity of Michigan6 Enterprise Value

7. FIN ©2001 M. P. NarayananUniversity of Michigan7 Value to EBITDA multiple: Example F Suppose you wish to value a target company using the following data: n 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. n Recent EBITDA of target company = $20 million n Cash in hand of target company = $5 million n Marketable securities held by target company = $45 million n Interest rate received on marketable securities = 6%. n Sum of long-term and short-term debt held by target = $75 million

8. FIN ©2001 M. P. NarayananUniversity of Michigan8 Value to EBITDA multiple: Example F Average (Value/ EBITDA) of recent transactions n (10.1+9.8+9.2+10.5+10.3)/5 = 9.98 F Interest income from marketable securities n 0.06  45 = $2.7 million F EBITDA – Interest income from marketable securities n 20 – 2.7 = $17.3 million F Estimated enterprise value of the target n 9.98  17.3 = $172.65 million F Add cash plus marketable securities n 172.65 + 5 + 45 = $222.65 million F Subtract debt to find equity value: 222.65 – 75 = $147.65 million.

9. FIN ©2001 M. P. NarayananUniversity of Michigan9 Valuation: Value to EBITDA multiple F Since this method measures enterprise value it accounts for different n capital structures n cash and security holdings F By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value. F Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive. F Gives a measure of cash flows that can be used to support debt payments in leveraged companies.

10. FIN ©2001 M. P. NarayananUniversity of Michigan10 Heuristic methods: drawbacks F While heuristic methods are simple, all of them share several common disadvantages: n they do not accurately reflect the synergies that may be generated in a takeover. n they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm under consideration. n They assume that the firm being valued is similar to the median or average firm in the industry. n They require that firms use uniform accounting practices.

11. FIN ©2001 M. P. NarayananUniversity of Michigan11 Valuation: DCF method F Here we follow the discounted cash flow (DCF) technique we used in capital budgeting: n Estimate expected cash flows considering the synergy in a takeover n Discount it at the appropriate cost of capital

12. FIN ©2001 M. P. NarayananUniversity of Michigan12 DCF methods: Starting data F Free Cash Flow (FCF) of the firm F Cost of debt of firm F Cost of equity of firm F Target debt ratio (debt to total value) of the firm.

13. FIN ©2001 M. P. NarayananUniversity of Michigan13 Template for Free Cash Flow “Income Statement”

14. FIN ©2001 M. P. NarayananUniversity of Michigan14 Template for Free Cash Flow F The goal of the template is to estimate cash flows, not profits. F Template is made up of three parts. n An “Income Statement” n Adjustments for non-cash items included in the “Income statement” to calculate taxes n Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc. F 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. F Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.

15. FIN ©2001 M. P. NarayananUniversity of Michigan15 Template for Free Cash Flow F 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. n Revenue items n Cost items n Depreciation items n Profit from asset sales F 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). F There are two type of capital items n Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E)) n Working capital

16. FIN ©2001 M. P. NarayananUniversity of Michigan16 Template for Free Cash Flow F It is important to recover both at the end of a finite-lived project. n Salvage the market value property plant and equipment n Recover the working capital left in the project (assume full recovery)

17. FIN ©2001 M. P. NarayananUniversity of Michigan17 Template for Free Cash Flow

18. FIN ©2001 M. P. NarayananUniversity of Michigan18 Estimating Horizon F For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it. F Since a company is assumed to have infinite life: n Estimate FCF on a yearly basis for about 5  10 years. n After that, calculate a “Terminal Value”, which is the ongoing value of the firm. F Terminal value is calculated one of two ways: n Estimate a long-term growth and use the constant growth perpetuity model. n Use a Enterprise value to EBIT multiple, or some such multiple

19. FIN ©2001 M. P. NarayananUniversity of Michigan19 Costs of debt and equity F Cost of debt can be approximated by the yield to maturity of the debt. F If it is not directly available, check the bond rating of the company and find the YTM of similar rated bonds. F Cost of equity n CAPM  Find  e and calculate required r e. Use Gordon-growth model and find expected r e. Under the assumption that market is efficient, this is the required r e.

20. FIN ©2001 M. P. NarayananUniversity of Michigan20 Model of a Firm Value from Operations FIRM DEBT and other liabilities EQUITY Value generated Value to Equity Equal if debt is fairly priced Value from investments Enterprise value

21. FIN ©2001 M. P. NarayananUniversity of Michigan21 Value of equity F Value of equity = Enterprise value + Value of cash and investments - Value of debt and other liabilities