Review of Valuation Methods

Advanced Corporate Finance
Spring 2011
Review Of Valuation Methods
Brandon Julio
Advanced Corporate Finance. Spring 2011 Brandon Julio
2
Plan of Attack

Important Assumptions

Traditional DCF vs. Risk-Neutral Valuation

Valuation Using Adjusted Present Value.

Comparing APV and WACC.

Discounted Cash Flow Valuation Methods.

Capital Cash Flow.

Equity Cash Flow.
3
Plan of Attack (cont.)

Valuation by Multiples.

Valuation of Private Companies.

Appendix: Computing Asset Betas and Equity Betas.
4
Overview of Assumptions

$ $

Corporate
Project

Financial
Market
Investment

Corporate
Manager
Risky Future Cash Flows
Risky Future Cash Flows
Investor
Let Manager
Invest For Me?
Invest Directly
On My Own?
Investors are rational.
Managers are rational.
Financial Markets are efficient.
Managers objective function:

Maximize shareholder wealth.
5
Two Approaches to Valuing Cash Flows
Risky Cash Flows
{ }
1
t
Risk Adjusted
E CF
V
r

=
+
{ }
1
t
Risk Free
E CF Risk Adjustment
V
r

=
+
{ }
*
1
t
Risk Free
E CF
V
r

=
+
Adj ust discount
rat e for risk.
Adj ust cash flows
for risk.
6
Example

Consider a project that pays an uncertain cash flow in one
year. The project pays 120 million in a good

state of
the world and 60 million in the bad

state of the world.
Suppose we know the probability of the good state is 0.70
and the appropriate risk-adjusted discount rate is 12%.
Assume the risk-free rate is 4%. Then:
07 . 91
) 12 . 0 1 (
102
102 ) 60 )( 70 . 0 1 ( ) 120 ( 70 . 0 ) (
=
+
=
= + =
V
CF E
This is the traditional DCF approach
7
Example, cont.

Alternatively, we could approach this in a different way.
Suppose we dont know the right risk-adjusted discount
rate. Can we adjust the cash flows and discount by the risk-

free rate to get the same value?
V V
CF E
=
+
= =
+
=
= + =
) 12 . 0 1 (
102
07 . 91
) 04 . 0 1 (
71 . 94
*
71 . 94 ) 60 )( 579 . 0 1 ( ) 120 ( 579 . 0 ) ( *
Notice that I have solved for a different set of probabilities that sets
the value equal to the risk-adjusted value.
This is the risk-neutral approach to valuation
8
Objective for Today: DCF Methods

We know how to value a 100% equity financed project.

Now we want to take financing into account. Recall financing
matters through:

Tax shields

Costs of financial distress

Bankruptcy costs

Agency Costs

There are different techniques in the valuation world. Much
more than the ones we will cover in this course.

We want to review the basics of WACC, APV, Discounted Cash
Flows (DCF), Equity Cash Flows (ECF), Capital Cash Flows
(CCF) and Multiples/Comparables. Next time: Real Options.
9
Two Different Methods
Two different methods for valuation with financing:

WACC (Weighted Average Cost of Capital).

APV (Adjusted Present Value).
Valuation Using APV
11
The Adjusted Present Value Method

An alternative approach to the WACC is to compute the
Adjusted Present Value (APV).

The two simple steps involved in computing the APV are:

Step 1: Value of the project as if all-equity financed: use the
after-tax cash flows and discount them at the cost of capital.
Remember that for an all-equity firm the cost of capital equals the
cost of equity.

Step 2: Add the present value of the tax shield (TS) generated by
the project.
APV

NPV
all equity

+ PV(TS)

APV is also known as valuation by components.
12
The Adjusted Present Value Method

This is simply MM Proposition I with taxes in action.
APV = V
L

= V
U

+ PV[TS]

We do this to separate the value of running the business from
the value created by financing.

Doing this allows us to identify the sources of value and to

discount different risks appropriately.

The APV method uses the value additivity

principle to evaluate
the contribution of both cash flows and increased debt tax
shields. It can easily be adapted to include other financing side
effects.
13
Important Caveat

In principle, financing should affect the value of a potential

project only if

the ability to use certain financing depends
directly on the decision to take the project.

Otherwise, if the firm can use the financing regardless of the
investment decision, the value of the financing is not
incremental to the project and should be ignored.

It follows that the tax benefits of debt (as well as the associated
costs) should be attributed to a project only if the project

increases the debt capacity

of the firm.
14
APV: Basic Steps

Step 1: Value free cash flows as if the firm were 100% equity

financed.

Calculate free cash flows (we are estimating enterprise value).

Unlever

the equity beta and calculate the return on equity if the firm had
no debt using an asset pricing model.

Discount the cash flows with the unlevered cost of capital.

Do a terminal value calculation.

Step 2: Value the tax shields separately.

Calculate expected interest shields.

Discount the tax shields at the appropriate

rate.

Do a terminal value calculation for the tax shields related to the terminal
value of cash flows.

Lets go through each of these steps in detail.
15
Step 1: Valuing the Cash Flows

Free Cash Flows are exactly what you need.

Get the FCF from running the business as an all-equity firm.

FCF = EBIT(1-

t
C

) + Change in Deferred Taxes + Depreciation

Increase in NWC

CAPX + Other.

We start with EBIT because this is what is available to be paid
to the owners

regardless of the existing debt/equity mix . We
dont want the tax consequences of capital structure to matter.

It is important to remember that getting the correct free cash
flow estimates will usually have a much larger impact on the
final value than obtaining the correct discount rate.

We typically have a forecast horizon of 5 years. Be careful
with cyclical industries and young growth firms.
16
Some Remarks About Free Cash Flows

Be careful with non-cash expenses and income.

For example, deferred taxes.

Should be added back since it is a non-cash expense. This is
tax that we owe, but do not presently have to pay.

Bottom Line:

Non-cash expenses should be summed-up to the FCF.

Non-cash income should be subtracted from the FCF.
17
Which Discount Rate?

You need the rate that would be appropriate to discount the
firms cash flows if the firm were 100% equity financed.

This rate is the expected return on equity if the firm were 100%

equity financed.

To get it, you need to:

Find comparables, i.e., publicly traded firms in same business.

Employ an asset pricing model (usually CAPM) to translate risk
exposures into expected returns.

Estimate their expected return on equity if they were 100% equity
financed, by unlevering

the equity betas.
18
Which Discount Rate? (cont.)

Unlever each comps |
E

to estimate its asset beta (more on this
later)

D

and E

are historical market values. If no market value for D,
use book value.

In D only include interest bearing debt.

Exclude Account Payables and Pension Liabilities.

Include interest bearing short-term and long-term debt.

Deduct Excess Cash (only) from debt.

Bottom Line: Beta is not perfect, but it is the best we have.
19
Which Discount Rate? (cont.)

Use the comps

|
A

to estimate the projects |
A

(e.g. average).

Use the estimated |
A

to calculate the all-equity cost of capital r
A
r
A

= r
f
+ |
A

* Market Risk Premium

Here is an obvious place where judgment is required. How do
you pick the risk-free rate and the excess return on the market?

Short-term or long-term for r
f

? Same horizon as the
investment.

There are plenty of estimates of risk premium of market over
Treasury Bonds.

Use r
A

to discount the projects FCF.
20
Estimates of the Equity Risk Premium

Historical Equity Risk Premium

There are plenty of estimates of risk premium of market over
Treasury Bonds. Historically 6%.

Ibbotson & Associates (2000): Realized average risk premium
over treasuries in 1999 was 9.32%.

Implied Equity Risk Premium

Fama

& French (2001): Risk premium implied by fundamentals
and stock prices over the 1872-2000 time period was between
2.55% and 4.32%.

Kaplan and Ruback

(1996): Risk premium implied by sample of
MBOs

was 7.8%

Equity Risk Premium

Survey Estimates

Graham and Harvey (2001) survey of CFOs: 10-year risk
premium ranges between 3.6% and 4.7%.

Welch (2001) survey of finance professors: 1-year risk premium
averaged 3.4%, 30-year premium averaged 5.5%.
21
Detour on the Discount Rate

Best check on the discount rate:

Sensitivity Analysis.

Re-do valuation with other discount rates (always!).

Getting fancy

with the discount rate is a low payoff activity.

Using term structure

(different risk-free rates for each period)
adds very little.

Using Fama-French (three-factor or four-factor) model instead of
CAPM makes no difference.

Instead better to calibrate.

How do we proceed with calibration?
22
Detour on the Discount Rate (cont.)
Three Basic Steps on Calibration

Value Company as it is.

Use current forecasts.

Find the discount rates.

Is estimated value close to the market value?

No? Try to understand why.

Make adjustments to get the market value.

Apply discount rate/growth rate to:

Other companies/investments.

Check whether assumptions seem sensible in other valuations.
23
Terminal Values
There are generally two ways to proceed to compute TV

Take cash flow (that presumably you already calculated earlier)
and do a perpetuity calculation.

Assume that you can sell the firm using a simple rule involving
P/Es

i.e. price will equal x

times earnings.
24
Terminal Values: Perpetuity Calculation

If you do a perpetuity calculation you probably will use the last
free cash flow and divide it by r
A

- g.

Terminal FCF in Last Year T. The main issue is to determine the
FCF in steady-state situation.

Careful with high-growing companies, cyclical industries.

Get FCF
T

and then apply formula:

Where do we get g?

Careful here: valuation is typically very sensitive to this.
T
FCF (1 )
TV =
A
g
r g
+

25
Terminal Values: Perpetuity Calculation (cont.)

To get PV(TV), need to discount back: PV(TV) = TV / (1 + r
A

)
T

Make sure FCF
n

used to get TV reflects g:

Adjust capital expenditures and depreciation.

Bottom Line: Are depreciation, NWC and other flows you
have in the cash flow estimate consistent with the g that you
choose?
26
Terminal Values: Multiples of Earnings

If you use a multiple of earnings to calculate the sale price, then
you need to calculate earnings

not free cash flows.

Where do you get the multiple from?

Another place where you can manipulate the answer.

Presumably you pick the multiple using comparable firms.

More on Valuation with Multiples later.
27
Step 2: Add PV[Tax Shield of Debt]

Need to account for the debt tax shields, including any
associated with the terminal value and discount these at the
appropriate interest rate.

These deductions depend on the interest payments and the tax
rate. Often the interest payments will appear on the financial
statements. If so use them.

If only the debt levels appear you need to translate them into
implied levels of interest payments.
28
What Interest Rate Do We Use to Discount TS?

The choice of the discount rate depends on the risk. What is the

risk of the tax shield? We dont actually know

In general the tax shield will have its own risk, which will
depend also on the probability that the government will change
its tax policy, and similar issues.

Estimating the risk of the tax shield would be very cumbersome
(and not worthwhile), thus typically we choose among two
assumptions: the risk of the tax shield is equal to the risk of the
debt

or the risk of the assets.

Since these are assumptions there is no absolute right or wrong
answer. However, one may claim that one criteria will probably
be closer the truth, depending on circumstances.
29
A Suggestion

If debt is predetermined or has a low level, risk of tax shields

similar to risk of repayments to debtholders; so r
D

is correct
discount rate.

If high level of debt (e.g. LBOs), or if level of debt varies with
firm value, then riskiness of tax shields similar to that of
operating assets and tax shields should be discounted at r
A
30

For example, in the article by Kaplan and Ruback, several LBOs

are considered. The level of debt is very high.

When leverage is 80-90% of the value of the firm, the risk of the
debt is close to the risk of the assets.

Then we might as well assume that the risk of the tax shield is
also equal to the risk of the assets for firms with very high
leverage.
31

Whatever assumption you make about the risk of the tax shield,
you have to take care to be consistent throughout the valuation.

In particular, remember that the assumption you make about the
risk of the tax shield also affects the equation you will use to

lever and unlever the beta.
32
Two Possible Scenarios
SCENARIO 1 Using r
A

Debt in the future is not fixed.

Debt and interest expense are tied to FCF.

Model when big changes in capital structure,

LBOs

(more highly leveraged transactions).

Bankruptcy.

In those cases, the ability to use tax shields has more systematic
risk than the ability to pay debt.

Int
t

comes from debt repayment schedule and interest rates.
1 2 T
2 T
Int Int Int
TS = Tax Rate * ...
(1 ) (1 ) (1 )
A A A
r r r
(
+ + +
(
+ + +

33
Two Possible Scenarios (cont.)
SCENARIO 2 Using r
D

You expect a predictable, stable and low level of debt.

Ability to use tax shield has the same systematic risk as the
ability to pay debt. Generally in less highly leveraged situations.

For permanent debt with the same risk as interest:
TS = Permanent Debt * Tax Rate = t * D
1 2 T
2 T
Int Int Int
TS = Tax Rate * ...
(1 ) (1 ) (1 )
D D D
r r r
(
+ + +
(
+ + +

34
Just to Check Things Are Clear

Remark 1: If debt is predetermined (D is constant) and has a
low level, risk of tax shield equal to risk of payments to debt
holders; so r
D

is the correct discount rate.

Remark 2: If high level of debt or if level of debt varies with
firm value (D/V is constant), then the risk of the tax shield is

similar to that of operating assets and tax shields should be
discounted at r
A

.

Remark 3: Some firms have high leverage or maintain a target
leverage ratio while maintaining an investment grade rating on
their debt. For these firms, the correct discount rate is probably
closer to r
D.
35
How Leverage Affects the Betas?

Whatever assumption you make about the risk of the tax shield,
you have to take care to be consistent throughout the valuation.

In particular, remember that the assumption you make about the
risk of the tax shield also affects the equation you will use to

lever
and unlever

the beta.

If the risk of the tax shield is equal to the risk of the debt

(D is
constant), then such equation is:

If instead the risk of the tax shield is equal to the risk of the
assets (D/V

is constant), then such equation is:
C
C C
(1 )
(1 ) (1 )
A D E
D t E
E D t E D t
| | |
= +
+ +
A D E
D E
E D E D
| | | = +
+ +
36
What About the TS Associated with the TV?

If you do a perpetuity calculation for the TV and the firm is
expected to have some debt then this matters!

Remember that you have to add any debt tax shields on NPV that
accrue beyond the terminal date.

There are many

ways to compute the terminal value of the tax
shields.

Again you do not have to get fancy. Common sense matters!

They are obviously short-cuts. The main thing is to recognize that
you are going to get some tax shields beyond

T and then do
something sensible.

Lets see 2 different ways
37
What About the TS Associated with the TV?
1.

If D stabilizes at a permanent (and low) level, D
T
.
2.

If (D/V) stabilizes at some level,

(D
T

=

* V
T

):
T C
D t TS TV * ) ( =
g r
r D t
TS TV
A
D T C
=
* *
) (
38
Comments on Step 2 (cont.)

For many projects, neither D nor D/V is expected to be stable.

Need to be careful and creative.

Firms on average tend to rebalance leverage towards a target, but
they do so slowly (at an average rate of 30% per year).

For instance, LBO debt levels are expected to decline.

In general you can estimate debt levels using:

Repayment schedule if one is available.

Financial forecasting.
and discount by a rate between r
D

and r
A

.
39
Extending the APV Method

You could also take care of the costs to financing that come
from financial distress, any issue costs, etc. Once again you
find the present value and subtract it.

You could also add the PV of the costs of financial distress.
How?

Write scenarios and include costs of distress in bad scenarios.

Often people omit PV(costs of distress) because it is difficult to
quantify.
APV vs. WACC
41
Pros and Cons of APV

Pros:

Implicit assumptions are very clear. No contamination.

Works even if debt is not permanent.

Is very easy if the level

of future debt is known.

Clearer: Puts the spot light on what is creating value. Beautiful!
Easier to track down where value comes from.

Assists in the decision of how to structure financing for projects.

More flexible: Just add other effects as separate terms.

Cons:

Requires explicitly calculating future debt levels.

It is increasingly used, but still less well known than WACC.
42
Pros and Cons of WACC
Pros:

Most widely used.

The inputs are easy to get.

If you have a precise debt to value policy, then it is easy and
relative accurate.

But this seems to be highly restrictive.

Less computations needed. It is very simple tool.

Only when project is similar to rest of the firm.
43
Pros and Cons of WACC (cont.)
Cons:

Mixes up the effects of assets and liabilities.

Errors/approximations in effect of liabilities contaminate the whole
valuation.

Does not reveal where the value is coming from.

Not very flexible. Cannot easily allow for changes in:

Other effects of financing (e.g., costs of distress, issue costs)

Non-constant debt ratios

Changes in tax rates
44
Practical Implications

In principle we can always use either WACC or APV. As long
as you follow all the steps and you are careful in making the
same assumptions you should obtain (approximately) the same
solution.

In practice, however, one of the two will be much simpler to
use depending on the situation.

For complex, changing or highly leveraged capital structure (i.e.
LBOs) APV is much better.

Otherwise, it does not matter much which method you use.

Lets consider two cases:

Debt is rebalanced.

Debt is predetermined.
45
Practical Implications (cont.)

If debt is rebalanced (i.e. the firm has a target debt/asset ratio):

Computing WACC is much easier.

APV is much more complex since you do NOT know D.

Bottom Line: In this case of rebalanced debt use WACC.

If debt is predetermined (i.e. firm knows the evolution of D):

APV is easy to compute by discounting future expected interest
payments.

WACC instead has a problem, because if the debt is not
rebalanced then D/V changes over time and so does WACC.

Bottom Line: In this case of predetermined debt use APV.
46
Two Remarks

Remark 1: In principle, you can always forecast D/V values,
compute a different WACC for each year and discount back by
using a different WACC every year. This is a headache!

Remark 2: For non-constant debt-ratios, could use different
WACC for each year but this is heavy and defeats the purpose.
Discounted Cash Flow Valuation Methods
48
Three Cash Flow Valuation Methods

The three methods differ in their measure of cash flows and the
discount rate applied to those cash flows.

The names for the three methods correspond to the type of cash
flow that is used in the valuation:

Capital Cash Flow (CCF)

Provides Enterprise Value.

Free Cash Flow (FCF)

Provides Enterprise Value.

Equity Cash Flow (ECF)

Provides Equity Value.

The three methods provide consistent valuations when applied
correctly.
49
FCF and CCF

CCF method includes the benefits of the tax shields as cash
flows.

The more the tax advantages, the higher the capital cash flow.

The discount rate for this method is the return on assets.

FCF method includes the tax benefits of deductible interest
payments in the discount rate as it uses WACC

The more the tax advantages, the lower the discount rate.

Because the tax advantages of debt are included in the discount
rate, the cash flows do not include the tax benefits of debt.

The difference between the FCF and the CCF is in the Interest
Tax Shield:
Capital Cash Flow = FCF + Interest Tax Shield
50
CCF and APV

Note that the expression of the CCF is close and resembles to
the APV expression we studied before.

In fact, when we use r
A
as the discount rate of both terms:

Thus, APV = NPV(CCF) discounted at r
A

. It is also called
Compressed APV.
FCF FCF ITS CCF
APV
C D
A A A A A
t r D
r r r r r
= + = + =
51
CCF and APV (cont.)

CCF uses actual taxes (projected tax payments).

Hence, you should always compute it starting from Net Income
because Net Income is already net of actual taxes.

CCF from a net income version:

CCF = Net-after tax income (NI) + Interest Expense (I) + Dep

Capx

Change in NWC + Other
52
When Should We Use CCF?

CCF valuation is generally useful for:

Highly Leveraged Transactions.

Firms in Financial Distress.

Bankruptcy.

In these cases we would have discounted the tax shield with r
A

However, we recommend using APV instead of CCF. Why?
53
Equity Cash Flow

ECF measures the cash flow available to stockholders after
payment to debt holders are deducted from operating cash
flows.

Payment to debt holders are sometimes called Debt Cash
Flows

(DCF), and they include interest and principal

payments.
ECF = CCF

DCF

As DCF are paid out of operating cash flows before equity cash
flows, debt cash flows are safer than equity cash flows.

ECF are riskier than cash flow measures that combine DCF and
ECF. And riskier cash flows have higher discount rates.
54
Equity Cash Flow (cont.)

ECF are calculated by subtracting taxes, interest and debt
repayments from operating cash flows and adding debt
additions.
ECF = Net Income + Dep

Capx

Change in NWC + Other +
Change in Debt

Notice that Increases in Debt help to finance increases in capital
expenditures and net working capital.

Alternatively, ECF can be calculated as CCF less DCF.

The discount rate used in the ECF is the return on equity and
the value we obtain is the equity value of the firm.
55
Equity Cash Flow (cont.)

ECF is extremely useful for:

Valuing financial institutions. Very difficult to use APV or
WACC in banks. Why?

Debt is part of the business of most financial institutions.

Very difficult to have an all equity bank.
56
Pros and Cons of ECF

In general, we prefer both APV and WACC to ECF.

APV is preferred to the ECF for many of the same reasons that
APV is superior to WACC.

The use of one discount rate for ECF requires that the firm have

a
constant debt to total capital ratio. If the debt to total capital ratio
varies over time, we need to calculate a different discount rate

for
the equity for each year.

It is much easier to make mistakes using the ECF. In particular, it
is critical to include increases in debt in the cash flows,
particularly in the terminal value calculation.
57
Pros and Cons of ECF

ECF tend to calculate equity values that are too low.

The method values equity as the discounted value of the expected

ECF. This is accurate as long as there is no probability that the
equity value will be less than or equal to 0.

Expected Debt Payments

Promised Debt Payments.
Valuation Using Multiples
59
Valuation Using Multiples

Valuation by multiples is a fancy name for market prices

divided by some measure of performance.

It assesses the value based on that of other (publicly-traded)

firms:
[Value/Key Characteristic]
Ind.Average

* Key Characteristic of Firm

Numerator of multiple is typically the total value of the firm.

Denominator of multiple is the characteristic that is important
for that industry:

clicks or subscribers for web site

paid miles flown for airlines

number of patents for a hi-tech firm.
60
Valuation by Multiples: Implicit Assumptions
1.

Comparable companies assumed to have expected cash
flows growing at the same rate

and have the same level of
risk

as the company being valued.
2.

The value of the company is assumed to vary in direct
proportion

with changes in the performance measure; i.e.
if expected EBITDA increases by 8%, expected firm value
also increases by 8%.

If these assumptions are valid, valuing by multiples
will be more

accurate than the DCF approach because it
incorporates current market expectations of cash flows
and discount rates.
61
Types of Multiples

Cash-flow-based Value

multiples:

MV of firm/Earnings, MV of firm /EBITDA, MV of firm /FCF.

Cash-flow-based Price

multiples:

Price/Earnings (P/E), Price/EBITDA, Price/FCF.

Asset-based Value

multiples:

MV of firm/BV of assets, MV of equity/BV of equity.

Industry-specific Value

multiples:

MV of firm/Hospital Beds, MV of firm/Number of Customers.
62
Procedure
Hope: Firms in the same business should have similar multiples.

Step 1: Identify firms in same business as the firm you wish to
value. Be careful not to induce a selection bias.

Step 2: Calculate multiple for comparable firms.

Step 3: Calculate average for the set of comparable firms. In
doing this we are coming up with an estimate of the multiple we
wish to use in valuing our firm. Equal-weighting vs. Distance-

weighting.

Step 4: Multiply average with the value of the characteristic for
the firm you wish to value.

Step 5: Often different multiples give you different answers:
you need to reflect what is economically reasonable.
63
Important Remarks

When choosing comparable firms you face a trade-off: too
many firms requires to select firms that are not truly
comparable; too few firms means that your average will reflect
idiosyncracies of those firms.

For firms with no earnings or limited asset base (e.g. hi-tech),

Price-to-patents multiples.

Price-to-subscribers multiples.

Or even price-to-Ph.D. multiples!

For transactions, can also use multiples for comparable

transactions.

Similar transaction values.

But be aware, everyone might be over/underpaying!
64
Important Remarks (cont.)

For similar public traded companies:

Use trading multiples.

They tell you what market thinks about the value.

Multiples based on equity value (or stock price, e.g., P/E) as
opposed to total firm value ignore effect of leverage on the cost
of equity (or assume the firms have similar leverage)

Beware if comparables have very different leverage.
65
Motivation for Multiples?

Firms in the same business should have similar multiples.

If the firms actual FCF is a perpetuity:
MV firm = FCF/(WACC-g) =>

MV firm/FCF = 1/(WACC-g)

Comparables will have a similar MV firm/FCF provided they:

Have the same WACC (requires similar D/(D+E)).

And are growing at a similar rate.
66
Bottom Line on Multiples

Multiples complement APV/DCF methodology:

Check on valuation; market based perspective.

Extremely useful when you do not have cash flow projections.

EBITDA or cash-flow multiples are preferable to (net) earnings
multiples.

More consistent treatment of leverage.

Companies with different leverage will have different P/E

multiples, even tough same business risk and growth.

Less ability to manipulate

Easier to manipulate net earnings through accountings than
EBITDA or cash flow.
67
Pros and Cons of Multiples
Pros:

Incorporates simply a lot of information from other valuations in a
simple way.

Embodies market consensus about discount rate and growth rate.

Free-ride on markets information.

Can provide discipline in valuation process by ensuring that your
valuation is in line with other valuations.

Sometimes, what you care about is what the market will pay, not
the fundamental value.
68
Pros and Cons of Multiples (cont.)
Cons:

Difficult to find true

comparables. Implicitly assumes all
comparables are alike in growth rates, cost of capital, and
business composition. Hard to find true comparables in real life.

Hard to incorporate firm-specific information. Particularly
problematic if operating changes are going to be implemented.

Relies on accounting measures being comparable too.

Differences in accounting practices can affect earnings and
equity-based multiples. Therefore better to use FCF and EBITDA
multiples.
69
Pros and Cons of Multiples (cont.)

Cons:

Book values can vary across firms depending on age of PPE.

If market is overpaying, you will too!
70
Bottom Line On Multiples

Because of the many limitations, never rely on just a single

multiple or on valuation based only on multiples.

Best to use multiples only as a check for the valuation based

on
discounted cash-flows.

After you have done a throughout

valuation, you can compare
your predicted multiples, such

as P/E and market-to-book, to
representative multiples of

similar firms.

If your predicted multiples are out of line then

you have to
convince yourselves (and your clients) that your

model is
reasonable.
71
Bottom Line On Multiples (cont.)

Because of accounting differences, be careful in using multiples

to compare firms across industries, and especially,

across
countries.

As a rule of thumb when choosing the basis for multiples,

remember that:

The higher up the basis is in the income

statement (e.g. sales) the
less it is subject to changes in

the accounting method.

On the other hand, the less it

reflects differences in operating
efficiency across firms (e.g. firms pricing policies, production
efficiency, etc.).
72
After Valuation is Done!

Three possible answers:

NPV >> 0

=

GO!!

NPV << 0

=

No Go*

NPV = 0

=

Think More.

*Are there future options in project?

Try to incorporate these in cash flows.

Are we overpaying?

Have we properly accounted for financial / capital structure
effects on real cash flows:

changes in incentives?

costs of financial distress?
73
Takeaways

It is important to separate the value created by underlying assets
and those coming from financing.

APV does this directly and is a very flexible tool. Sometimes it

can be difficult because you need to know the future levels of
debt.

Both WACC and APV force you to get the asset beta, so you
have to be able to do this!

If applied correctly, both give the same answer.

APV is aesthetically cleaner in terms of the source of the value

generation. APV does not mix the valuation of operation with
the effects of financing.
74
Takeaways (cont.)

For APV we need to know the level of debt outstanding each
year

more suitable for LBOs.

For WACC we need to know the D/V ratio each year.

You should understand the conceptual differences between
these two methods and why in principle we prefer APV.

Remember there are other cash flows methods you should bear
in mind. Go through the examples and be sure you are capable
of computing each of the cash flows.

Best to use multiples only as a check for the valuation based

on
discounted cash-flows.
Example (Be Sure To Go Through It!)
Valuation Of Private Companies
84
Valuing Private Companies

There are three major complications in the case of a private
company:

We have much less information available.

Estimating Cost of Equity.

Estimating Cost of Debt.

Estimating Cash Flows.

Effect of Illiquidity on Value.

Control Issues.
85
I. Less Information: Cost of Equity
The problem with a private company is that there are no past
prices to estimate risk parameters (betas).
Two Possible Solutions
1.

Estimate

of a comparable traded firm.

Remember to correct for different capital structure.

A simple test to see if the group of comparable firms is truly
comparable is to estimate a correlation between the revenues or
operating income of the comparable firms and the firm being
valued.

Even after we compute the
A
from comparable companies, we
do not have a market value of debt and equity to compute
leverage.
86
I. Less Information: Cost of Equity (cont.)
2.

Assume that the private firm will move to the industry average
debt ratio.

The

for the private firm will then also converge on the industry
average beta.

Might not happen immediately but over the long term.

Alternatively you may try to estimate the optimal debt ratio for

the company, based upon its operating income and cost of
capital.
87
I. Less Information: Cost of Debt

The main problem is that private firms generally do not access
public debt markets, and are therefore not rated.

This problem might also happen with public companies.

Most debt on the books is bank debt, and the interest expense
on this debt might not reflect the rate at which they can borrow.

One possible solution is to assume that the private firms can
borrow at the same rate as similar firms in the industry.

Alternatively, you can estimate the appropriate bond rating for
the company, based upon financial ratios, and use the interest
rate related to the estimated bond rating.
88
I. Less Information: Cost of Debt (cont.)

Finally, if the debt on the books of the company is long-term
and recent, the cost of debt can be calculated using the interest
expense and the debt outstanding.

Caveat: If the firm borrowed the money towards the end of the
financial year, the interest expenses for the year will not reflect
the interest rate on debt.
89
I. Less Information: Cash Flows
There are special problems associated with estimating cash

flows for a private firm:

Shorter History

Private firms often have been around for much shorter time
periods than most publicly traded firms.

There is less historical information available on them.

Different Accounting Standards.

The accounting statements for private firms are often based upon

different accounting standards than public firms, which operate
under much tighter constraints on what to report and when to
report.
90
I. Less Information: Cash Flows (cont.)

Mix of Personal and Business Expenses.

In the case of private firms some personal expenses may be
reported as business expenses.

Separating Salaries from Dividends.

It is difficult to tell where salaries end and dividends begin in a
private firm, since they both end up with the owner.

Rules of Thumb

Dealing With Special Problems.

Re-state earnings using consistent accounting standards.

If any of the expenses are personal, estimate the income without

these expenses.

Estimate a reasonable salary based upon the services the owner
provides the firm.
91
II. Effect of Illiquidity on Value

There is a general agreement that the value of the company
should be lower because of illiquidity.

The problem is by how much? Lots of disagreement!

Some recent studies suggest that the liquidity discount is
between 20-30% for private firms.

Adjust subjectively for size.

Make the discount smaller for larger firms.

Some Facts:

Discounts should be reduced by:
1.

Roughly 6% for a firm with $100M in revenue.
2.

Up to 11% for a company with $1B in revenue.

If earnings are negative, increase the discount.
92
III. Effects of Control

Purchasers pay a premium for control positions.

Many studies show that control block trade at a premium for
public companies.

This is because once you have control you can improve the
company.

It is almost like a takeover.

There is no guideline on how to compute the control premium
in DCF.

You should take into account in your projections what you think
you can accomplish with control!

Alternatively, you can use transaction multiples.

However, trying to find comparables both in terms of transaction

and firm is difficult.
Appendix:
Computing Asset and Equity Betas
94
Computing Asset Betas and Equity Betas
How to Measure |
A

?

The value of the levered firm is given by V
L

= D + E.

Since, V
L

= V
U
+ PV(TS), then V
U

= D + E -

PV(TS).

And therefore:

Which we can be re-written as:
U U U
D E PV(TS)
V V V
A D E TS | | | | = +
U
V D E PV(TS) A D E TS | | | | = +
95
Computing Asset Betas and Equity Betas (cont.)

Now we need to assume something about |
TS

.

Assumption 1: The risk of the tax savings is the same as the
risk of the debt that generates it (|
TS
= |
D

).

Then the previous equation becomes:

And since V
U

= V -

PV(TS), we have:
D - PV(TS) E
V - PV(TS) V - PV(TS)
D E | | | = +
U U U
D E PV(TS)
V V V
A D E D | | | | = +
96

This formula simplifies under some special cases.

If D is constant:

If, in addition, the debt is riskless (|
D

= 0):
D(1 ) E
V D V D
C
D E
C C
t
t t
| | |
= +

D
1 (1 )
E
( )
E
C
A
t
|
| =
+
97

Assumption 2: The risk of the tax savings is the same as the
risk of the existing assets (|
TS
= |
A

).

Then we are left with,

And since, V
L

=V
U

+ PV(TS) we have that:

Conclusion: We can compute |
A

just using the values from the
levered firm in the Finance I formula.
U (V PV(TS)) D E
A D E
| | | + = +
D E
V V
D E | | | = +

Review of Valuation Methods

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Review of Valuation Methods

Uploaded by

Copyright:

Available Formats

Advanced Corporate Finance

Advanced Corporate Finance. Spring 2011 Brandon Julio

You might also like