Crash Course Company Valuation

Crash Course – Company Valuation The Absolute Basics

What is Being Valued? Enterprise value – is the value of the firm to all providers of capital.. Equity, debt and other. Equity value – is the value of the firm to the providers of equity capital only, i.e. Shares. Cashflows to the enterprise are discounted using cost of capital to the enterprise Cashflows to equity are discounted using cost of equity capital.

Valuation Approach – the Choices Cashflow Valuation 

DCF



EVA

Multiples 

Enterprise



Equity



Operational

Asset based

– break up scenarios

Optimal Deprival Value – market power Capitalisation Rate

– real estate assets

Presentation Logic Deals with: Cost of capital

– common to all methods

Capital structure – common to all methods Cashflow model Multiple model

Capital Structure Generally the capital structure consists of: 3.

4.

Equity – representing business and asset risk Debt

– representing financial risk

Debt is lower cost than equity, but Using more debt adds financial risk, and Thus – increases the cost of equity Debt may have tax advantages.

Cost of Capital Value is destroyed unless projects and companies meet or beat their cost of capital: 1.

2.

3.

4.

Cost of capital is an opportunity cost – the sacrifice to investing in the company Cost of capital represents the risks in investing in the company All providers face their own cost of capital – debt, equity, or a mixture The company faces a mix or blend called weighted average cost of capital.

All Roads Lead to Cost of Capital Despite their apparent differences, all valuation methods: 3.

4.

5.

Can and are related to a cost of capital – DCF, EVA, Cap rate, ODV, asset value Multiples can be directly linked to cost of capital through the reciprocal relationship Express cost of capital components in one way or another

The Cost of Debt Capital The market cost of raising the marginal tranche of debt capital (the next increment)... 3.

The riskfree rate (as proxied by [say] well traded government debt in country of cashflow origin)

Plus 5.

A debt premium reflecting industry and company business risk

As determined by rating or market data.

The Cost of Equity Capital The market cost of raising the marginal tranche of equity capital (the next increment)... 3.

The riskfree rate (as proxied by [say] well traded government debt in country of cashflow origin)

Plus 6.

The premium for investing in equities (ERP equity risk premium) of 4.0% – 7.0%

Times

Equity Beta (the index of company risk)

Two Betas – Equity and Asset Equity beta = asset beta / (1 – debt % ) 

Only equity beta can be measured in the market

Asset beta = equity beta * (1 – debt % ) 

Asset beta must be derived from equity beta

Building an equity beta 

Establish the equity beta for an industry



Find asset beta given industry capital structure



Use company capital structure to find company equity beta

Draw data from Bloomberg or similar

Summarising.... Cost of debt = risk free + debt risk premium Cost of equity = risk free + (equity beta * ERP) In the capital structure of debt and equity: 

Equity is valued at the cost of equity



Debt is valued at the cost of debt

Last twist: Debt is adjusted for tax deductibility... Multiply it by (1 – Tc).... The corporate tax rate.

Weighted Average Cost of Capital

Riskfree Debt Tax rate rate Premium Cost of Debt 5.0% 2.0% 30.0% Cost of Equity 5.0% N/A N/A Percent debt Percent equity TOTAL

ERP

Equity Beta N/A N/A 5% 1.25

40% Weighted cost debt 60% Weighted cost equity 100% WACC

1.96% 6.75% 8.71%

4.9% 11.3%

The Cashflow Valuation Equation Value of near term cashflows Plus

Terminal value Discounted to Present value at: 7.

The WACC for the value of the enterprise

8.

The flows to equity for the value of equity

Cashflow to the enterprise is.... Earnings before interest and taxes (EBIT) Minus Cash taxes on EBIT Minus Investments Plus Depreciation Plus (minus) Change in Working capital equals Free Cash Flow…. Available to ALL INVESTORS

Estimating Terminal Value 2.

4.

6.

8.

Estimate a constant growth rate ( g ) from last year of the near term flows Multiply the estimated cashflow of the last year of the near forecast period by 1 + g Divide this value by WACC minus g to get terminal value Discount TV back to the present using WACC.

Enterprise and Equity Value Enterprise value = near term plus terminal Equity value = enterprise value less debt Test: 

Cashflow sensitivities



Cost of capital sensitivities



Terminal value sensitivities (growth rate)

The Valuation Multiple Equation Based on comparative analysis Comparisons drawn from: 

Market observations



Transaction observations



Fundamental data

All adjusted to “normalise” data and allow as analysis of “like with like” to greatest extent possible or feasible.

Multiple Valuation - Process Process to calculate: 

Identify an appropriate variable



Find the necessary inputs for the calculation



Normalise - adjust the numbers to remove extraordinary or one off effects



Compute ratio – numerous formulae available



Apply multiple to company being valued



Check against another method

Enterprise Multiples Estimate value of the enterprise to all capital providers: EBITDA – most “cash like”, skirts accounting issues, captures operating costs, only deals with tax indirectly. Revenue – useful with negative or zero earnings, skirts accounting treatment, difficult to “launder”.

Equity Multiples Estimate value of the enterprise to equity capital providers: P|EBIT – avoids tax and capital structure differences, pre tax relationship to other methods. P|E – very popular, oft quoted, simple to understand, difficult to compare because of tax and capital structure differences. NOTE: 1 / P|EBIT = (pre tax) ROIC

Operating Multiples Many industries have unique operating multiples which can be used comparatively: Media Energy Accommodation Tourism Agriculture Telecommunication

P | number of subscribers P | KWh production capacity P | number of room P | visitor nights / spend P | output per stock unit P | fixed / mobile subscribers

Identical process to other cases. Identical weaknesses.

Multiples - Characteristics Advantages 

Simple and resource light



Easy to communicate



Commonly used

Disadvantages 

Single variable focus simplistic



Assume “straight line” trend



Subjective in normalising and comparing

Conclusions Valuation is... A blend of art and science but a disciplined and systematic blend. Thoroughly dependent on all of the explicit and implicit assumptions made. An estimation process whose outer limits ought to be tested for revision purposes. Likely to perform best when it reflects “fit for purpose” decisions in design.