Finance Theory II - Wrap-Up of Valuation Section A

Wrap-up Final Exam • Rules of the game: → No laptops → Closed books → Two (2) letter-sized cheat sheets → Bring a calculator Aside: Incentives • Whenever structuring a deal, be it on the RHS or the LHS of the balance sheet, make sure that all players have the right incentives. • Example: 1. You want to see a decent review of the course material. 2. The professor is motivated by his teaching ratings (because he doesn’t want the Dean to beat him up). Ÿ It is a bad idea to fill out the teaching rates before the professor has delivered the review! You are inviting moral hazard. Ÿ Similar to the Southland case – don’t let crucial players cash out too early! Valuation by Multiples: • Assess the firm’s value based on that of publicly traded comparables. • 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 • (Book) Asset-based multiples: → MV of firm/BV of assets, MV of equity/BV of equity Procedure • Hope: Firms in the same business should have similar multiples (e.g. P/E). → Requires similar levels of risk. → Requires similar expected growth rates. • STEP 1: Identify firms in same business as the firm you want to value. • STEP 2: Calculate P/E ratio for comps and come up with an estimate of P/E for the firm you want to value (e.g. take the average of comps’ P/E). • STEP 3: Multiply the estimated P/E by the actual Net Income of the firm you want to value. Remarks • 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-PhD. multiples! • For transactions, can also use multiples for comparable transactions (e.g. similar takeovers). • 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 comps have very different leverage. Comparables: Pros and Cons Pros: • Incorporates a lot of information from other valuations in a simple way. • Embodies market consensus about (comp’s) discount rate and growth rate. • Free-ride on market’s information. • Can provide discipline in valuation process by ensuring that your valuation is in line with other valuations. Cons: • Implicitly assumes that comps are alike in growth rates, cost of capital, and business composition. Hard to find true comps. • Hard time incorporating firm specific information. Particularly problematic if operating changes are going to be implemented. • Accounting differences, particularly with earnings and equity-based measures. Multiples of FCF and EBITDA preferable for this reason. • Book values can vary across firms depending on age of PPE. • If everyone uses comps, who actually does fundamental analysis? Wrap-up of Valuation Valuation Valuation tools: • Free cash flows • Cost of capital: WACC and APV • Real options Valuing companies • DCF analysis: → Forecast horizon and terminal values → EVA: When is growth good? • Comparables, Multiples. Estimating the FCF • Free cash flows (FCF) are the expected after-tax cash flows that the firm would generate if it were 100% equity financed. FCF = EBIT*(1-t) + Depreciation - CAPX - ∆NWC FCF = EBITD*(1-t) + t * Depreciation - CAPX - ∆NWC FCF = EBIT*(1-t) - ∆NA Recall: • NWC = Current assets – Current liabilities • NA = Assets – Current liabilities. Some Things to Keep In Mind: • Formulas need to be adapted to particular situations: → Need to understand the economics (e.g. Southland’s asset sales). • Use all incremental cash flows: → Ignore sunk costs, count opportunity costs, avoid “accounting illusions”… • Don’t forget FCF at the end of the project’s life: → If liquidated: SV*(1-t) + t * PPE, recoup NWC. → If not liquidated: Terminal values. • FCF ignores the tax shield provided by the firm’s debt. • We deal with it separately in APV or WACC. Do not include the effects of financing at this stage: You would count them twice! APV – Adjusted Present Value • Step 1: Value if 100% equity, i.e. use kA to discount the project’s FCF k A = rf + β A ⋅ Market Risk Premium • Step 2: Add PV(Tax Shield) → Count only tax savings actually attributable to the project. → Use the marginal (as opposed to the average) tax rate. → Use expected (as opposed to maximal) interest payments. • Caveat: For high D/V, should count expected costs of financial distress. Weighted Average Cost of Capital (WACC) • Approach: Adjust the discount rate to account for the tax shield. WACC = D E k D (1 − t) + kE D+E D+E • Most widely used DCF analysis method. • The aim is to avoid 1st order mistakes: → Everything in WACC is project-specific (except for tax rate t). → Firm-wide WACC is OK only if project comparable to the firm → WACC can be used only if D/V is reasonably stable Embedded Real Options: Real Options = Managerial flexibility to react to new information. • Sometimes, much of a project’s value is in embedded options. • Conditions for there to be an option: (1) New information will possibly arrive in the future. (2) When it arrives, the new information may affect decisions. • Frequently encountered options: Options to grow, abandon, expand/contract, time, switch (inputs, outputs, processes, etc.) • Valuation: → Black-Scholes → Scenario analysis and decision trees Take-Aways: • Main merit of DCF analysis: Forces to argue where value comes from Î Most important step is a reasonable forecast of FCF. • Sales forecasts: Reasonable given the firm’s resources, the industry, and competition? What market share is needed? • Margin forecasts: Reasonable given potential competition/entry barriers and bargaining position with suppliers and customers? • CAPX and other investment forecasts: Consistent with the sales and margin forecasts? • Terminal value: Does it make sense? • Sensitivity analysis: What variables and assumptions are crucial to the value? Get more information about these levers. Take-Aways cont.: • Valuation by multiples and DCF valuation methods are complements, not substitutes! • Comparables and multiples are important but: → don’t tell you where value comes from; → whether comparables are really comparable. • DCF analysis (+ real options) forces to justify valuation but: → only as good as the data input; → relies on imperfect models. • Go back and forth between the two approaches. Conclusion Financing • The bulk of the value is created on the LHS by making good investment decisions. • You can destroy much value by mismanaging your RHS: Financial policy should be supporting your business strategy. • You cannot make sound financial decisions without knowing the implications for the business. • Avoid one-size-fit-all approaches. • Finance is too important to leave it to finance people. Valuation • Making sound business decisions requires valuing them. • This involves mostly knowing the business (to make appropriate cash-flow forecasts and scenario analyses) • But also some finance: → What discount rate? → Valuation exercises help to identify the key value drivers and often inform the business strategy. • Avoid one-size-fit-all approaches. • Business is too important to leave it to business people.