Finance Theory II - Wrap-Up of Valuation Section B

Wrap-up of Valuation Final Exam ƒ Rules of the game: ¾ No laptops ¾ Closed books ¾ Cheat sheet 2 Valuation Valuation tools: ƒ Free cash flows ƒ Cost of capital: WACC and APV ƒ Real options Valuing companies ƒ DCF analysis: ¾ Forecast horizon and terminal values ¾ EVA: When is growth good? ƒ Comparables, Multiples 3 Estimating the FCF ƒ 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) + Dep. - CAPX - ∆NWC FCF = EBITD*(1-t) + t * Dep. - CAPX - ∆NWC FCF = EBIT*(1-t) - ∆NA Recall: ƒ NWC = Current assets – Current liabilities ƒ NA = Assets – Current liabilities. 4 FCF = EBIT*(1-t) + Dep. - CAPX - ∆WC ƒ This expression amends EBIT(1-t) which is an accounting measure of cash flow into an economic measure. ƒ CAPX not reported as cash outflow but is one D - CAPX ƒ Depreciation ¾ is reported as cash outflow but is not one D Add (1-t)*Dep ¾ however, depreciation does imply a cash inflow of t*Dep. ¾ Altogether D + Dep ƒ Working capital has an opportunity cost D - ∆NWC 5 Other Things to Keep In Mind ƒ Formulas need to be adapted in particular situations ¾ Need to understand the economics (e.g., Southland’s asset sales) ƒ Use all incremental cash flows: ¾ Ignore sunk costs, Count opportunity costs, Avoid “accounting illusions”… ƒ Don’t forget FCF at the end of the project’s life: ¾ If liquidated: SV*(1-t) + t * PPE ¾ Even if not liquidated, recoup WC ƒ ƒ 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! 6 APV Step 1: Value if 100% equity 1. Identify comps, i.e., publicly traded pure plays in same business. 2. Unlever each comp’s βE to estimate its βA using βA = βE E E+D (OK if the comp’s D not too high (+ can assume their D/V is stable)) 3. Use the comps’ βA to estimate the project’s βA (e.g., as average). 4. Use estimated βA to calculate the all-equity cost of capital kA k A = rf + β A ⋅ Market Risk Premium 5. Use kA to discount the project’s FCF 7 Why We Need to Unlever ƒ Comps may have different leverage ƒ Equity in a firm with debt is more risky than equity in a firm without debt because debt receives some of the safe cashflows. Note: Business Risk and Financial Risk ƒ ƒ ƒ Financial risk has nothing to do with costs of financial distress! Similar firms have similar business risk (βA) but can have different financial risk (βE-βA) if they have different leverage. As leverage increases, equity becomes riskier (i.e. βE Ò). 8 APV Step 2: Add PV (Tax Shield) ƒ If the project’s D is constant over time, then PV(TS) = t*D*kD / kD = t*D ƒ If the project’s D/V is constant, then PV(TS) = t*D*kD / kA ƒ If there is a known debt policy or repayment schedule ¾ you can simply forecast actual debt levels and discount by a rate between kD and kA 9 APV Step 2: Add PV (Tax Shield), Remarks ƒ Count only debt attributed to the project ¾ Recall: If a project is 100% debt finance, some of the debt is probably issued against firm’s other assets ƒ Make sure to discount expected not maximum tax shields ¾ This is particularly important for high D/V ƒ For high D/V, should count costs of financial distress ƒ Recall: Use the marginal (as opposed to the average) tax rate 10 Weighted Average Cost of Capital (WACC) ƒ Approach: Adjust the discount rate to account for the tax shield. WACC = ƒ ƒ 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: ¾ A priori, WACC is project-specific (except for tax rate t) ¾ Firm-wide WACC is OK only if project comparable to the firm 11 Leverage ratio: D/(D+E) ƒ What we want: The debt that is incremental to the project, i.e., that could not be raised w/o the project. ƒ 1st-order mistakes we want to avoid: ¾ Use the deal’s leverage ratio; ¾ Use the “acquirer”’s leverage ratio. ƒ Imperfect approach to what we want: ¾ Target leverage ratio if project/firm were a stand-alone ƒ How we get there: ¾ Get D/V from comps, business plan, checklist, etc. 12 Cost of debt capital: kD ƒ What we want: Expected return for creditors if project were a stand-alone with leverage ratio D/(D+E) estimated above. ƒ Imperfect approach to what we want: kD close the interest rate charged to project as stand-alone (unless debt is very risky). ƒ How we get there: ¾ Find comps with similar leverage + recent interest rate. ¾ Estimate the debt rating and examine corporate yield curve. ƒ 1st-order mistakes we want to avoid: ¾ Use the interest rate in the deal or of the “acquirer”; 13 Effective Marginal Tax Rate t ƒ Marginal tax rate of firm undertaking the project: t 14 Using CAPM to Estimate kE 1. Find comps for the project under consideration. 2. Unlever each comp’s βE (using its D/(D+E)): βA = βE E E + D 3. Use the comps’ βA to estimate the project’s βA (e.g. average). 4. Relever the project’s estimated βA (using its own D/(D+E)): βE = D⎤ E+D ⎡ β A = ⎢1 + ⎥ β A E⎦ E ⎣ 5. Use the estimated βE to calculate the project’s cost of equity kE: k E = rf + β E ⋅ Market Risk Premium Note: These (un-) levering formulas are OK only if the (comp) firm’s debt is not too risky and its D/V is reasonably stable. 15 Remarks ƒ WACC can be used only if D/V is reasonably stable ƒ Use APV when debt is very risky and/or when D/V is unstable (recall the Southland LBO case) ƒ WACC is an attribute of the project, not the firm (except tax rate) ƒ OK to use the firm’s WACC when project is very much like the firm (because the firm happens to be a comp for the project). ƒ Few companies have WACC that they can use for all projects (recall our discussion of GE). 16 Real options Embedded options ƒ Follow-up investments ƒ Option to abandon the project ƒ Option to wait before investing ƒ Option to expand / change production methods Key issues ƒ Identification ƒ Valuation 17 Identify significant options ƒ Look for clues in project’s description and cash flow pattern ¾ “Phases”, “Strategic investment”, “Scenarios”… ¾ Large expenditures are likely discretionary ƒ Is there an option? Verify two conditions: (1) News will possibly arrive in the future; (2) When it arrives, the news may affect decisions. ƒ Search for the uncertainty that managers face: ¾ What is the main thing that managers will learn over time? ¾ How will they exploit that information? 18 Practical Issue: Simplifications ƒ Search for significant options ¾ E.g., option to shut down the plant may not be very valuable (why?) ¾ Look for primary sources of uncertainty ƒ Cut the projects into simple options ¾ You might want to ignore nested options (difficult to value) ƒ Use European rather than American option ƒ Ignoring some adverse effects of waiting (e.g. possible entry) A simplified model that is dominated by the project gives a lower bound for the project’s value (and vice versa). 19 Value the options Step 1: ƒ Start with the simple DCF analysis ¾ Pretend that there is no option embedded in the project ¾ This benchmark constitute a lower bound for the project’s value Step 2: ƒ Value the option ¾ Decision trees (dynamic DCF) ¾ Option pricing models (Black-Scholes) 20 Mapping: Project Æ Call Option Project Call Option Expenditure required to acquire the assets X Exercise price Value of the operating assets to be acquired S Stock price (price of the underlying asset) Length of time the decision may be deferred T Time to expiration Riskiness of the operating assets σ2 Variance of stock return r Risk-free rate of return Time value of money 21 Practical Issue: What Volatility? What do we want? ƒ Standard deviation of returns for the underlying asset ƒ In case of real options, the underlying is the PV of the project’s CFs Imperfect ways to get it? ƒ Informed guess ¾ 20-30% per year is not remarkably high for a single project. ƒ Data ¾ Historical return volatilities on comparable traded assets ¾ Implied volatilities can be computed from quoted option prices ƒ Simulations 22 Valuing Companies ƒ Terminal values: ¾ Liquidation ¾ Flat, growing, or decreasing perpetuity ƒ EVA: When is growth good? ƒ Comparables, Multiples. 23 Terminal Values ƒ Liquidation: Should be adjusted (e.g. if cannot recoup all A/R, etc.) SV * (1-t) + t*PPE + WC ƒ Growing perpetuity: Take EBIT and NA in last year of forecast TV = [(1+g)*EBIT*(1-t) - g*NA] / (k-g) ƒ Flat perpetuity: TV = EBIT*(1-t) / k 24 Terminal Values, Remarks ƒ Growing perpetuity formula assumes a linear relationship between EBIT and NA ƒ Don’t forget to take PVTV ƒ Forecast horizon: Company is reasonably stable afterwards 25 EVA ƒ Growth is valuable when (very roughly!): EVA = EBIT*(1-t) - k*NA > 0 ƒ or EBIT*(1-t) / NA > k Growth is good if the cost of scaling up NA is offset by the value of increased revenues. Remarks: ƒ Assumes linearity between EBIT and NA and that NA is a good measure of marginal “replacement cost”, now and in the future. ƒ EVA has nothing to do with sustainable growth. 26 EVA: Bottom Line Use EVA as… ƒ … a simple measure of whether a business is generating value and whether growth is enhancing value ƒ … as a way of setting goals to enhance value Beware of EVA for... ƒ … young companies ƒ … companies in rapidly changing business environment ƒ … companies in which book values are not accurate measures of marginal replacement cost. 27 Multiples ƒ Assess the value based on that of publicly traded comps ƒ Cash-flow based Value multiples ¾ MV(firm)/Earnings, MV(firm)/EBITDA, MV(firm)/FCF,... ƒ Cash-flow based Price multiples: ¾ Price/Earnings, Price/EBITDA, Price/FCF,... ƒ Asset-based multiples: ¾ MV(firm)/BV(assets), MV(equity)/BV(equity),... 28 Motivation for Multiples? ƒ Assumption 1: ¾ E = CF to shareholders ¾ E is a perpetuity E P= kE − g ƒ ⇒ P 1 = E kE − g Assumption 2: ¾ Comps have the same kE => This requires similar leverage! ¾ Comps are growing at a similar rate g 29 Multiples: Pros and Cons Pros: ƒ Incorporates simply a lot of information from other valuations ƒ Embodies market consensus ƒ Can provide discipline for DCF valuation: Ask yourself “How do I explain the difference?” ƒ Sometimes, what you care about is what the market will pay, not the fundamental value (e.g., Venture firm will want out). Cons: ƒ Hard to incorporate firm specific information. ƒ Relies on accounting measures being comparable too. 30 Other Things to Think About Control: ƒ With a controlling stake, influence operations, implement synergies and capture (part of) their value ƒ Also, entrepreneur might care about “the vision” Large individual shareholder (e.g., entrepreneur): ƒ Maybe very undiversified, at least for a while Liquidity: ƒ Especially for private companies ƒ Note: Need to account for IPO plans 31 Valuation: Conclusion ƒ Main merit of DCF analysis: Forces to argue where value comes from D Most important step is a reasonable forecast of FCF. ƒ 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. ƒ ƒ ƒ ƒ 32 Valuation: Conclusion ƒ The different methods are not mutually exclusive. ƒ Comparables and multiples are important but: ¾ don’t tell you where value comes from; ¾ whether comparables are really comparable. ƒ DCF analysis (+ Real options) forces to justify valuation but: ¾ only as good as the data input; ¾ relies on imperfect models. ƒ Go back and forth between the two approaches. 33 Course: Conclusion What We Have Been About ƒ Acquire a few general tools: ¾ Capital structure ¾ DCF analysis ¾ Comparales and multiples ƒ Avoiding 1st order misconceptions (list your own below if any): ¾ ¾ ¾ etc. ƒ Developing a healthy skepticism. 35 Financing ƒ The bulk of the value is created on the LHS by making good investment decisions. ƒ You can destroy much value by mismanaging your RHS: Financial policy should be supporting your business strategy. ƒ You cannot make sound financial decisions without knowing the implications for the business. ƒ Avoid one-size-fit-all approaches. ƒ Finance is too serious to leave it to finance people. 36 Valuation ƒ Making sound business decisions requires valuing them. ƒ This involves mostly knowing the business (to make appropriate cash-flow forecasts and scenario analysis, etc.) ƒ But also some finance: ¾ What discount rate? ¾ Valuation exercises can indicate key value levers,... ƒ Avoid one-size-fit-all approaches. ƒ Business is too serious to leave it to business people. 37