Riskmathics

Pricing Companies and Mergers & Acquisitions

Day 3

Adjustments in Valuation

Adjustments

The most significant errors in valuation occur after you think you are
done, where you are tempted to start adding or subtracting
arbitrary amounts from your carefully estimated value for items that
sound reasonable - illiquidity, control, synergy, etc.

We have to fight this temptation because it undercuts the integrity of

the entire valuation process... Illiquidity, control, synergy could well
be important but we should try to assess the value rather than
assume that it is always 25% or some other arbitrary amount of the
estimated value.

Changing the Dish

A $324 bowl of noodles at Niu

Ba Ba in Taipei, Taiwan (Chef:
Wang Cong-yuan).

$1.25 instant noodles.

Adjustments
Enterprise Value (EV)

PV(FCFF) Value of operating assets = EV

+ Value of Cash

Operating vs. non-operating cash

Discount cash?

+ Other Non-Operating Assets

Unused or underutilized assets?

+/- Holdings in Other Companies

Majority vs. minority holdings

How to value holdings? What if non-public firms?
Add or subtract?

= Value of Firm

Discount for complexity of the firm?

Premium for intangibles (e.g., brand name)?

- Value of Debt

Interest-bearing debt
Book or market value?

- Value of Other Liabilities

Underfunded pension and health liabilities?

Law suits and other contingent liabilities?

= Value of Equity

Truncation risk?
Premium for control?

- Value of Equity in Options

Issued vs. future options?

Vested vs. non-vested?
How to value options?

= Value of Equity in Common Stock

= Value of Equity in Common Stock / # Shares

Divide by primary, diluted, or outstanding shares?

Discount for illiquidity?

1) Value of Cash

The Value of Cash

An analyst is valuing a company with a significant cash balance and

argues that the market will penalize the company for holding cash
because the cash earns a return that is lower than the companys
cost of capital (WACC).
True?
False?

Whats the Value of 100 Mexican Peso of Cash?

(Inside a Company)

Dealing with Cash in Valuation

The simplest and most direct way of dealing with cash is to keep it
out of the company valuation until the very end.

The cash flows should be before interest income from the cash, and
the discount rate should not be contaminated by the cash.

Once the operating assets have been valued, you simply add back
the value of the cash. Separate the valuation of operating
assets and cash.

But

Example

When does cash have a discount?

When does cash have a premium?

Example: Hewlett Packard

Recent history of very bad acquisitions.

Two very large acquisitions ($13.9B for Electronic Data Systems and
$11B for Autonomy), but written off about $8B of that already.

Companies dont own cash they manage the cash on behalf of

their shareholders.

Do you want HP to manage your cash?

Discount Cash?

Some analysts argue that (excess) cash should be discounted

because it earns a low return. Not correct!

If the cash is invested in marketable securities (e.g., government

bonds), it should earn a low return. If the return is the risk-free rate,
given that it is a risk-free investment, cash does neither add, nor
destroy, the value of the company.

Managers can do suboptimal and stupid things with cash (e.g.,

overpriced acquisitions, pie-in-the sky projects) and you have to
account for this possibility. This is the reason to discount cash!

Discount should be a function of corporate governance, past history

of the company/management/acquisitions, etc.

Market Value of $1 in Cash

2) Other Non-Operating Assets

Other Non-Operating Assets?

Assume you have discounted FCFF at the WACC and have an

enterprise value. Should you add the present value of:
Headquarter building in Hong Kong?
Vacant land owned by the company in Australia?
Patents (currently used in the production of the products)?
Brand name (accounting estimate of the intangible value)?
Art collection (acquired by current CEO, using corporate funds)?
Goodwill?

Example: The Playboy Mansion ($80-100M)

Hugh Heffner, 1926-?

Other Non-Operating Assets

Unused or underutilized assets:

If firm has assets that are not fully utilized, you have not valued it!
Value the asset and add to the value of the firm.

Overfunded corporate pension plan:

If firm has defined benefit plan and its value exceeds the firms expected
pension liability.
Add excess pension plan value to the firm.
Caveats:
Collective bargaining agreement may prevent firm from claiming the plan.
Withdrawls from pension plans may get taxed at much higher rates.

3) Holdings in Other Companies

Categories of Holdings in Other Companies

Minority passive holdings.

Only dividends from the holdings are shown in the income statement (below
operating income line), and original investment on the balance sheet.
Example: At one point, 70% of Japanese VC firm SoftBank was Yahoo holding
(a few years after the initial minority investment). Still, nothing showed up in
Softbanks income statement because Yahoo didnt pay dividends, and only
$50M in balance sheet though it was worth $7B!

Minority active holdings.

Most minority holdings are active (e.g., sit on the board).
The portion of net income is shown in the income statement, but below the
operating income line, and the original investment plus the portion of
retained earnings on the balance sheet.

Majority active holdings.

The financial statements are 100% consolidated.
Minority interest.

Example: Tata Motors Holdings

Example

Assume that you have valued Company A using consolidated

financials for $1B (using FCFF and WACC) and that the firm has
$200M in debt. How much is the equity in Company A worth?

Now assume that you are told that Company A owns 10% of
Company B and that the holdings are accounted for as minority
passive holdings. If the market cap of Company B is $500M, how
much is the equity in Company A worth?

Now add on the assumption that Company A owns 60% of Company

C and that the holdings are fully consolidated. The holding in
Company C is booked at $40M in Company As balance sheet
(minority interest). How much is the equity in Company A worth?

What are the problems?

In Perfect World
1) Value the parent company without any holdings. This will require
using unconsolidated financial statements for both parents and each
holding rather than using consolidated ones.
2) Value each of the holdings individually. If use the market values of
the holdings, errors the market makes in valuing them are automatically
built into the valuation, which is not good.
3) Value of the equity in the parent company with N crossholdings:
Value of non-consolidated parent company
Debt of non-consolidated parent company
+

jN

% Owned of Company j (Value of Company j - Debt of Company j)

j 1

Toyota Japanese Nightmare (Keiretsu)

Compromise in Practice
1) Market value method: If the holdings are publicly traded, take
market value and multiply by proportion the firm holds. (If market is
misvaluing the holding, you would carry that mistake over, if you dont
value also the holding intrinsically.) If the holding is a considerable
portion (>10%) of the value of the company, it is worth considering
doing a DCF of the holding.
2) Relative valuation method: Convert the book values you have on
the balance sheet by using the average price to book (P/B) ratio of
the industry in which the holdings operate. Clearly imperfect, but
most often better than relying on book values being equal to market
values, and often this is all the information that is available anyway,
so we cant really do any better than this.

4) Complexity

Example

You are an investor valuing two exactly identical firms based on

financial information identical operating income, growth, risk, return
on capital etc. Company A is in a single business and has transparent
financials. Company B is complex and in multiple businesses, with
opaque structure. Which firm, if any, would you value more highly?
Company A: It is simple to value.
Company B: It is more diversified and therefore has lower risk.
Neither: They have the same financials and should have the same value.

Complexity in Valuation

There is no room for complexity in standard valuation models.

Why not? Because this is one of these idiosyncratic firm-specific

factors that is diversified away in the CAPM. What companies dont
tell investors cant hurt them.

Is this really a realistic assumption? You invest in 100 complex

companies, and firm-specific idiosyncrasies cancel each other out
because of diversification. What information do managers not tell
investors? Good news or not-so-good news?

Accounting scandal: We made $5M more than we previously told you!

Example: Tyco International

Acquisition growth strategy.

Created very complex company.

Management decided to not reveal bad information, which was

possible (in the short term) because of complexity.

When revealed, Tycos stock 80% .

Interestingly, GEs stock 15% . Why?

Amount of Data in Financial Statements

Company
General Electric
Microsoft
Walmart
Exxon Mobil
Pfizer
Citigroup
Intel
AIG
Johnson & Johnson
IBM

Number of Pages in 10K

410
218
244
332
460
1026
215
720
218
353

Complexity Score
Operating Income
Multiple business segments
One-time income or expenses
Income or expenses from non-specified sources
Items in income statement that are volatile
Tax Rate
Multiple geographical segments
Different tax and reporting books
Headquarters in tax haven
Volatile effective tax rate
Capex & Acquisitions
Volatile capital expenditures
Frequent and large acquisitions
Stock payment for acquisitions
Working Capital
Non-specified current assets and current liabilities
Volatile working capital
Growth
Off-balance sheet assets and liabilities (operating leases and
Significant stock buybacks
Volatile return on capital
Unsustainably high return on capital
Cost of Capital
Multiple business segments
Operations in emerging markets
Public debt
Debt rating
Off-balance sheet debt
Adjustments
Holdings in other companies
Dual-class shares
Equity options
Complexity Score

Number of businesses (with >10% of revenues)

Percent of operating income
Percent of operating income
Percent of operating income

15
8.00%
12.00%
20.00%

Complexity Weight
2
10
10
5

Complexity Factor
30
0.8
1.2
1

Percent of revenues from non-domestic countries

Yes / No
Yes / No
Yes / No

60.00%
Yes
No
No

3
3
3
2

1.8
3
0
0

Yes / No
Yes / No
Yes / No

Yes
Yes
Yes

2
4
4

2
4
4

Yes / No
Yes / No

No
Yes

3
2

0
2

Yes
Yes
Yes
Yes

Yes
Yes
Yes
No

3
3
5
5

3
3
5
0

20
50.00%
Yes
Yes
Yes

1
5
2
2
5

20
2.5
0
0
5

4.00%
No
2.50%

20
10
10

0.8
0
0.25

/
/
/
/

No
No
No
No

Number of businesses (with >10% of revenues)

Percent of revenues in emerging markets
Yes / No
Yes / No
Yes / No
Percent of book assets
Yes / No
Percentage of shares outstanding

88.3

Complexity Score: Study

No correlation between Complexity Score and size of firm.

Some small companies are very complex.
Some large companies are simple.

Emerging market companies are 15-20% more complex than firms

in developed markets, primarily because of crossholdings.

The most transparent company in study: Indian company Infosys.

Disclosure laws in emerging markets put a floor, not a cap, on
disclosure. Companies can choose not to be complex.

Firms that grow through acquisitions are about 25% more complex
than those that grow internally.

Companies with a capital/financing arm (e.g., GE Capital) are also

much more complex.

Most Complex Company in Study

Operating Income
Multiple business segments
One-time income or expenses
Income or expenses from non-specified sources
Items in income statement that are volatile
Tax Rate
Multiple geographical segments
Different tax and reporting books
Headquarters in tax haven
Volatile effective tax rate
Capex & Acquisitions
Volatile capital expenditures
Frequent and large acquisitions
Stock payment for acquisitions
Working Capital
Non-specified current assets and current liabilities
Volatile working capital
Growth
Off-balance sheet assets and liabilities (operating leases and
Significant stock buybacks
Volatile return on capital
Unsustainably high return on capital
Cost of Capital
Multiple business segments
Operations in emerging markets
Public debt
Debt rating
Off-balance sheet debt
Adjustments
Holdings in other companies
Dual-class shares
Equity options
Complexity Score

Number of businesses (with >10% of revenues)

Percent of operating income
Percent of operating income
Percent of operating income

15
8.00%
12.00%
20.00%

Complexity Weight
2
10
10
5

Complexity Factor
30
0.8
1.2
1

Percent of revenues from non-domestic countries

Yes / No
Yes / No
Yes / No

60.00%
Yes
No
No

3
3
3
2

1.8
3
0
0

Yes / No
Yes / No
Yes / No

Yes
Yes
Yes

2
4
4

2
4
4

Yes / No
Yes / No

No
Yes

3
2

0
2

Yes
Yes
Yes
Yes

Yes
Yes
Yes
No

3
3
5
5

3
3
5
0

20
50.00%
Yes
Yes
Yes

1
5
2
2
5

20
2.5
0
0
5

4.00%
No
2.50%

20
10
10

0.8
0
0.25

/
/
/
/

No
No
No
No

Number of businesses (with >10% of revenues)

Percent of revenues in emerging markets
Yes / No
Yes / No
Yes / No
Percent of book assets
Yes / No
Percentage of shares outstanding

88.3

Dealing with Complexity

DCF:
Aggressive analyst: No adjustment for complexity.
Conservative analyst: Avoid investing in complex companies altogether.
Compromise. Value the firm and adjust for complexity:
Cash flows.
Cost of capital.
Growth rate and length of growth period.

Multiples:
Regression for 100 largest market cap firms:
PB = 0.65 + 15.3 ROE 0.55 Beta + 3.04 Expected g 0.003 # 10K Pages
100 additional 10K pages lowers PB ratio by 0.3.

5) Value of Intangibles

Example

Suppose you estimate the value of Coca Cola using FCFF and
WACC. At the end of the valuation, what is a reasonable premium to
add for the Coca Cola brand name?
5-10% premium.
25% premium.
Some other premium.

Example: Coca Cola vs. Cott

Revenues
High growth period
Length
Reinvestment rate
Operating margin (after tax)
Return on capital (after tax)
Growth
WACC
Stable growth period
Reinvestment rate
Return on capital (after tax)
Growth
WACC
Value of Firm

Coca Cola
$21,962.00

with Cott's Operating Margins

$21,962.00

10
50%
15.57%
20.84%
10.42%
7.65%

10
50%
5.28%
7.06%
3.53%
7.65%

52.28%
7.65%
4%
7.65%
$79,611.00

52.28%
7.65%
4%
7.65%
$15,371.00

Value of Brand Name

= $79,611 - $15,371 = $64,240

Premium

= $64,240 / $15,371 = 317%

Which Smart Phone Has the Strongest Brand?

Which Brand is Most Difficult to Value?

Coca Cola?

Sony?

Goldman Sachs?

Example: Goldman Sachs

The Goldman Sachs reputation.

One of the most difficult intangibles to value.

Seems to be able to get out a little but before everyone else (e.g., dotcom stocks, mortgage-backed securities, etc.) Put option.

Adding a premium for this is clearly very difficult!

WD-40 in Shanghai

Fake

Valuing Different Categories of Intangibles

Independent and cash flow
generating intangibles

Not independent and cash flow

generating to the firm

No cash flow now but potential for

cash flows in future

Examples

Copyrights, trademarks,
licenses, franchises,
professional practices
(medial, dental)

Brand names, quality and morale

of work force, technological
expertise, corporate reputation

Undeveloped patents, operating or

financial flexibility (to expand into
new products/markets or abandon
existing ones)

Valuation

Estimate expected cash

flows from the product or
service and discount back at
appropriate discount rate.

Compare DCF value of firm with

intangible with firm without (if you
can find one).
Assume that all excess returns of
firm are due to intangible.
Compare multiples at which firm
trades to sector averages.

Option valuation
Value undeveloped patent as option
to develop the underlying product.
Value expansion option as call
option.
Value abandonment option as put
option.

Challenges

Life is usually finite and

terminal value may be small.
Cash flows and value may
be person dependent (for
professional practices).

With multiple intangibles (brand

name and reputation for service), it
becomes difficult to break down
individual components.

Exclusivity is required.
Difficult to replicate and arbitrage
(making option pricing models
dicey)

6) Value of Debt

Whats Debt?

For WACC estimation. Focus on only interest-bearing debt, both

long-term and short-term.

Dont try to be conservative by including extra items in debt when

estimating the cost of capital because that will simply reduce the
WACC and increase the value of the firm ( not conservative!)

When deducting Debt from Firm Value. Could be more

expansive in the definition of debt.

Book Value or Market Value

You are valuing a distressed telecom company and have arrived at an

estimate of $1B for the enterprise value (using a discounted cash flow
valuation). The company has $1B in face value of debt outstanding but
the debt is trading at 50% of book/face value (because of the distress).
What is the value of the equity to you as an investor?
The equity is worth nothing (EV minus Book/Face Value of Debt)
The equity is worth $500M (EV minus Market Value of Debt)
Explain.

Would your answer be different if you were told that the liquidation value
of the assets of the firm today is $1.2B and that you were planning to
liquidate the firm today?

Lawsuits and Other Contingent Liabilities

5-10% of large U.S. companies are subject to lawsuits at any given

point in time

BlackBerry: An individual claimed they stole the core technology

content took 5 years to resolve litigation. How to value?

Phillip Morris (tobacco) lost lawsuit. $5B (!) liability.

Merck: Sued for Vioxx. Settled for much less than the lawsuit.

Value of Contingent Liability = Probability Liability Occur x Value of

Liability Contingent on Occurring.

7) Value of Control

Controlling vs. Minority Shareholders

Controlling shareholders decide:

Strategy.
Companies to acquire.
Capital expenditures.
Dividends.
Board.
Etc.

Minority shareholders have little (if any) to say on these matters;

their rights are to participate in dividends (which controlling
shareholders decide on), and capital gains (if there are any).

What is the Value of Control?

1) The probability that control of the firm will change.
The probability that management will be replaced, either through i)
acquisition, or ii) existing shareholders exercising governance.

2) Value of controlling the company.

This means i) the increase in value that can be brought by changes in
the way the company is managed and run, and ii) the private benefits of
being in control.

Value of Control = Expected Value (Value of Company with Change

in Control Value of Company without Change in Control) + Private
Benefits of Control.

Zero Probability of Change in Control?

Estimating Control Premium

FactSet Mergerstat / BVR

http://www.bvmarketdata.com/
Control Premium Study

8) Truncation Risk

Going Concern Assumption

Standard valuations are built on the assumption of a going concern,

i.e., the firm has continuing operations and there is no significant
threat to these operations.
DCF: Terminal value based on infinite life.
Multiples: Most comparables are non-distress firms.

If there is significant truncation risk, i.e., the firm will stop existing or
your equity position will be extinguished, the going concern value
overvalues the company.

Examples of Truncation Risks

Act of God: Hurricanes, typhoons, earthquakes, etc.

Terrorism and war: Investing in Afghanistan

Expropriation: In some countries, successful businesses can be

targeted by governments for expropriation (e.g., oil companies in
Argentina or Russia), with equity investors getting well under the fair
value as their compensation.

Default / Distress / Failure: If a company cant produce enough cash

flows from operations and/or raise external capital, then game over.

Methods
1) Adjust cash flows: Very difficult, and increasingly so over time
because you have to consider the cumulative probability of the
truncation risk event over time.
2) Adjust cost of capital: Dramatically jack up the discount rate is
problematic because reflects increased probability of both poor, but
also good, cash flows in the future.
3) Scenarios:
Truncation event with probability 1-p.
Non-truncation event (normal state-of-the -world) with probability p.
Estimate the expected value.

9) Employee Stock Options

David Choe

A graffiti artist who painted the walls of Facebooks first offices in Palo
Alto, California, was paid with 3.77 million stock options in the
company, which were worth $144.2 million at the IPO

Stock Options

In recent years, firms in the U.S. (and increasingly so also in Europe)

have started to use employee stock options, particularly to executives,
as a part of their compensation.

These stock options are generally:

Long term expiration time.
Issued at-the-money.
On volatile stocks (e.g., start-up and tech companies).

Why Do Stock Options Affect Firm Value?

Any options issued by a firm, whether to executives, or to employees,

or to investors (= convertibles and warrants) create claims on the
equity of the firm. Lower value to common stock.

Failing to fully take into account this claim on the equity in valuation will
result in an overestimation of the value of equity per share.

Effects of Stock Options

i) Effect of options granted in the past.
ii) Effect of expected future options.

i) Options Granted in the Past

Collect data on all options outstanding (vested + non-vested), with

average exercise price and average time to expiration.

Value these options, taking into account early exercise, dilution

adjustment, vesting, etc.

Subtract the value of all the options from the value of the equity and
divide by the actual number of shares outstanding (NOT diluted or
partially diluted number shares).

Example

XYZ company has $100M in FCFF, growing 3% a year in perpetuity

and a WACC of 8%. It has 100M shares outstanding and $1B in debt.
Value of firm = $100M / (0.08 0.03)
- Debt
= Equity
Equity per share

= $2,000M
- $1,000M
= $1,000M
$1,000M / 100M = $10

Example, Contd

XYZ decides to give 10M options at the money (with exercise price of
$10) to its CEO and other top-executives. What effect will this have
on the value of equity per share?
None, because the options are not in-the-money.
Decrease by 10%, because the number of shares will increase by 10M.
Decrease by less than 10%, because the options will bring in cash into the
firm but they have time value.

Dealing with Options the Correct Way

1) Value the operating assets of the firm. Enterprise Value.
2) Adjustments. Value of Equity (i.e., all of the equity).
3) Subtract (estimated) value of other equity claims:
Value of Employee Options: Adjusted Black-Scholes.
Value of Warrants = Market Price per Warrant x Number of Warrants.
Value of Conversion Option = Market Value of Convertible Bonds - Value
of Straight Debt Portion of Convertible Bonds.

4) Divide the value of equity in common stock by the number of shares

currently outstanding.

Example, Contd

Current stock price = $10.

Weighted-average exercise price = $10.
Weighted-average time to expiration = 10 years.
Annualized standard deviation = 40%.
Annualized dividend yield = 0%.
Risk-free rate = 4%.

Using a dilution-adjusted Black-Scholes model:

N (d1) = 0.8199
N (d2) = 0.3624

Value per option = 0.8199x$9.58 - 0.3624x$10xexp[-(0.04)(10)] = $5.42

Dilution-adjusted stock price = $9.58
(100M x $10 + 10M x Value of Option) / (100M + 10M).

Iterations in Excel solves the circularity

Example, Contd
Input
Current Stock Price:
Weighted Average Exercise Price:
Weighted Average Time to Expiration:
Annualized Standard Deviation:
Annualized Dividend Yield:
Risk-Free Rate:
Number of Options Already Granted:
Number of Shares Outstanding:

$10.00
$10.00
10
40.00%
0.00%
4.00%
10.00
100.00

Blac k -Sc holes Opt ion Pric ing Model

Current Stock Price:
Weighted Average Exercise Price:
Weighted Average Time to Expiration:
Annualized Variance:
Annualized Dividend Yield:
Risk-Free Rate:
Dividend-Adjusted Risk-Free Rate:
Number of Options Already Granted:
Number of Shares Outstanding:
d1:
N(d1):
d2:
N(d2):
Options:
1) Black-Scholes Value per Option:
2) Manual Input:
Value per Option:
Value of All Options (Pre-Tax & Pre-Vesting):

$10.00
$10.00
10
16.00%
0.00%
4.00%
4.00%
10.00
100.00
0.9151
0.8199
-0.3498
0.3632
1
$5.42
$10.00
$5.42
$54.23

Adjus t ment s
Options Expected to Vest:
Tax Rate:
Value of All Options (After-Tax & After-Vesting):

90.00%
40.00%
$29.29

Exercise Time?
100.00%

Adjusted
$9.58
$10.00

10

Example, Contd

Using the value per call option of $5.42, we can now estimate the
value of equity per share considering options:
Value of firm = $100M / (0.08-0.03)
- Debt
= Equity
Value of options already granted
Adjusted for vesting & tax
= Value of equity in common stock
/ Number of shares outstanding
Equity per share

= $2,000M
- $1,000M
= $1,000M
= $54.23M
$29.29M
= $970.71M
/ 100M
= $9.71

ii) Expected Future Options

Estimate the value of option granted each year over the past several
years as a percent of revenues.

Forecast out the value of option grants as a percent of revenues into

future years, allowing for the fact that as revenues get larger, option
grants as a percent of revenues will become smaller.

Consider this line item as part of operating expenses each year. This
will reduce the operating margin and cash flow each year.

Valuation of Private Companies

Process for Valuing Private Companies

In principle, the valuation process is the same as when valuing a

public company (e.g., discounting FCFF using WACC).

But generally two problems compared to public company valuation:

i) No market value for neither debt nor equity.

ii) Financial statements issues because they generally go back fewer
years, have fewer details, and have many more holes in them.

i) No Market Values

You may not realize how much you use market values in DCF
valuation until you dont have them

Market values as inputs:

No market value of debt or equity. Any inputs that require them
cannot be estimated (e.g., no D/V ratio to lever betas).
No market prices to value options to employees.

Market value as output: When valuing public companies, the

market value on the stock exchange serves as a measure of
reasonableness. For a private company, the value stands alone
(sometimes very lonely)

Market price based risk measures, such as beta and debt ratings,
are generally not available for private firms.

ii) Financial Statements

Shorter history: Private firms often have been around for much
shorter time periods than most public firms. Less historical
information available on them.

Intermingling of personal and business expenses: In the case of

private firms, some personal expenses may be reported as business
expenses (e.g., company car for private use).

Separating salaries from dividends: It is difficult to know

where salaries end and dividends begin in a private firm, since they
both end up with the owner.

Different accounting standards: The accounting statements for

private firms are often based upon different accounting standards
than public firms (not GAAP!), which operate under much stricter
constraints on what and when to report.

Post-It-Note Accounting GAAP

Can Not Value Private Companies

Without Knowing Why?

Show valuation: Curious how much the business is worth

Estate taxes.

Divorce court.

Sale to a private company.

Sale to public company.

IPO.

Depending on why, the value of a private company will be different!

Private to Private Transaction

In private to private transactions, a private business is sold by one

individual to another. There are three key valuation challenges we
have to confront in such transactions:
Neither the buyer nor the seller is diversified. Risk and return
models that focus on just the risk that cannot be diversified away will
seriously underestimate the discount rates.
Key person value. There may be a significant personal component
to the value. In other words, the revenues and operating profit of the
business reflect not just the potential of the business but the presence
of the current owner.
The investment is illiquid. The buyer of the business will have to
factor in an illiquidity discount to estimate the value of the business.

Small Private Service Businesses

Example: Valuing a Restaurant

You have been asked to value an upscale French restaurant for sale
by the owner (who is also the chef). Both the restaurant and the chef
are well regarded, and business has been good for the last 3 years.

The potential buyer is a former investment banker, who tired of the rat
race, and has decided to cash out all of his savings and use the entire
amount to invest in the restaurant. He cant cook

You have access to the financial statements for the last 3 years for the
restaurant. In the most recent year, the restaurant reported $1.2M in
revenues and $400,000 in pre-tax operating income. While the firm
has no conventional debt outstanding, it has a lease commitment of
$120,000 each year for the next 12 years.

Historical Financial Statements

Revenues
- Operating lease expense
- Salaries
- Material
- Other operating expenses
= Operating income
- Taxes
= Net income

2011
$800
$120
$180
$200
$120
$180
$72
$108

2012
$1,100
$120
$200
$275
$165
$340
$136
$204

2013
$1,200
$120
$200
$300
$180
$400
$160
$240

Operating at ~100% capacity

12 years left on lease
Owner-chef is not paid salary
25% of revenues
15% of revenues
40% tax rate

i) Discount Rates

Recall that conventional risk and return models in finance, e.g., the
CAPM, are built on the assumption that the marginal investors in
the company are well-diversified and that they therefore only care
about the risk that cannot be diversified away. That risk is often
measured with beta(s), estimated by looking at historical stock
returns for the company.

In this private company valuation, both assumptions are violated.

Beta

Accounting beta?
Problems are that i) earnings are only measured once a year so require
many years of data and ii) earnings may be managed.

Fundamental beta?
Beta as function of: ROE, Fixed Assets / Total Assets, BV of Debt / (BV
of Debt + BV of Equity), Expected Annual Growth in Net Income over 5
Years, Effective Tax Rate. Predicted fundamental beta. One
problem is that R-squared is <10%.

Bottom-up beta?

Bottom-Up Beta

The average unlevered beta across 75 publicly traded restaurants in

the U.S. is 0.86. Problem: Most publicly traded restaurants are fastfood chains (e.g., McDonalds, KFC).

There is an argument to be made that the beta for an upscale French

restaurant is more likely to reflect high-end specialty retailers (e.g.,
Saks Fifth Avenue, Tiffanys) than it is restaurants. The average
unlevered beta for 45 publicly traded high-end retailers is 1.18.

Adjusting for Non-Diversification Total Beta

Estimating Total Beta

Unlevered Total Beta =

= Unlevered Market Beta (CAPM) / Correlation with Market.

To go from market beta to total beta, we require a measure of how

much of the risk in the firm comes from the market and how much is
firm-specific.

From the regressions of publicly traded firms that yield the bottom-up
beta should provide an answer:
The average R-squared across the high-end retailer regressions is 25%.
Because betas are based on standard deviations, we take the correlation
coefficient (the square root of the R-squared) as our measure of the
proportion of the risk that is market risk.

Unlevered Total Beta

= Unlevered Market Beta (CAPM) / Correlation with Market
= 1.18 / 0.25 = 2.36.

Example: Market Beta or Total Beta?

Valuing a company for sale to an individual or private business?

Valuing a company for sale to a public firm?

Valuing a company for sale to a private equity (PE) fund?

Valuing a privately owned company for an IPO?

Cost of Equity

We will assume that this private restaurant will have a debt to equity
(D/E) ratio (14.33%) similar to the average publicly traded restaurant
even though we used retailers to the unlevered beta.

Levered total beta = 2.36 (1 + (1-0.4) x 14.33%) = 2.56.

Cost of equity = 3.0% + 2.56 x 5.0% = 15.81%.

Cost of Debt

While the firm does not have a rating or any recent bank loans to use
as reference, it does have a reported operating income and lease
expenses (treated as interest expenses):

ICR = EBIT / Interest (Lease) Expense = 400,000 / 120,000 = 3.33.

Rating based on ICR = BB+. Default spread = 3.00%.

After-tax Cost of Debt = (Risk-free rate + Default spread) x (1 Tax

Rate) = (3.00% + 3.00%) x (1 - 0.40) = 3.60%.

WACC

To compute the WACC, we will use the same industry average debt
ratio that we used to lever the betas:

Cost of capital = 15.81% (100/114.33) + 3.60% (14.33/114.33) =

14.28%.

ii) Adjust Financial Statements

Revenues
- Operating lease expense
- Salaries
- Material
- Other operating expenses
= Operating income
- Interest expenses
- Taxes
= Net income

2011
$800
$120
$180
$200
$120
$180

2012
$1,100
$120
$200
$275
$165
$340

2013
$1,200
$120
$200
$300
$180
$400

$72
$108

$136
$204

$160
$240

Year
1
2
3
4
5
6
7
8
9
10
11
12

Lease
120
120
120
120
120
120
120
120
120
120
120
120

2013 Adjust
$1,200
$0
Leases are financial expenses
$350
Chef cost $150 / year
$300
$180
$370
$60
6% x $1,006 = PV of $120 for 12 years @ 6%
$124
$186

PV (Lease)
$113.21
$106.80
$100.75
$95.05
$89.67
$84.60
$79.81
$75.29
$71.03
$67.01
$63.21
$59.64
$1,006.06

Growth & Terminal Value

Firms own past historical growth: Use with even more caution
because accounting standards are more loose (e.g., no GAAP).

Experts growth estimates:

No equity research analyst reports.
Use managements projections with even more caution because of bias
if they are selling the firm

Fundamental growth: Assume a 2% growth rate and a 20% ROC.

Reinvestment rate = 10%.

Transition from one owner/CEO is much more complicated and may

not be successful so may have to liquidate the firm instead.
Truncation risk?

iii) Key Person Value

Attempt to separately value the company i) with and ii) without the
key person built into cash flows. Key person value.

Size is completely dependent on specific firm and circumstances.

The key person value is even larger if the key person starts a
competing business. May be reduced with non-compete and
non-solicitation contracts.

Examples: i) Buy restaurant from celebrity chef. What if he leaves?

What if he leaves and starts a competing restaurant? Noncompete clause. ii) Buy doctors practice from retiring doctor.
What if patients came for that specific doctor? Key person
stays onboard for some years.

Adjusting Cash Flows

It is possible that if the current owner/chef sells and moves on, there
will be a drop off in revenues. If you are buying the restaurant, you
should consider this drop off when valuing the restaurant.

If 20% of the patrons come to the restaurant because of the chef,

the expected operating income will be lower if the chef leaves.
Operating income (current chef) = $370,000
Operating income (also adjusted for chef departure) = $296,000

Relevant Also in Public Firms

In 2011, Steve Jobs announced that he was stepping down as CEO of

Apple. The stock lost $30B in market value on the announcement.

Valuation

Inputs:

Adjusted EBIT = $296,000

Tax rate = 40%
Reinvestment rate = 10%
WACC = 14.27%
Growth = 2%

Enterprise Value = FCFF / (WACC g) = Expected EBIT (1 Tax

rate) (1 RIR) / (WACC g) = 296,000 (1.02) (1 0.4) (1 0.10) /
(0.1428 0.02) = $1.328M.

Value of Equity = $1.328M $1.006M (PV of leases) = $ 0.323M.

Value of Liquidity

What is Illiquidity?

The cost of buyers remorse: It is the cost of reversing an

investment after you made it.

Defined this way, all assets are illiquid. The difference is a

continuum, where some assets are more illiquid than others.

The idea that public firms are liquid and private businesses are not
is overly simplistic!

Determinants of Illiquidity

Macroeconomic conditions.

Liquidity of the assets owned by the firm.

Financial conditions of the firm.

Size of the firm.

Length of investment period.

Possibility of going public in the future.

Empirical Evidence

In private company valuation, the illiquidity discount is a topic that

analysts constantly debate

Despite all the discussion, seems to result in a simple rule of thumb:

The discount for a private firm is 20-30% and does not vary much
across different private firms.

Can we improve?

1) Restricted Stock Studies

Securities issued by a company, but not registered with the

Securities and Exchange Commission (SEC), that can be sold
through private placements, but cannot be resold in the open stock
market for some time.

Studies: 20-30% discount.

Problems: Small samples, and private equity investors may provide

services to the firm for which the discount is compensation.

Estimating Illiquidity Discount

Research study developed the following relation between the size

of the restricted stock discount and the characteristics of the firm:

Estimating Illiquidity Discount

2) IPO Studies

Discounts on private placements prior to public offerings, relative to

the post-IPO price.

Studies: 45-50% discount.

Problems:
Very large discounts!
Not arms length?
(family & friends)

Biased Samples

With both the Restricted Stock and the IPO studies, there is a
significant sampling bias problem.

The companies that make restricted stock offerings are likely to be

small, financially distressed firms that have run out of conventional
financing options.

The IPOs where equity investors sell their stake in the five months prior
to the IPO at a large discount are likely to be IPOs that have significant
uncertainty associated with them.

One study concluded that the illiquidity alone accounted for a

discount of only <10% (leaving the balance of 20-25% to be explained
by sampling problems).

3) Bid-Ask Spread Regression

All traded companies are illiquid!

We can regress the bid-ask spread (as a percent of the price) against
variables that can be measured for a private firm.

Spread = 0.145 0.0022 ln (Annual Revenues) 0.015 (DERN) 0.016

(Cash / Firm Value) 0.11 ($ Monthly Trading Volume / Firm Value).

You could plug in the values for a private firm into this regression (with
zero trading volume) and estimate the predicted spread for the firm.

Example: Restaurant

Fixed discount: 25% $0.321 (1 0.25) = $0.241M.

Adjust for revenue and profitability: $0.321 (1 0.2875) = $0.229M.

Bid-ask spread regression: = 0.145 0.0022 ln (1.2) 0.015 (1) 0.016

(0.05) 0.11 (0) = 12.88% $0.321 (1 0.1288) = $0.280M.

Public to Private Transaction:

What is Different?

The key difference between this scenario and a private to private

transaction is that the seller of the business is not diversified but the
buyer is or at least the investors in the buyer are. Consequently,
they can look at the same firm and see very different amounts of risk
in the company with the seller seeing more risk than the buyer.

The cash flows may also be affected by the fact that the tax rates for
publicly traded companies can diverge from those of private owners.

There should be no illiquidity discount to a public buyer because

investors in the public buyer can sell their holdings in a market.

WACC Comparison:
Private vs. Public Buyer of Restaurant

Unlevered beta
D/E
Tax rate
Pre-tax cost of debt
Levered beta
Risk-free rate
ERP
Cost of equity
After-tax cost of debt
WACC

Private
2.36
14.33%
40.00%
6.00%
2.56
3.00%
5.00%
15.81%
3.60%
14.28%

Public
1.18
14.33%
40.00%
6.00%
1.28
3.00%
5.00%
9.41%
3.60%
8.68%

Equity Comparison:
Private vs. Public Buyer of Restaurant
Adjusted EBIT
Key person discount
EBIT
Growth
Reinvestment rate
FCFF Year +1
WACC
EV
Debt
Equity
Liquidity discount
Equity

Private
$370.00
20.00%
$296.00
2.00%
10.00%
$163.04
14.28%
$1,327.27
$1,006.06
$321.21
12.88%
$279.84

Public
$370.00
20.00%
$296.00
2.00%
10.00%
$163.04
8.68%
$2,440.89
$1,006.06
$1,434.83
0.00%
$1,434.83

So What Price to Ask For?

Assume that you represent the owner/chef of the restaurant and that
you were asking for a reasonable price for the restaurant. What
would you ask for?
$280,000
$1.43M
Some other number

If it is some other number, what will determine what you will

ultimately get for your business?

Rolling Up Private Businesses in Public Company