MSc.

Finance and International Business Master Thesis Authors: Doreen Nassaka and Zarema Rottenburg Advisor: Baran Siyahhan

Analysis of corporate valuation theories and a valuation of ISS A/S

1st August 2011 Aarhus School of Business and Social Sciences Aarhus University

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Acknowledgements
We would like to thank our advisor, Baran Siyahhan, for his helpful and constructive guidance. We would also like to thank our friends and family for their support and patience.

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Executive summary In this paper various corporate valuation theories are analysed, and selected corporate valuation theories are applied to the case company International Service Systems, ISS A/S (ISS). ISS is a Danish founded multinational, multibusiness company, which operates within the facility services industry. The company was public until 2005 when it was acquired by two equity funds: Swedish EQT Partners and American Goldman Sachs Capital Partners. In the period 2005-2010, ISS has been acquiring many companies in order to expand geographically. In the future ISS expects to focus on organic growth, and limit their growth through acquisitions to emerging markets. ISS has suffered operating losses in the whole period when it was private and has obtained high amounts of debt. This has lead to high financial expenses for the company and an inability to pay off its debt on time. In order to improve its capital structure ISS decided to go public again on the Copenhagen stock exchange. The initial public offering (IPO) was planned in March 2011, but was postponed due to the instability of the financial markets. The corporate valuation theories analysed in this paper are the discounted cash flow (DCF) model, the dividend discount model (DDM), the residual income model (RIM), real options valuation (ROV) and valuation using multiples. Furthermore, two methods for determining the expected rate of return on a companys stock are evaluated, these are: the capital asset pricing model (CAPM) and the Fama and French three factor model. Based on the analysis, the DCF model is selected as the primary corporate valuation model in this thesis, and the capital asset pricing model (CAPM) is chosen to estimate the cost of equity for the company. Additionally, real options analysis is applied as an extension of the DCF model, in order to capture the value of the managers flexibility in relation to ISS expansion in emerging markets. Lastly, the valuation using multiples is conducted in order to evaluate whether the results obtained from the DCF and real options valuation are reasonable. In the valuation process ISS corporate environment is studied by means of a strategic analysis. Additionally, the company value from the DCF model is calculated based on the forecasted free cash flow in the explicit forecasting period and the estimated continuing value after the explicit forecast period.

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In the real options analysis a five year option to expand in South Korea is valued and added to the value obtained from the DCF model. The value of the real option is estimated by using the binomial model. The valuation using multiples is conducted based on ISS identified peer group of seven similar companies, and two multiples EV/EBITDA and EV/S are used in the analysis. The valuation process is finished off with a discussion of the results and a comparison of these results to equity values of ISS published by professional analysts and to the expected IPO share price published by ISS. ISS firm value from the DCF model is DKK 55,173 million, the equity value is DKK 39,049 million and the share price is DKK 167.59. The enterprise value including the real options is DKK 56,279 million, the equity value is DKK 40,154 million and the share price is DKK 172.34. From the multiples analysis, ISS enterprise value, equity value and share price are estimated within the range DKK 40,641 - 48,959 million, DKK 24,516 - 32,834 million and DKK 105 141, respectively. The equity value obtained from the DCF and the real options analysis is compared to the published equity value estimates from professional analysts that are within the range of DKK 39.4-49 billion. The estimated share price of DKK 172.34 is compared to the IPO share price that is within the range of DKK 100 DKK 135. The difference in the share price may be due to the fact that it is a second-time IPO and that the company has high debt levels. It is concluded that the enterprise value for ISS of DKK 56,279 million is reasonable, and that the share price of DKK 172.34 represents the fair market value of the companys shares.

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Table of contents
Executive summary .............................................................................................................................. 1 1. Introduction ...................................................................................................................................... 8 2. Description of ISS ............................................................................................................................ 9 3. Problem statement .......................................................................................................................... 10 4. Definitions ...................................................................................................................................... 11 5. Delimitations .................................................................................................................................. 11 6. Data collection and validity ........................................................................................................... 12 7. Analysis of the corporate valuation theories .................................................................................. 12 7.1 The discounted cash flow method ................................................................................................ 13 7.1.1 Step 1: The calculation of free cash flow .............................................................................. 13 7.1.2 Step 2: The weighted average cost of capital ........................................................................ 14 7.1.3 Step 3: Identifying the continuing value ............................................................................... 23 7.1.4 Step 4: Calculating the company value ................................................................................. 24 7.1.5 Evaluation of the DCF method ............................................................................................. 25 7.2 Dividend discount model (DDM) ................................................................................................ 25 7.2.1 Advantages and disadvantages of the DDM ......................................................................... 27 7.2.2 Evaluation of the DDM ......................................................................................................... 28 7.3 Residual income model (RIM) ..................................................................................................... 28 7.3.1 Advantages and disadvantages of the RIM ........................................................................... 29 7.3.2 Evaluation of RIM ................................................................................................................ 32 7.4 Real Options Valuation (ROV) .................................................................................................... 32 Page 5 of 112

7.4.1 Advantages and disadvantages of real options ..................................................................... 33 7.4.2 The binomial model .............................................................................................................. 34 7.4.3 The Black and Scholes model ............................................................................................... 36 7.4.4 Evaluation of real options ..................................................................................................... 37 7.5 Valuation using multiples ............................................................................................................ 37 7.5.1 Advantages and disadvantages of multiples ......................................................................... 40 7.5.2 Evaluation of the multiples method ...................................................................................... 41 8. Valuation of multibusiness companies .......................................................................................... 41 8.1 Challenges of valuing multibusiness companies ..................................................................... 42 8.2 Summary .................................................................................................................................. 43 9. The choice of corporate valuation theories .................................................................................... 43 10. Structure of the valuation process ................................................................................................ 44 11. Strategic analysis of ISS .............................................................................................................. 45 11.1 PESTEL analysis........................................................................................................................ 46 11.2 Porters five forces analysis ....................................................................................................... 49 11.3 Core competencies ..................................................................................................................... 52 11.4 SWOT analysis .......................................................................................................................... 53 12. Valuation of ISS using the DCF model ....................................................................................... 56 12.1 Step 1: Choice between using aggregated or disaggregated numbers ................................... 56 12.2 Step 2: Currency choice ......................................................................................................... 57 12.3 Step 3: Calculation of free cash flow ..................................................................................... 57 12.3.1 The reformulated statement of shareholders equity (SE) .................................................. 58 12.3.2 The reformulated balance sheet .......................................................................................... 58 Page 6 of 112

12.3.3 The reformulated income statement .................................................................................... 60 12.3.4 Trend analysis ..................................................................................................................... 60 12.3.5 Profitability analysis ........................................................................................................... 62 12.3.6 Summary of the financial statement analysis ...................................................................... 68 12.3.7 The amount of free cash flow ............................................................................................. 69 12.3.8 Forecasting free cash flow .................................................................................................. 69 12.4 Step 4: Estimating the weighted average cost of capital ........................................................ 77 12.5 Step 5: Calculating the continuing value ............................................................................... 83 12.6 Step 6: Calculating the company value .................................................................................. 83 12.7 Scenario analysis .................................................................................................................... 84 12.8 Sensitivity analysis ................................................................................................................. 86 13. Valuation of ISS using real options ............................................................................................. 87 13.1 Step 1: The value of ISS without flexibility .......................................................................... 90 13.2 Step 2: Event tree for ISS ....................................................................................................... 90 13.3 Step 3: Decision tree for ISS .................................................................................................. 92 13.4 Step 4: The value of ISS with flexibility................................................................................ 93 14. Valuation of ISS using multiples ................................................................................................. 94 15. Discussion of the results .............................................................................................................. 95 16. Conclusion ................................................................................................................................... 99 References ........................................................................................................................................ 102 List of appendices ............................................................................................................................ 111

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1. Introduction The purpose of this master thesis is to analyse and discuss different theories of corporate valuation, and to apply the most appropriate ones to the case company International Service Systems, ISS A/S (ISS). Corporate valuation has been of great interest to the authors throughout the master course; however, this topic has not been covered in details in the corporate finance classes attended by the authors. It was therefore decided to focus on this topic in the final master dissertation. The intention of this assignment is to apply theoretical knowledge about company valuation to a real life case by using external publically available data such as annual reports and published articles. It is preferred to analyse the company from an external point of view because obtaining internal data from the company often makes the analysis process slower because the authors will have to depend on data provided by the companys employees. ISS has been chosen as the case company due to its interesting financial history, the large media coverage at the time the thesis topic was chosen, and the fact that it is a challenge to value this company with the traditional financial valuation tools. The financial history of ISS is considered to be interesting because it started out as a small private company in Copenhagen in 1901, became a public company in 1977 and was acquired through a leveraged buyout by two private equity funds in 2005. Burdened by huge amounts of debt, ISS was considering another private sale or a second IPO in 2010/2011. Valuation of ISS is challenging because ISS is a very large, private, multinational, multibusiness company, which offers different facility services to private and public customers. However, due to the rumours about a sale or an IPO at the end of 2010 and the beginning of 2011 numerous articles about ISS were published stating factors such as the estimated corporate value of the company, its expected growth rate and the expected share price. Furthermore, due to the size of ISS and its past as a public company, all the annual reports for ISS are published for all the years. So even though performing an external valuation of ISS is a challenge, it is not unachievable with the publically available information, and ISS was therefore chosen as the case company.

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2. Description of ISS ISS was founded in 1901 as a Danish security firm by 20 night watchmen in Copenhagen, Denmark and in 1934 the company began offering cleaning services. In 1977, ISS was listed on the Copenhagen Stock Exchange, and in 2005 the company was bought by FS Invest S. R.L, which is located in Luxembourg, and de-listed from the Copenhagen Stock Exchange (issworld.com). Today, ISS is one of the worlds largest private companies owned by FS Invest S. R.L, a company that is owned by two private equity funds: Swedish EQT Partners and American Goldman Sachs Capital Partners, whereby each fund owns 54% and 44% of the share capital, respectively. The remaining 2% of the shares are owned by some employees at the top management level of the company (ISS Annual report, 2010). ISS operates under a decentralized organizational structure. ISS headquarter is currently located in Copenhagen, where they assist their regional and local management in the different countries (ISS Annual report, 2010). By applying decentralized decision making, ISS focuses on strong local leadership and independent decision making, in order to quickly respond to customers demands and needs (issworld.com). In 2010, ISS had revenues of DKK 74 billion and a net loss of DKK 532 million. This loss is an improvement from the net loss of DKK 1,629 million in 2009 (ISS Annual report, 2010). With its 522,700 employees, ISS provides facility services to over 200,000 public- and privatesector customers in the business to business (B2B) market, that are located in 53 countries in Europe, Asia, North America, South America and Pacific. Facility services includes the following six services (the numbers in the parenthesis represent the percentage of the total revenue in 2010 for the ISS group): cleaning services (52%), property services (20%), catering services (9%), support services (8%), security services (7%) and facility management services (4%) (ISS Annual report 2010). The abovementioned services can be delivered separately or as integrated solutions (issworld.com). The cleaning services include daily cleaning (e.g. dust control and wash room services), periodical cleaning (e.g. carpet and window cleaning), special cleaning (e.g. telephone and computer cleaning, laundry services) and segment cleaning (e.g. office, health care and retail cleaning). To maintain the value of the companys customers buildings and surroundings, ISS offers property services that include building maintenance (e.g. painting services, repairs and replacements), ground maintenance (e.g. road services and landscaping), environment maintenance (e.g. pest control and waste management), energy (e.g. water supply, lighting and power) and damage control (e.g.

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dehumidification). The catering services include contract catering (e.g. hospitality services and staff dining), vending machines, event catering, and confectionery services (e.g. coffee shops and fruit service). Additionally, the support services consist of activities related to the front office (e.g. reception and hostess services), back office (e.g. mail handling, call centers and office supplies), welfare facilities (e.g. sports facilities and fruit services) and labor supply (e.g. temporally workers and recruitment). ISS focuses on keeping its customers employees and properties safe, thus security services contain these activities: physical security (e.g. manned guarding and emergency response), surveillance (e.g. monitoring and alarm response), technical installations (e.g. car park management, fire and gas detection), work place emergency management (e.g. first aid services and emergency evacuation) and consulting services (e.g. security training). Lastly, the company offers its customers Integrated Facility Services, whereby the different services can be combined into one solution in order to reduce overhead costs as well as allocate resources more efficiently (issworld.com). At the end of 2010, ISS owners were considering to change the capital structure of the company once again either by selling ISS to another private owner or to let it go public (Webb and Espana, 2010). Even though several equity funds were preparing bids for ISS, the owners decided to go company public (www.altassets.net). The IPO was planned for March 2011 on the Copenhagen stock exchange, but was postponed due to the instability of the financial markets (www.issworld.com). For the purpose of the calculations in this paper, it is assumed that ISS will go public in 2012.

3. Problem statement The purpose of this master thesis is to analyse and discuss different theories of corporate valuation, determine which theories are relevant for valuing ISS, and apply them to estimate ISS firm value. The theories that will be examined include the discounted cash flow (DCF) model, the dividend discount model (DDM), the residual income model (RIM), real options valuation (ROV) and valuation using multiples. In relation to the DCF model, two methods for determining the expected rate of return on a companys stock will be evaluated, these are: the capital asset pricing model (CAPM) and the Fama and French three factor model. The corporate valuation theories will be analysed based on a literature review that for example includes a discussion of advantages and disadvantages of the different theories.

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In relation to valuing ISS, a strategic and a financial analysis of the company will be performed. In the strategic analysis, ISS corporate environment will be studied using the PESTEL analysis, Porters five forces, and the SWOT analysis. Furthermore, ISS core competences will be identified. In the financial analysis, the relevant corporate valuation theories will be applied to ISS. As part of the analysis, ISS financial statements will be reformulated in order to identify the companys main value drivers. Based on the financial analysis, ISS enterprise value, equity value and share price will be determined. Additionally, the equity value of ISS, estimated based on the strategic and financial analysis will be compared to official equity value estimates published by professional analysts, and the estimated share price will be compared to the expected IPO share price published by ISS. If there is a considerable difference between the results, possible reasons for the difference will be discussed. The structure of this paper is as follows: sections 1 to 2 include an introduction and the description of ISS, in sections 7 to 9 corporate valuation theories are discussed and the relevant theories are identified, in sections 11 to 14 the strategic and financial analysis of ISS are performed, and finally sections 15 and 16 contain a discussion of the results and a conclusion of the study. Appendix O contains an overview of the thesis structure.

4. Definitions Due to the fact that formulas are stated with different notations in the literature, the notations of some formulas are changed when necessary in order to achieve notation consistency in this paper. Furthermore, due to the fact that there are several abbreviations used throughout this paper, a list of abbreviations has been made in appendix P.

5. Delimitations This section states the delimitations relevant for this paper. Only financial theories will be analysed in depth and discussed based on a literature review. Marketing models will not be discussed, but just applied to the case company due to the fact that this paper focuses on a financial valuation of

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the company. Corporate valuation theories will not be derived1 in this thesis, because the main focus is on the possible application of these theories to a real life company.

6. Data collection and validity All the information that is used in this thesis whether it is from news papers, the internet or books is publically available. The main source of financial information about ISS is from ISS annual reports. However, some of the information from ISS is considered to be subjective and providing a more positive picture of ISS and has thus been used with precaution. The data from other sources is considered to have an objective opinion about ISS.

7. Analysis of the corporate valuation theories In general the value of an asset equals the present value of the cash flows that it will generate in the future. This methodology can be used to value single projects, investments and also whole companies. What matters in relation to the present value of the cash flows is the timing of the cash flow and the risk level (Benninga and Sarig, 1997). According to Damodaran (1996), valuation methods can be generally grouped into the following three categories: discounted cash flow valuation, relative valuation and contingent claim valuation. Discounted cash flow methods forecast future cash flows of an asset, and discount them at a given rate in order to get the assets present value. Relative valuation methods determine the value of an asset by comparing variables such as earnings, cash flows, book value or sales, and contingent claim valuations apply option pricing models to measure the value of an asset. These methods can lead to different results depending on the assumptions used in each method. Benninga and Sarig (1997) advise to use more than just one valuation method to estimate the firm value. It is advised to use more than one method because there is a great deal of uncertainty in relation to value estimation as it involves predicting future returns of the company, and if the different methods give similar results it implies that the estimated value is sensible. Due to the advice from Benninga and Sarig (1997) various valuation models will be discussed in this section and the relevant methods will be used to analyse ISS in sections 12-14

For example the underlying assumptions of the models will not be discussed

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7.1 The discounted cash flow method In the discounted cash flow (DCF) method, the value of an asset is calculated based on the present value (PV) of future cash flows generated by the asset. These cash flows are discounted by using a rate that represents their risk (Damodaran, 2010 3). According to Miller and Modigliani (1961), the DCF approach can be used to value a whole company, (Cooper and Argyris et al., 1998) whereby the company is considered as a lot of projects combined. To determine the firm value, the PV of future cash flows from all the projects in the firms operations are identified (Penman, 2010). Furthermore, the cash flows in the DCF method can be estimated using different cash flow proxies such as dividends, free cash flow (FCF) or accounting earnings (Koller et. al, 2005). The DCF model using the dividends proxy is discussed in section 7.2, the DCF model using the FCF proxy is discussed in section 7.1 and the DCF model using accounting earnings, i.e. the residual income model is discussed in section 7.3. Given very strict consistent assumptions, valuation using the DCF method with the various cash flow proxies should result in similar firm value estimates. However, empirical evidence shows that the different proxies lead to different firm value estimates (Torrez et al. 2006). There are two approaches to the DCF analysis: one is to value the firm as if it was only equity financed: i.e. the equity valuation and the other is to value the whole firm including all its claimholders: i.e. the firm or enterprise valuation (Damodaran, 1996). Since the focus of this paper is on firm valuation, the latter method is discussed further. The DCF model can be set up by using four steps suggested by Penman (2010). In the first step, a companys free cash flow is estimated to a given year. The second step involves determining the weighted average cost of capital (WACC) and discounting the free cash flows using this discount rate so as to determine their net present values (NPV). Additionally, the continuing value is identified in the third step, and the determination of the company value is explained in step four. Lastly, an evaluation of the DCF method is made. Appendix A includes an overview of the steps in the DCF model. 7.1.1 Step 1: The calculation of free cash flow Free cash flow is the difference between cash flow from operations and cash investment in operations (Penman, 2010 p. 341). It is the cash flow that is available to investors after investments in fixed assets and working capital (Brealey and Myers et al., 2007). FCF is also independent of leverage (Koller et. al, 2005) and it determines a companys capability to pay off its debt and equity claims (Penman, 2010). Additionally, FCF is a good indicator of the companys

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ability to generate cash and therefore also profit. A negative FCF does not mean that the companys operations are unprofitable, but it could be a sign that the company is growing fast and is therefore making large investments. Fast growth is good for the company as long as it is earning more than the cost of capital on its investments (Brealey and Myers et al., 2007). In order to forecast a companys future cash flows, it is necessary to evaluate its past financial performance first. This way the main drivers of a companys value: the return on invested capital (ROIC), the growth rate and free cash flow can be identified. Moreover, it is also possible to conclude whether the company has generated value, if it has grown as well as compare its performance to competitors. However, ROIC and FCF cannot be calculated directly from a companys reported financial statements, thus it is necessary to reformulate these statements so as to identify a companys operating items, non-operating items and financial structure (Koller et. al, 2005). The limitations of free cash flow include its inability to identify value created that does not involve cash flows, the fact that it evaluates investments as loss of value, and the option to increase the FCF by e.g. investing less (Penman, 2010). 7.1.2 Step 2: The weighted average cost of capital The weighted average cost of capital is the rate of return that investors expect from investing in a given company instead of other companies with similar risk (Brealey & Myers et al., 2007). As mentioned earlier, WACC is used to discount the free cash flow. It is one of the most important features of the DCF model, because a small change in WACC can lead to major changes in firm value (Steiger, 2010). To successfully apply WACC, it is important to have uniformity between the inputs of WACC and free cash flow regarding factors such as duration and the risk of financial securities. WACC and FCF must both be calculated on an after-tax basis and in the same currency (Koller et. al, 2005). If a firm is considered as a combination of projects, as mentioned earlier, then WACC is the suitable discount rate representing the riskiness of the cash flows from all the projects (Penman, 2010). WACC can be calculated by determining its three components: the after-tax cost of debt, the cost of equity and the companys target capital structure (Koller et. al, 2005). Thus, the formula for WACC is (Brealey & Myers et al., 2007): WACC = Where D/V = Target level of debt to enterprise value using market values

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E/V = Target level of equity to enterprise value using market values = cost of debt = cost of equity = companys marginal income tax rate The following sections include an explanation of how to determine the after-tax cost of debt and the cost of equity in the WACC formula. The cost of debt The cost of debt is the rate that a company pays to borrow money (Damodaran, 2009). There are three factors needed to calculate the cost of debt: the risk free rate, the default spread and the tax rate (Damodaran, 2010). The risk free rate is discussed below in relation to the CAPM. The second factor, which is the default spread2 can be determined in three ways, which are chosen depending on the company to be evaluated: a) if a company has outstanding bonds, then the cost of debt can be calculated by applying the current market interest rate (yield to maturity, YTM) on the companys long-term bonds, b) if a firm has bond ratings from rating agencies such as Moodys or Standard and Poor (S&P) , the default spread can be determined based on the ratings (Steiger, 2010), and c) if the firm is not rated, an artificial rating can be made based on the firms interest coverage ratio (EBIT/ Interest expense) (Damodaran, 2009)3. The last part for determining the cost of debt is the tax rate. Interest payments on debt are subtracted from income before tax is determined, thus taking on debt can act as a tax shield (Brealey & Myers et al., 2007). The formula for the after tax cost of debt is (Damodaran, 2010): After tax cost of debt = (Risk free rate + Default spread) (1- marginal tax rate) The advantages of debt besides the tax shield include committing managers to operate efficiently in order to fulfill principal and interest payments and encouraging lenders to monitor the firm

Borrowers of the firm bear the risk of not getting their expected payments (interest and principal). To compensate for this risk, the lenders add a default or credit spread to the risk free rate (Damodaran, 2010). A credit spread is the difference between the risk free rate and the interest rate that a company pays to borrow money (Steiger, 2010).
3

In option one, long-term bonds are applied because short term bonds do not match the duration of the companys free cash flow forecasts (Koller et. al, 2005). Option one is suitable if the firm has liquid bonds that represent the overall debt of the firm. In option three, the higher the interest coverage ratio the higher the ratings.

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(Binsbergen et al., 2010). Even though interest expenses are tax deductible, companies do not borrow to the maximum, because of the disadvantages of extreme borrowing such as financial distress (Scholze, 2010). There is also an explicit cost and implicit cost to debt financing; the explicit cost is the interest rate that bond holders require from the company and the implicit cost relates to the fact that when a firm borrows more money, its equity becomes more risky, thus equity holders demand a higher return to compensate for this risk (Brealey & Myers et al., 2007). The cost of equity The cost of equity can be calculated by using asset pricing models that help to determine the expected rate of return on a companys stock. There are three asset pricing models: the capital asset pricing model (CAPM), Fame and French three factor model and the arbitrage pricing theory (APT). The main difference between these models is the way they identify a stocks risk. The CAPM, which is the most widely used model, states that a stocks risk depends on its sensitivity to the stock market, Fame and Frenchs model claims that a stocks risk is based on its sensitivity to three factors: the stock market, a portfolio based on firm size and a portfolio based on book-tomarket ratios, and the APT extends Fame and Frenchs model, by arguing that a securitys rick depends on even more factors (Koller et. al, 2005; Bartholdy and Paula, 2003). However, the APT does not specify these factors, and for this reason it will not be discussed further in this paper. Instead the two main models: the CAPM and Fame and Frenchs model are discussed below. The capital asset pricing model The capital asset pricing model, which was introduced by Sharpe (1964), Linter (1965) and Black (1972) based on Markowitzs (1952) portfolio theory, explains the relationship between risk and expected return and it is stated as (Torrez et al. 2006):

Where:

= expected return on security i = risk free rate = sensitivity of the stocks return to the return on the market portfolio = expected return of the market

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Based on the CAPM model, a stocks expected return is determined by two things: a) the time value of money and b) the risk premium. The time value of money is represented by the risk free rate (rf), i.e. investors are compensated for putting their money in any investment over a period of time. Additionally, the extra return that investors demand for taking on risk is called the risk premium i.e. premium , this return depends on the risk measure (Brealey & Myers et al., 2007). , and the market risk

In addition, risk can be divided into unique risk (unsystematic or firm-specific risk) and market risk (systematic risk). Unique risk is specific to the individual firm and possibly its direct competition and it can be diversified away as the investor increases the number of securities in his portfolio. Market risk, which is caused by macroeconomic factors such as changes in interest rates, oil prices and foreign exchange rates that affect the whole stock market, cannot be diversified away (Brealey & Myers et al., 2007). According to the CAPM, the risk free rate and the market risk premium are the same for all companies; it is only beta that is different for each company (Koller et. al, 2005), thus the main idea of the CAPM is that the variance of a stock by itself is not an important determinant of the stocks expected return, instead it is the covariance of the stocks return with the return on a given market index that is important. Thus, the CAPM is developed as a method to evaluate market risk (Mukherji, 2011; Hillier et al., 2008). The following sections consist of a discussion of the inputs to the CAPM: the risk free rate, beta, and the market risk premium as well as an evaluation of this theory. Determining the risk free rate Risk is determined as the possibility that an investment's actual return will differ from the expected return, (Damodaran, 2008) whilst for a risk free investment, the actual return will always be equal to the expected return (Vukovi, 2010). This will occur only if these two conditions are fulfilled; that there is no default risk and there is no reinvestment risk. No default risk means that there should be no chance that the issuer of the security will not accomplish his contract, and no reinvestment risk implies that there ought to be no possibility that interest earned from an investment may have to be reinvested at a lower interest rate. In conclusion, if the requirements for a financial instrument to be risk free are the nonexistence of default risk and reinvestment risk, then the risk free rate can only vary, depending on the investment period (Damodaran, 2008).

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The risk free rate can be determined by looking at the long-term government default-free bonds4. Government bonds have different maturities ranging from for example one months to 20 years (e.g. for U.S. Treasury issue bonds). Considering the fact that different bonds have different maturities that can lead to different yields to maturity, a companys cash flows must be discounted by using a bond with a similar maturity. For companies in the U.S., the most frequent applied proxy is a 10year government bond. For European firms, the 10 year Germany Eurobond can be used, because it is believed to have a higher liquidity and lower credit risk compared to bonds of other European countries. Moreover, as mentioned earlier, in order to consider inflation consistency, the cash flows and the cost of capital should be stated in the same currency (Koller et al., 2005). Estimating beta As stated earlier, a stocks expected return depends on its beta, which is a measure of how much the stock price fluctuates in relation to the market (the stocks volatility) (Koller et. al., 2005). The beta value for the market is 1.0, stocks with a beta greater than 1.0 are sensitive to market fluctuations whilst stocks with a beta less than 1.0 are less sensitive to market fluctuations (Brealey and Myers et al., 2007). Unfortunately, beta cannot be directly observed, thus it must be estimated. This is often done by using the market model, whereby the returns on a stock are regressed against a markets return over a given time period. The market model can be stated as (Damodaran, 1999):

Where: Ri is the return on stock i, Rm is the return on the market index and beta () is the slope of the regression. While the market model seems good in theory, there are some practical issues related to estimating the beta because this theory does not specify the market index, time period and return interval5 to be used. Therefore, the betas estimated by different analysts for the same firm will be different depending on the time period, return interval and market index applied (Damodaran, 1999). According to the CAPM, investors are risk averse and they demand a higher return for taking on additional risk as stated earlier. The advantage of the beta, which is the mostly used measure of an

Koller et. Al (2005) defines the risk free rate as a return on a portfolio or security that does not correlate with the market ( i.e. with a CAPM = 0). In theory, a zero-beta portfolio can be calculated; however the process will be expensive and complicated. This is why long-term government default- free bonds are often used. These bonds are not entirely risk-free and have very low betas. 5 Stock returns can be determined daily, weekly, monthly, quarterly or yearly.

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assets riskiness (Shalit and Yitzhaki, 2002) is that it provides a quantifiable way of evaluating the required return on a risky investment as well as helping investors recognize attractive stocks based on their risk preferences. Additionally, beta is a good standard for discussing market efficiency, and for evaluating a stocks performance compared to the market (Liang, 2006). Beta is a very important part in the CAPM model and the usefulness of CAPM mostly depends on the accuracy of beta (Grsoy and Rejepova, 2007). As stated earlier, beta measures market risk by evaluating the volatility of a stock to a given index. One of the disadvantages of beta is the fact that it only considers the risk caused by macroeconomic factors on a companys stocks, and firm-specific risk is not fully evaluated by the beta. Beta is therefore an unreliable measure that does not compute the total risk of a firm, because a given firm may have a high level of firm-specific risk but a low level of market risk (Gunlaugsson, 2007). Another problem with betas from a regression analysis is that they are based on historical data and companies tend to change over time6. Thus historical betas are hardly good representatives of the firms current and future structure (Damodaran, 1999). Moreover, beta estimates are noisy since they are statistical estimates, with standard errors (Damodaran, 2011, p.5). In Fama and French (1992)s paper about the trustworthiness of past betas, they concluded that the CAPM beta does not explains the last 50 years of average stock returns. Damodaran (2011) suggests improving the accuracy of the regression betas by using bottom up betas. This refers to a beta that is estimated by using the average betas of similar firms in the industry. This beta should also be adjusted for variations in financial leverage. Furthermore, unlike public firms, private firms do not have past price information to use in a linear regression. Private firm owners, e.g. private equity funds often choose to invest money in just one or few companies and therefore they do not have very diversified portfolios compared to public firm owners7, thus estimating beta for private firms needs to be done in a different way in order to get a reliable beta. To get a beta for private firms, the analysts can for example 1) regress accounting earnings against changes in earnings for a market index to get accounting betas, 2) regress the betas of a given market index to a private firms ratios such as book debt/equity and
6

Firms for example: terminate businesses, invest in new businesses and acquire firms. They also change their financial leverage by issuing or paying off debt as well as pay dividends and buy back shares. Firms also grow over time. All these events will change a firms beta (Damodaran, 1999). 7 One of the assumptions of the CAPM is that investors have well diversified portfolios, in which they diversify all firm-specific risk, thus only market risk is relevant as mentioned earlier. For private firms, beta understates the effect of market risk.

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book value of assets to get fundamental betas or 3) look at average betas for similar public firms to get bottom-up betas (Damodaran, 2009). Calculating the market risk premium The market risk premium (MRP) is a challenging measure to estimate, because the

expected return on the market cannot be directly observed (Bowman, 2001). Therefore, a universally accepted model for estimating the MRP does not exist. It is common practice to determine the market risk premiums by using past risk premiums, this refers to premiums that investors have earned over long periods for example 75 years. An alternative option for determining the MRP involves calculating a forward looking premium from current stock price levels and expected future cash flows (Koller et al., 2005). Assuming that investors make their expectations based on their past experiences, the average of historical returns can be expected to have the main influence on investors future expectations (Officer and Bishop, 2008). If investors who are believed to be risk averse, havent changed their attitude towards risk in the past 75 years, then historical returns are a sensible proxy for future expectations (Koller et. al, 2005). Bowman (2001) claims that historical estimates are not suitable to be used in the CAPM, which is a forward looking model that relies on investors future expectations. However, due to the lack of reliability in forecast methods, historical estimates are often applied in the CAPM (Officer and Bishop, 2008). Evaluation of the CAPM Having introduced the CAPM in the previous sections, this section will include an evaluation of this theory. The main benefit of the CAPM is that, it is helpful in explaining the relationship between risk and return of a given investment (Fame and French, 2004). Unfortunately, empirical evidence shows that the CAPM is not completely valid in explaining stock returns, instead there are other factors besides beta that give better reasons (Gunlaugsson, 2007) such as firm size and book-tomarket ratios (Fame and French, 1992). Moreover, Roll (1977) argued that since a true market portfolio cannot be identified, or replaced by a proxy such as a stock market index, the CAPM can never be truly tested (Grsoy and Rejepova, 2007). There is also the challenge of testing the market model, i.e. the joint hypothesis problem, where there is simultaneous testing of both the model and the market, and this makes the results of the test inconclusive (Hillier et al., 2008). In conclusion, the CAPM is the most applied and criticized model in finance (Damodaran, 2010). Page 20 of 112

Fama-French three-factor model As already mentioned, the CAPM model is useful in explaining portfolios that are related to the market. However, if a portfolio is not closely related to the market, the CAPM is less helpful in explaining its returns. For this reason, Fama and French (1992; 1993) developed the CAPM further by suggesting that besides market risk, a stock portfolios risk also depends on the firm size and the book-to-market ratio (Fama, 2007). In the Fama-French model, the excess returns on a given stock are regressed on: the excess returns on the market (like in the CAPM), the excess returns on small minus big stocks (SMB) and the excess returns on high book-to-market stocks minus low book-tomarket stocks (HML) (Koller et al., 2005). SMB represents the size premium, i.e. the fact that stocks of companies with small market capitalization (cap) tend to result in higher returns than large cap stocks. HML represents the value premium, i.e. the tendency that companies with high book-tomarket ratios (value stocks) generate higher returns than those with low book-to-market ratios (growth stocks) (Womack et al., 2003). When calculating the Fame-French regression analysis, returns for three portfolios: the market portfolio, the SMB portfolio and the HML portfolio are needed (Koller et al., 2005; Bundoo 2008).The regression can be stated as (Koller et al., 2005): Where: is the return on portfolio, + is a constant, is the risk free rate, is the coefficient for

the excess return of the market portfolio over the risk free rate, market,

is the return of the stock

is the coefficient for the excess average return of portfolios with SMB, represents SML, is the coefficient for the excess average return of HML portfolios,

represents HML, and is the error term. The three-factor model implies that investors can target a given level of return by weighting their portfolios as desired on each of the three risk factors (Womack et al., 2003). Furthermore, small cap stocks yield a higher expected return because they are believed to be more risky (Fama, 2007). This is for example due to the fact that they offer fewer opportunities for diversification and they are less capable of dealing with negative financial results (Womack et al., 2003). In their 1995 study, Fama and French (1995) concluded that companies with high book-to-market ratios are often distressed compared to those with low book-to-market ratios. For this reason, investors of firms with high book-to-market ratios achieve greater expected returns for holding less beneficial and more risky stocks (Bundoo 2008).

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Evaluation of the Fama-French three-factor model In conclusion, empirical evidence shows that the Fama-French model has a higher explanatory power than the CAPM with its R2 values of 0.95 and above (Womack et al., 2003). In other words a combination of beta, size, and value explains 95% of a diversified portfolios return. Unfortunately, similar to the CAPM, the Fama-French model also has some practical issues regarding for example the amount of data to be used for estimating the risk premium, the return interval and the time period for the regression. Koller et al. (2005) suggests that these practical issues exist because the Fama-French model is relatively new. Additionally, several studies (Bartholdy and Peare, 2003; Lam, 2005) have compared the results from the one-factor model (CAPM) and the three-factor model, and have concluded that neither model is better than the other. Overview of the WACC formula As stated earlier WACC is the expected rate of return on a firms securities (e.g. equity, debt and preferred stock), whereby each security is weighted proportionally on the firms market value. The WACC formula is generally written as if the company only has two securities: debt and equity in its capital structure. The cost of debt is the current market interest rate that is required by a firms bondholders and the cost of equity is the expected return on a firms stocks. If a firms capital structure changes, the rates of return demanded by bondholders and stockholders will change; for instance if a company issues more debt, this will increase the risk of both its debt- and stockholders, who will require a higher return to compensate for this risk as mentioned earlier. However, this does not automatically indicate that the WACC will increase. Research by Miller and Modigliani, claims that by assuming that the company does not pay taxes, WACC will remain the same regardless of whether the amount of debt and equity changes (Brealey & Myers et al., 2007) Furthermore, in order to determine the appropriate capital structure in the WACC formula, it is important to use target weights instead of the companys current capital structure. This is because a companys capital structure may change in the coming years, as mentioned earlier, and using todays structure may lead to an overestimation (or underestimation) of the value of tax shields for a firm whose debt level may increase (or decrease) (Koller et. al, 2005). Koller et. al, (2005) suggest

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determining a companys target capital structure by first examining its current capital structure and then forming some expectations about the future. In order to calculate the WACC, the after tax cost of debt, the cost of equity, and target value weights are inserted in the WACC formula. This rate is used to discount the free cash flows and the continuing value to the present. Thus, the next section discusses the calculation of the continuing value. 7.1.3 Step 3: Identifying the continuing value A companys value can be determined by dividing the expected cash flows into two periods as stated below (Copeland et al., 2000; Russell, 2007; Jennergren, 2008;): Value = PV of cash flows during the explicit forecast period + PV of cash flows after the explicit forecast period

The explicit forecast period is the period, in which detailed forecasts of a companys cash flows are made for a given period up to a specific year, the horizon year (H). The second part of the formula is the continuing value (terminal value or horizon value), which is the value of the firm after the explicit forecast period. According to Brealey & Myers et al. (2007), a firms continuing value can be stated as:

Where: PVH is the value at horizon, i.e. the value of FCF in periods H+1, H+2 etc. The continuing value can be determined in two ways: one way is to assume that the firm will be liquidated in the horizon year and estimate the value of its assets in that year (Damodaran, 2010 2). The other method is to use the constant-growth formula, by assuming that the firm is going concern, i.e. it will continue to grow up to infinity after the horizon year (Brealey & Myers, 1991; Russell, 2007). Since the analysis of ISS will be based on the assumption that it is a going concern company, the constant-growth formula is discussed below. In a going concern firm, it is not realistic to precisely forecast free cash flow to the year infinity, thus the horizon year, which is the year when the firms business is expected to have a stable growth rate, is often used (Brealey and Myers, 1991; Morris, 1994; Russell, 2007).

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To use the constant-growth formula, the analyst needs the FCF for the first year after the horizon year (year H+1), a long-run growth rate (g) and WACC as the discount rate (r), thus the formula for the PV at horizon is (Brealey and Myers, 1991):

Even though theoretically the computation of the continuing value seems easy, in reality it is challenging to estimate the development of a company between the horizon year and infinity (Financial Times, 2005). Several researches claim that continuing value calculations often account for more than half of the total firm value, and that a small change in the perpetual growth rate leads to major changes in firm value (Morris, 1994; Brealey & Myers et al., 2007; Steiger, 2010). The large impact of the continuing value can be due to the fact that a firms cash outflows in the explicit forecast period are caused by investments that are expected to generate cash inflows after the explicit forecast period (Copeland et al., 2000). 7.1.4 Step 4: Calculating the company value Finally, the value of the firm can be determined as the discounted free cash flow up to a horizon year (H) plus the forecasted value of the firm at the horizon, that is (Brealey & Myers et al., 2007):

Once the company value is estimated, the equity value can be calculated by subtracting net debt and minority interest from the company value (Penman, 2010). As mentioned earlier, the DCF analysis involves predicting free cash flows for the next five to fifteen years. For this reason, it is necessary to make assumptions about a companys future situation (Steiger, 2010). Predicting the future always involves uncertainty and risk (Koller et. al, 2005) but methods such as scenario analysis, sensitivity analysis, decision trees and simulations can help in analyzing the uncertainty related to the valuation results, as well as ensure whether the assumptions used are realistic (Damodaran, 2007). Scenario and sensitivity analysis will be used in this paper in order to analyze the effect of different assumptions about both macroeconomic and asset specific variables.

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7.1.5 Evaluation of the DCF method After looking at the procedure of the discounted cash flow analysis, this section includes an evaluation of the method's strengths and weaknesses. One of the advantages of the DCF method is that it is intuitively easy to understand; the value of a company depends on its future cash flows (Morris, 1994). This method focuses on cash flows, which is a real measure that is simple to explain. The DCF method also works regardless of a companys accounting principles (Penman, 2010). When analyzing a company using this method, the analyst performs a useful exercise by identifying a companys value drivers as well as examining its growth and risk (Damodaran, 2010 3). In general, the DCF method is perceived to be the best method for company valuations, but only if the company is profitable (Russell, 2007). The limitations of the DCF method include its large dependency on WACC and continuing value assumptions, this is because small changes in these values have a considerable impact on firm value as stated earlier ( Steiger, 2010; Copeland et al., 2000). For this reason, the DCF method can be easily manipulated by the analyst in order to achieve a given result. Additionally, it requires a lot of information to determine a companys future cash flows, growth rates and discount rates. Similar to any other analytical tools, the DCF must be used with caution. The results from any model depend on the models inputs: it is garbage in, garbage out(Damodaran, 2010 3 p. 11).

7.2 Dividend discount model (DDM) According to Brealey et al., (2009), DDM is a stock valuation tool that is used to determine stock prices as the present value of future expected dividends discounted back at a certain rate. Michaud and Davis (1982), state that one of the main objectives of the DDM is to improve the process of stock valuation. The simplest DDM model is the DDM with no growth, where the discount rate (r) equals the rate of return demanded by investors investing in other stocks at the same risk level, is the value of the stock and as (Brealey et al., 2009): is next years dividend. The DDM with no growth can be stated

A more advanced DDM is the DDM with constant growth. This model assumes that a companys dividend payouts grow over the years. Because it is too time consuming to forecast dividends for every single year in the future, the calculations are simplified by forecasting dividends for the next

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period, and then forecasting a single growth rate with which the dividends will grow in all the following periods. It is assumed that there is an infinite number of periods in the model and the dividend growth rate (g) has to be less than the discount rate (r) (Brealey et al., 2009). The DDM with constant growth can be written as:

If the growth is not constant the formula above cannot be used. Additionally, for mature industries, growth is fairly stable and constant growth DDM is a good model. According to Penman (1998), it is common in practice to forecast dividends for a limited number of years and then to calculate a terminal value at the horizon; this corresponds to the DDM with non-constant growth. In order to use the DDM with non-constant growth, it is necessary to set the investment horizon (H). Until the investment horizon the dividends should be estimated for each period individually and after the investment horizon the companys growth is expected to settle down. In order to estimate the stock price, the dividends until the investment horizon year are discounted back to present value and at the end the terminal value is added. The terminal value is the estimated present value of the stock price at the horizon (Brealey et al., 2009). The formula for the DDM with non-constant growth is:

Moreover, the DDM can also be used to determine the cost of equity for a company. In the simple models, it is assumed that the only cost of equity a company has is the dividend payout. If the market price of the firm is known, the rate of return can just be isolated and it equals to the companys cost of equity (Mills and Robertson, 2004).

According to Penman (1998), it is often claimed in the literature that the DDM does not perform very well when company value with a finite horizon has to be estimated. The calculation of terminal value is considered to be problematic in the financial literature, and many different formulas for calculating terminal value have been developed over the years. Whilst using alternative valuation models such as discounted cash flow model or residual income model often results in a firm value that is similar to the firm value estimated using the dividend discount model, it is the different ways

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of calculating terminal value that cause the largest variations (Penman, 1998). Terminal value basically consists of an estimate of all future cash flows, or in the case of DDM, all future dividends, and these are discounted back and summed up to a single number. According to Penman (1998), a calculation of terminal value is only needed if the discounted payoffs up to the horizon do not capture the total value of the firm. A more detailed discussion of terminal value is been given in section 7.1.3. 7.2.1 Advantages and disadvantages of the DDM According to Hand and Landsman (2005), there are various issues related to the use of the present value of expected future dividends as an estimate for the company value. In short, Hand and Landsman (2005) argue that dividends are often positively priced even when they should not be due to the financial situation of the company, and when these dividends are used to estimate the firm value the result is often wrong. Hand and Landsman (2005) suggest that dividends are positively priced because they are based on public information that is trying to predict a companys future abnormal earnings. This means that the price of the dividends is correlated with the analytical forecasts in the market, which can often be wrong, and not based on internal measures for a firms ability to achieve abnormal earnings. Hand and Landsman (2005) find in their analysis that investors often misprice the current earnings and the equity value of a firm which leads to positively priced dividends. In contrast to the Hand and Landsman (2005) study, Fama and French (1998) and Akbar and Stark (2003), find a positive relation between firm value and dividends. The results of their analysis show that dividends are based on information about future expected cash flows and can therefore be used to estimate firm value. However, Michaud et al. (1983), argues that the DDM contains little market valuation information and the firm value estimated using the DDM is therefore subject to error. According to Hand and Landsman (2005), a main problem is information asymmetry between the information available to the managers of the company and the information available to the shareholders. The managers can pay out a certain amount of dividends to send a certain signal out to the shareholders and the market. For example managers can pay out high dividends to signal that they are doing a very good job and are expecting high abnormal returns in the future. This is a situation where the principal-agency problem may arise, i.e. managers who act as agents for the principals (the shareholders), will act in their own best interest (Grossman and Hart, 1983). According to Hand and Landsman (2005), under the agency cost hypothesis, it is argued that dividends are a more reliable measure if the current earnings of the company are positive and the

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company has free cash flow. On the other hand, under the profitability signalling hypothesis, it is argued that dividends are more reliable as a measure, if the company is currently suffering from negative earnings, because if the company can afford to pay out dividends in such a state it must be because the managers are almost certain of future positive earnings. Penman (2010) states that dividends are not a good measure to estimate firm value, because the company can obtain loans to finance the dividend payouts, and in this case dividends do not represent the earnings the company generates. According to Miller and Modigliani (1961), the dividends are irrelevant to the calculation of firm value. They show in their article that firm value depends on the firms earnings and level of investment. Miller and Modigliani (1961) specifically point out the irrelevance of the dividends in relation to an acquisition. If an investor is interested in acquiring a firm, the investor is free to determine the level of the dividends in the future and the firm value calculated based on future expected dividends does not make sense in that case. The firm value important to the acquirer is based on the expected earnings of the firm and its investment opportunities, which will provide additional earnings in the future. 7.2.2 Evaluation of the DDM The DDM is a type of discounted cash flow model as mentioned earlier. The essence of the DDM is the fact that it uses dividends as the proxy for cash flows. Using dividends to estimate firm value is widely criticized in the literature mainly because dividends are more often than not determined by the management, so they can be subject to manipulation and are therefore not as reliable as other proxies for cash flows. Additionally, using the DDM to estimate the value of private companies is problematic since private companies do not pay out dividends in the same way as public companies.

7.3 Residual income model (RIM) Ohlson (1991) argues that due to the dividend policy irrelevance concept presented in Miller and Modigliani (1961), the value of a firm should not be calculated based on dividends, but based on a more fundamental variable which does not depend on dividends. Based on the analysis Ohlson (1991) concludes that the variable earnings is a good replacement for dividends because earnings do not depend on dividends and could be used to estimate company value. As a continuation of his research from 1991, Ohlson (1995) defines a valuation model, which is based on residual income. However, according to Xiaoquan and Bon-Soo (2005), the idea of a residual income model can be traced back to Preinreich (1938) and is thereby not a new discovery. Page 28 of 112

According to Ohlson (1995), residual income is the amount by which a companys net income exceeds the required return on the firms equity. The residual income is thereby a measure of the additional value created for the shareholder, which is also known as abnormal earnings or economic value added (EVA). Ohlson (1995) derives the RIM from the DDM using among other things the clean surplus relation to prove his point. The clean surplus relation states that the current book value equals beginning book value with an addition of current earnings and a subtraction of current dividends. Mathematically the clean surplus relation is defined as:

Where, B is the book value for period (t and t-1), E is the earnings for period t and D represents the dividends for period t. Ohlson (1995) derives the formula for the residual income model by isolating the dividends in the clean surplus relation, and replacing the dividend term in the dividend discount model with the obtained equation. After replacing the dividend term, Ohlson (1995) gets a formula for calculating firm value, which does not contain dividends. The residual income model is given by:

The RIM calculates the firm value by adding two parts: the current book value, future periods (RIt = Et rBt-1)8, and re is the required rate of return on equity.

plus the present

value of future residual income. Where Bt is the book value in period t, RIt is the residual income in

The residual income model, unlike other valuation models, puts emphasis on accounting data instead of financial data. All the numbers except for the required rate of return on the firms equity are accounting numbers, which can be obtained from the firms financial statements (Ohlson, 1995). The book value used in the model is a sum of the book value of owners equity and the book value of operating net assets, which can be obtained from the balance sheet. And the residual income is based on operating earnings which can be obtained from the income statement (Skogsvik, 2002). 7.3.1 Advantages and disadvantages of the RIM According to Ohlson (1995), the residual income model moves the focus away from the wellknown dividend discount model and instead the value of the firm is calculated as a sum of current
8

RI is equal to net income in period ( Et) minus the cost of equity in currency i.e re * income is net income minus a charge for the use of shareholders capital.

. In other words, residual

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book value and present value of expected future abnormal earnings. The fact that the RIM is based on book value and abnormal earnings is a major advantage according to Xiaoquan and Bon-Soo (2005) because they believe that these variables contain more important information in relation to firm value than dividends alone, which are used in the DDM. Additionally, by estimating earnings instead of dividends, it is necessary for the analysts to investigate the factors explaining the firms performance which leads to a deeper understanding of the companys activities (Bernard, 1995; Penman, 2007). Furthermore, Xiaoquan and Bon-Soo (2005) find the fact that the RIM does not use dividends to calculate the firm value very beneficial because it can easily be applied to companies, which do not pay out dividends on a regular basis. One of the disadvantages of using earnings in firm valuation is that future earnings are affected by external events, which cannot be predicted at the time of estimation. Thus, valuations based on earnings can result in imprecise value calculations (Bernard, 1995). Xiaoquan and Bon-Soo (2005) state that the dividends are present in the RIM, they are just defined broadly as the difference between earnings and changes in book value, and these dividends include both regular dividends and other types of cash payouts (e.g. share repurchases) to the shareholders. According to Penman (2007), the fact that the RIM relies on accounting numbers can both be seen as an advantage and a disadvantage. It is an advantage that the already recognized book values can be used in the valuation model. On the other hand, accounting numbers can be manipulated and this will affect the calculated firm value. For this reason, it is important to evaluate the quality of the numbers in the financial statements before applying them in order to obtain a useful result (Rees ,1997). Even though the RIM is sensitive to accounting manipulation, there are some types of manipulation it is actually protected from. If accrual accounting is used to create earnings by for example recording lower book values at present and recognising higher income in the future, it looks like the company is earning more, but in reality no additional value is created. In the RIM, this type of accounting will not result in a higher firm value because the beginning book value will be used in the calculation (Penman, 2007). An important observation made by Skogvik (2002) in relation to the RIM is the fact that it is not correct to treat the required rate of return on the firms equity as a constant if the firms capital structure is expected to change over time. However, applying different rates of return to the model based on the expected capital structure makes the model much more complicated.

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When applying the RIM, the forecast horizon should also be considered like in the other valuation models. The RIM can be constructed in a way that is similar to the DDM model, where residual earnings for a number of years are forecasted and discounted back and a continuing value is added at the end to capture the added value from residual earnings at the horizon. The formula for the residual income model with a continuing value calculation can be stated as (Penman, 2007):

Where RIt+1 is the residual income for the first the year after the horizon. In case it is forecasted that the company will experience constant growth at horizon, the continuing value term can be modified to:

Where g is the growth rate and g should always be less that re . According to Penman (2007), there is often more weight on the continuing value compared to the value calculated up to horizon in the DDM and the DCF model. But in the RIM when the continuing value term is added, there is more emphasis on the value created up to horizon, which can be estimated with more certainty than the value at horizon. Penman (2007) argues that because of this feature the results from the RIM are more certain compared to the results obtained using the DDM and the DCF. Additionally, previous researches undertaken by various authors have compared the performance of the DDM, RIM and the DCF model and concluded that the RIM gives more accurate value estimates and explains more of the variation in stock prices (Xiaoquan and Bon-Soo, 2005). According to Rees (1997) it can be difficult to apply the RIM in practice because it contains expected abnormal earnings, which can be difficult to estimate. He states, that it is therefore important to use valid forecasts to predict reliable future abnormal earnings. Additionally, Rees (1997) claims that it might not be enough to look at book values and expected abnormal earnings to calculate firm value in practice, additional factors such as financial management of the firm, dividend payouts, debt levels and capital expenditure should also be considered.

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To prove his statements, Rees (1997) performs a statistical analysis on a number of public limited UK companies, excluding financial companies, property companies and investment trusts. He tests whether dividends, amount of debt and capital investments have an impact on firm value. His analysis shows that earnings paid out as dividends have a higher impact on firm value than retained earnings, and that capital investments have a positive impact on firm value in contrast to debt which has a negative impact. Ohlson (2001) states that all other factors that can affect company value should also be investigated in addition to the value calculated using the RIM. Therefore the RIM is not sufficient on its own to capture the actual value of the company. 7.3.2 Evaluation of RIM Based on the analysis performed in this section, it can be seen that the RIM is a relatively new model compared to the other popular valuation models such as the DDM and the DCF model. One of the important features that distinguish the RIM from the other valuation models is the fact that it is based on accounting numbers. Whether the use of accounting numbers is an advantage or a disadvantage is widely discussed in the literature, and there is no final conclusion on the discussion because there are both pros and cons.

7.4 Real Options Valuation (ROV) An option is the right, but not the obligation to buy or sell an underlying asset under the terms that are specified in the contract (Damodaran, 1994). Options can be exercised before the expiration date (American options), at the expiration date (European options), or not at all. Additionally, options are especially valuable in environments that are characterized by uncertainty, because they give the opportunity to make a decision after seeing how the events turned out. Originally options have been used in the financial theory, but have later been extended to cover non-financial assets; these are known as real options (Amram and Kulatilaka, 2000). A real option is the right, but not the obligation to take action at an agreed price within the options life (Copeland and Antikarov, 2003). In general real options are mainly used by managers to evaluate single investments or project decisions in a company (Koller et al., 2005). In order to value options, methods such as the Black-Sholes model and the binomial model can be applied (Damodaran, 2010 3). These two methods are discussed further in sections 7.4.2 and 7.4.3.

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Brovles (2003) claims that methods such as DCF are too simplistic to capture the actual value of the company and a better value estimation is achieved if the future options of the company are considered using a real options framework. Moreover, Damodaran (1994) states that even in cases where the traditional DCF method gives a sensible result; real options give another perspective on valuation which can be useful. According to Koller et al. (2005) the standard DCF method does not consider managerial flexibility, that is, the fact that managers react to changes in the economic environment and thereby adjust the companys plans and strategies. According to Damodaran (2002), real options include for example the options to expand, delay or abandon a project these are all examples of managerial flexibility which creates value. The DCF method often understates the firm value because it only considers future cash flows and not the firms future options to expand or invest and thereby achieve unexpected success. These options can be accounted for when using the real options frame work (Damodaran, 2001). The analysis conducted by Andrs-Alonso et al. (2006) shows that the total market value of a firm consists of two parts, these are: the value of the firms existing assets and the value of the firms real options. In order to apply the real options method to company valuation, it is therefore necessary to first determine the value of the underlying asset using another method such as DCF, if the assets price cannot be directly observed in the market, the actual method of applying ROV is discusses further in section 7.4.2. For this reason the ROV does not replace the traditional DCF method, but is a complementary method (Koller et al., 2005). 7.4.1 Advantages and disadvantages of real options Damodaran (2001), discusses some of the limitations of the real options pricing models, he mentions that the variance of the underlying asset might change over the life of the option which makes the option valuation more complicated. Furthermore, it might not be possible to exercises a real option instantly which affects the options value. According to Koller et al. (2005), the ROV depends on precise estimates of the value and variance of the underlying asset; otherwise it will lead to incorrect estimates of the flexibility value. There are therefore some issues with the application of real options theory in practice. According to Damodaran (2005), another danger is the fact that the required inputs of the ROV can be manipulated which makes the resulting value biased. According to Kemna (1993), when applying ROV to real life cases it is beneficial to limit the number of options to the most important ones, because having too many options makes the model

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more difficult and confusing and is not necessarily adding more value. Furthermore, when there is some sort of political uncertainty in the macroeconomic environment the relevance of ROV increases because more companies choose to postpone their investments in order to wait and see what happens (Copeland and Antikarov, 2003). 7.4.2 The binomial model The binomial option pricing model, which is a discrete model for valuing European and American options, was created by Cox, Ross, and Rubinstein in 1979. This model, separates the time to maturity of an option into discrete intervals, whereby during each interval, the price of an asset for example a stock follows a binomial process moving from its original value, S, either to Su (with probability p) or to Sd (with probability 1-p). Afterwards the value of the option can be determined by working backwards from maturity (Cox et al., 1979). According to Koller et al. (2005), real options valuation can be done in four steps as illustrated in figure 7.1. Figure 7.1 The four step process to estimate value of real options

1.Estimate NPV of the underlying asset without flexibility

2.Model uncertainty in an event tree

3.Model flexibility in a decision tree

4.Estimate the NPV with flexibility

Source: Adapted from Koller et al. (2005, p. 560)

Step 1: The value without flexibility In the first step of the real options valuation, the present value of the underlying asset without flexibility is determined (Koller et al., 2005). If the valued asset is a whole company, then the company is valued first using another method, e.g. DCF model, and this value is then used as the value of the underlying asset.

Step 2: Event tree According to Koller et al. (2005) it is necessary to model the different possible values of the underlying asset in an event tree in the second step. The values can either be modelled in a

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geometric event tree9 or an arithmetic event tree10. Koller et al. (2005) recommend using a geometric event tree rather than an arithmetic event tree due to the fact that a geometric event tree does not produce negative values. The up- and downward movements in the geometric event tree can be determined as (Koller et al., 2005):

Where: is the annualized volatility of the underlying asset, and T is the number of years per upward movement. According to Damodaran (2002), there are three different approaches to estimating annual volatility: 1) use the variance in cash flows from the companys earlier similar investments, 2) use simulation to estimate possible cash flows, find the present values, and then calculate the variance across the present values, or 3) use the variance in values of similar firms in the industry as a proxy. After the up- and downward movements are determined, the probabilities of these movements can be calculated as (Koller et al., 2005):

Where: r is the cost of capital of the underlying asset. According to Koller et al. (2005), the values in the event tree can be verified using the estimated probabilities pu and pd. The values can be calculated as:

Step 3: Decision tree

10

Geometric event tree: The asset value at time t+1 is determined by multiplying the asset value at time t with a factor Arithmetic tree: The asset value at time t+1 is determined by adding a value to the asset value at time t

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In order to model flexibility, decision points are added to the event tree from the second step and thereby a decision tree is obtained. The decision points are added by estimating a percentage increase in company value due to the expansion and the costs of expansion. If the value with expansion is higher than the value without expansion the company chooses to expand and this value is thus stated in the decision tree at a given time (Koller et al., 2005). Step 4: The value with flexibility The value of the real option is determined in the fourth step. One of the methods to determine the value is to use risk-neutral valuation. In this method the probabilities are adjusted to risk-neutral probabilities using the formulas (Koller et al., 2005):

Then by working from right to left the values estimated at each point in time in the decision tree can be discounted back at the risk-free rate. This way the total asset value including the value of the option is estimated. The binomial model is helpful in valuing American options, thereby providing the owner with an intermediate decision making tool at a given point in time until expiration. This model is mathematically simple compared to the Black and Scholes model (Cox et al. 1979). The major drawback of the binomial model is its quite slow process, especially when calculating many prices in a short period of time (Subramani, 2009) as well as the large number of required inputs, which are the expected future prices at each node (Damoradan, 2005). 7.4.3 The Black and Scholes model The Black-Scholes model from 1972 is not an alternative to the binomial model; rather, it is one limiting case of the binomial model (Damodaran, 1994). Both models have similar assumptions except that the Black-Scholes model only follows a continuous process, which does not allow for price jumps of the assets prices (Damodaran, 2005). The Black and Scholes model for valuing a call option can be stated as (Damodaran, 1994):

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Where

Additionally, S is the current value of the underlying asset, K is the strike price of the option, t is the time to expiration of the option, rf is the risk free rate for the life of the option, and variance in the ln(value) of the underlying asset. The above stated model was originally created for valuing European options, on securities that do not pay dividends. This means that this model does not consider an early exercise and dividend payments, both of which affect the value of options. Recognizing the limitations of the BlackScholes Model, the binomial model is considered to be more accurate because it includes several factors such as the possibility of early exercise and other factors like dividends (Cox et al. 1979). 7.4.4 Evaluation of real options Based on the literature review, it is found that real options is a useful tool to capture the value of managers flexibility, i.e. their future options, in relation to company valuation. In general, real options analysis is not an independent method, but rather an extension of the DCF model. The two popular models for option valuation, discussed in this section, are the Black-Scholes model and the binomial model. According to the recommendations from the literature, the binomial model is the preferred choice, when valuing real options. is the

7.5 Valuation using multiples Valuation using multiples is a broadly used supplementary method to the well-known discounted cash flow method, when it comes to company valuation (Benninga and Sarig, 1997), according to Yoo (2006), the popularity of this method is mainly caused by its simplicity. In general, multiples are the average price divided with a certain performance measure; therefore many different multiples can be calculated for a firm. The primary ratio which is generally used to estimate value is the price/earnings (P/E) ratio (Benninga and Sarig, 1997) and the two other ratios which are commonly used are the price/book value (P/B) ratio, and the price/sales (P/S) ratio (Damodaran, 1994). According to the analysis performed by Lie and Lie (2002), where they test the accuracy of ten different multiples through an empirical study of 8621 companies, the P/B ratio generates more

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exact and unbiased results than the other multiples including the P/E and P/S ratios. According to Koller et al. (2005) P/E ratio can generate imprecise results because it is systematically affected by the capital structure of the company, and, furthermore, the earnings used in the ratio are affected by non-operating revenues and expenses. For example deduction of a non-cash expense which is a non-operating item, results in lower earnings, but does not affect the firm value. The P/S ratio gives the least accurate results both according to Lie and Lie (2002) and Dragos (2009). In contrast, Liu et al. (2002) state that the P/E ratio performs best based on their empirical analysis. Cheng and McNamara (2000) analyse the performance of P/E and P/B ratios in relation to valuation based on 30,310 observations of company data over 20 years and conclude that a combination of these two ratios gives the most exact results, however if one ratio has to be chosen then the P/E ratio is found to be superior to the P/B ratio. Besides the abovementioned multiples that focus on the price, i.e. the equity, there are also those, that focus on enterprise value. A commonly used enterprise value multiple is the enterprise-valueto-EBITDA (EV/EBITDA), where EBITDA stands for earnings before interest, taxes, depreciation and amortization (Koller et al., 2005). Increasing P/E is often associated with company growth by investors, however, Koller et al. (2005) argue that it is more correct to draw conclusions about a companys growth based on increases in the EV/EBITDA multiple because it also considers the return on invested capital (ROIC). And according to Koller et al. (2005), it is only possible to conclude that a company is growing, based on increase in a multiple, when the companys ROIC is higher than the cost of capital. Additionally, Koller et al. (2005) recommend using the EV/EBITDA multiple because it is independent of capital structure, and can thus be easily applied to comparable companies that have different capital structure. Koller et al. (2005) also discuss the sales multiple and state that this multiple can be used when the valued company has small or negative profits, however they recommend using the EV/S ratio instead of the P/S. Benninga and Sarig (1997) state that valuation using multiples often requires several average ratios in order to be applicable in practice. According to Yoo (2006), if the multiples are calculated based on historical numbers, then it is advised to use several multiples for valuation in order to improve the accuracy of the result. If the multiples are calculated based on a mixture of historical data and forecasted earnings then no improvements in the estimated firm value is observed, and it is thus enough to limit the valuation procedure to multiples that are based on forecasted earnings (Yoo,

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2006). This means that forecasted earnings should be used rather than historical data whenever possible (Koller et al., 2005). Damodaran (1994) states that there are at least two approaches to multiples valuation; one is the fundamentals approach, where the multiples are related to the fundamentals of the firm such as growth rates in earnings or cash flows, and the second one is the comparables approach, where multiples are estimated from the comparable firms. Alford (1992) discusses how to identify comparable firms, and states that choosing comparable firms based on several factors such as risk levels, growth rates and industry provides the most precise valuation results, however several firms that are so similar can be difficult to find in one industry. Therefore, using just one factor for identifying a comparable firm can be suggested. Selecting comparable firms based on risk levels or earnings growth is supported by the literature, but better results are achieved when the comparable firms are chosen based on the industry, and especially when the industry is defined narrowly (Alford, 1992). This view is also supported by Benninga and Sarig (1997) who write, that a clear definition of which industry the firm operates in is necessary to identify comparable firms. Based on the research conducted by Alford (1992) selecting comparable firms based both on industry and size does not improve the results compared to a selection based purely on industry. Cheng and McNamara (2000), find that industry is the most important factor for selecting comparable firms when P/E and P/B ratios are used for valuation. Cheng and McNamara (2002) recommend to use at least six comparable firms to estimate the average industry multiples, and in general they state that the larger the number of firms in a given industry, the better value estimates can be obtained. According to Benninga and Sarig (1997) the procedure of multiples valuation starts with selecting comparable firms. There are two main goals in the selection of comparable firms process and these are: selecting firms that are very similar to the valued company and selecting a relatively large sample of firms in order to get unbiased average multiples. Once the sample is in place, it is necessary to choose the relevant bases for multiples and then calculate the average ratios for the peer group. The estimated average ratios are then multiplied by the valued firms actual accounting numbers, whereby a value estimate is obtained (Cheng and McNamara, 2000).

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7.5.1 Advantages and disadvantages of multiples According to Damodaran (1994), it is beneficial to apply multiples, because they are easy to relate to and quick to calculate compared to other valuation methods. However, multiples are also easy to misuse and manipulate, particularly when the comparable approach is used, because the analyst can choose which firms to compare to in order to obtain a desired result. Additionally, valuation using multiples requires that there is a large number of comparable firms being traded in the market, and that these firms are priced correctly, which is not always the case in reality (Damodaran, 1994). Moreover, in the multiples method, the firm value is not obtained through the analysis of the firm like it is in for example the DCF model, but through a comparison to similar companies, which can easily lead to errors in the estimated value (Damodaran, 1994). Yoo (2006) also acknowledges the weaknesses of the multiples method and calls the obtained value and approximation rather than exact value estimation. Taking the weaknesses of the multiples method into account, it can be used, as suggested by Benninga and Sarig (1997), not as a primary method to value a company, but as a secondary method to verify that the result obtained from the primary valuation model is realistic. According to Copeland et al. (2000), valuation using multiples is a very limited method because it is often only earnings from the current year or the next year that are considered in the valuation. In relation to this, Liu et al. (2002) suggest that forecasted future earnings for several years should be used for value estimation, because they contain more value-relevant information than historical data. Copeland et al. (2000) state that the value estimated using multiples, which is based on earnings is not essential to investors, because in reality it is cash flows that matter and not earnings. Using multiples from comparative companies can thereby be misleading because companies can have similar levels of earnings, but different levels of cash flows, which lead to different company values, but this is ignored by the multiples approach (Copeland et al, 2000). However, in situations when earnings do reflect the actual cash flow level of the company, the earnings multiple performs well according to Copeland et al. (2000). In order to make the valuation using multiples more accurate Copeland et al. (2000) suggests including the investments required to generate the earnings and the risk associated with these investments into the equation. Alford (1992) finds that the value calculated using the multiples method is more accurate for large companies. This is explained by the fact that large companies generate their earnings from a higher number of different projects, which gives more diversification in their earnings, so that on average

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extraordinary profits and losses offset each other. This finding is also supported by the results from the analysis made by Lie and Lie (2002). According to Alford (1992), valuation using the P/E ratio is often applied in case of initial public offering (IPO). Kim and Ritter (1999) analyse the valuation using multiples method in relation to IPOs, and find that valuation based on P/E and P/S ratios provides satisfying results only if future forecasted numbers are used. Additionally, Kim and Ritter (1999) conclude that multiples analysis gives more accurate results for older firms than for young firms. Bhojraj and Lee (2002) state that using the firms own historical multiples provides the best results for public firms, however, because this data is not available for private firms, multiples obtained from comparable firms is a good tool to value private firms. 7.5.2 Evaluation of the multiples method Based on the literature review, it can be concluded that valuation using multiples is a simple method that can be used to obtain approximate firm values, and verify the results obtained using other valuation methods. There seems to be a disagreement in the literature about which ratio performs best. According to some sources the P/E ratio gives the best results and according to other sources the P/B ratio is the most accurate. However, the fact that the P/S ratio performs worse to the P/E and P/B ratios is proved in various analyses. Moreover, Koller et al. (2005) suggest using the EV/EBITDA multiple to deal with differences in capital structure of the comparable companies, and to use EV/S multiple for firms with negative profits. The multiples method is most often applied by estimating the ratios from the comparable firms. There is much discussion in the literature about how to identify the comparable firms, but many authors conclude that choosing the comparable firms based on industry provides satisfying results. It appears that multiples valuation is most effective when it is applied to large, old companies and when the multiples are calculated using forecasted earnings. Finally, some researchers claim that valuation using multiples is useful to value private companies and IPOs.

8. Valuation of multibusiness companies According to Koller et al. (2005), many large companies operate in multiple industries. Operating in different industries usually leads to the net income and growth being very diverse for the different operating units of the company. Damodaran (2009, 2) states that when a company operates in multiple businesses and in multiple countries the valuation of the whole company becomes much more challenging than valuation of a single business company. When a company operates in several industries, Koller et al. (2005) recommend valuing each operating unit individually and then Page 41 of 112

summing up the values of the different units to obtain an overall value for the entire firm. However, Damodaran (2009, 2) does not agree with this suggestion and states that the value of the entire firm could be more or less than just the sum of its parts. The company value could be more than the sum, if all the business units of the company create valuable synergies. On the other hand, the company value could be less than the sum of its parts, if the business units being one company results in lower efficiency than if these business units were individual companies. Technically to value a multibusiness company using the DCF method, separate financial statements and individual cost of capital estimates are needed for each business unit. Furthermore, the determination of levered beta is necessary to value the company, here again it is advised to estimate separate betas for each business unit rather than one beta for the whole company, as this practice has proved to give more exact results. When all the necessary input variables including cash flow estimates for each business unit are obtained, the whole firm can be valued as a sum of the business unit values (Koller et al., 2005). 8.1 Challenges of valuing multibusiness companies One of the challenges in valuing multibusiness companies as a sum of its parts is that there are usually high centralized costs in the company, which cannot be spread out to the various business units, this challenge is mentioned by both Koller et al. (2005) and Damodaran (2009, 2 ). The complexity of valuing multibusiness firms increases, if the firms have many intercompany transactions where the different business units for example sell goods to each other or lend each other money (Damodaran, 2009, 2). In relation to that, Koller et al. (2005) suggests treating the intercompany transactions like transactions with external partners and consider them in the valuation process. Another challenge that Damodaran (2009, 2) mentions in relation to valuation of multinational companies is that the cash flows from the firms operating activities are most likely in different currencies. This creates a challenge because the different currencies can have different inflation rates, discount rates and risk free rates. According to Damodaran (2009, 2) there are also issues that arise if valuation using multiples is applied to a multinational, multibusiness company. The main challenge is that, it is very difficult to find comparable firms that have exactly the same product mix. One solution could be to find comparable companies for each business unit; however this solution does not necessarily give correct results.

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8.2 Summary It is obvious from the literature review, that valuation of multibusiness companies that operate across different countries is much more complicated than valuing a single business domestic company, regardless of which valuation approach (consolidated or separate) is used. Valuing a multibusiness company is more challenging, however not impossible according to Damodaran (2009, 2).

9. The choice of corporate valuation theories The discounted cash flow analysis is chosen as the primary method to value ISS. Even though this analysis provides better estimates for companies with positive earnings as stated in section 7.1, it will still be applied to value ISS, because of the methods wide application and in-depth analysis of the companys value drivers, sources of growth and risk. The cash flows in the discounted cash flow analysis can be estimated by using for example dividends (DDM), residual income (RIM) or free cash flows (DCF) as discussed in sections 7.1 7.3. It is decided not to apply the DDM to value ISS, because dividends are often determined by a firms management and do not necessarily reflect a given years earnings. For example when ISS was public they paid out DKK 88 million in dividends from a profit of DKK 286 million in 2003. In 2004 the dividends were DKK 177 million, while the profit was DKK 131 million (ISS Annual report, 2004). However, when ISS became private in 2005 they paid out DKK 7.2 billion in dividends and in 2006 they paid out DKK 1.3 billion, whereas their actual profit for the year was DKK 948 million in 2005 and DKK 911 million in 200611 (ISS Annual report, 2006). Therefore, dividends are assumed not to be a reliable measure for valuation of a private company like ISS. The RIM model will also not be used to value ISS, because it is mainly based on accounting numbers and there is no agreement in the literature as to whether this is a benefit or not. Instead the DCF model with free cash flows will be applied, because the company has had positive cash flows even though there was a loss on the income statement (ISS Investor meeting, 2011). For this reason it is decided that the DCF model with free cash flows can be successfully applied to ISS.
11

These numbers are different from the numbers presented in appendix H, because these numbers are from the annual reports of ISS, i.e. the daughter company. The numbers in appendix H are from the consolidated income statements in the parent companys, i.e. FS Fundings, annual reports. FS Funding was renamed to ISS A/S in 2007.

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In the WACC formula, which is used for discounting the free cash flows to the present, the CAPM is chosen instead of the Fame and French three-factor model because empirical evidence concludes that neither of the two models performs better than the other, but CAPM is more often used in practice. Due to the fact that the DCF model is better for analyzing a profitable company and ISS has had negative earnings in the last five years, the DCF method will be supplemented with the real options analysis. The real options analysis will be used to capture the value of the flexibility that the companys managers have. To estimate the value of ISS real options the binomial model will be used, because it is the recommended choice in relation to real options. Lastly, a multiples analysis will be made in order to verify the value calculated using the DCF method and the real options analysis. The P/E ratio is meaningless when a firms earnings are negative, instead the P/B ratio or P/S ratio can be used. However, book values are more meaningful, when valuing the assets of a firm that has tangible assets. This means that for service firms, the P/S ratio, which is based on revenues and profit margins, may be more appropriate (Damodaran, 1996). However, based on the literature review in section 7.5, the P/S ratio is not practical to use and Koller et al. (2005) suggest using the EV/S ratio instead. The EV/S is recommended for companies with low or negative profits, which is the case for ISS as can be seen in appendix H. Thus the EV/S and the EV/EBITDA multiples will be applied to ISS.

10. Structure of the valuation process According to Benninga and Sarig (1997) a standard valuation process of a company consists of five stages: 1. Study of the corporate environment Benninga and Sarig (1997) write that this stage is necessary to understand the firms operations and market conditions, and to form some expectations about the future development which can be used in the forecasting stage. In this paper it is done by performing a strategic analysis of ISS in section 11.

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2. Examination of the firms expected financial performance After understanding the corporate environment that the valued firm operates in, it is necessary to analyse the firms historical financial performance and forecast the firms future expected financial performance (Benninga and Sarig, 1997). The historical performance of ISS is analysed by reformulating the companys financial statements in sections 12.3.1 12.3.3, and in section 12.3.8 ISS future FCF are forecasted based on the strategic analysis and the analysis of the historical performance. 3. Conversion of the firms expected financial performance to values In the third stage, the forecasted cash flows of the firm are discounted back to present values and a firm value is obtained (Benninga and Sarig, 1997). For ISS the forecasted FCF are discounted back by using WACC and added to the discounted continuing value in section 12.6. Furthermore, an option to expand is applied in section 13, and added to the value estimated with the DCF method, and thereby a total firm value is found. 4. Exploration of alternative valuation techniques The fourth stage considers alternative valuation techniques to verify the firm value obtained in stage 3 (Benninga and Sarig, 1997). In this thesis valuation using multiples is applied to ISS in section 14, to verify the results from the DCF and real options analysis. 5. Consideration of the implications of the estimated values Finally, the results should be considered in a relevant context, i.e. discussed in relation to the purpose of the valuation (Benninga and Sarig, 1997). This is done in section 15, where the obtained results are discussed in relation to the IPO and officially published value estimates for ISS.

11. Strategic analysis of ISS As mentioned in section 10 the first stage in the company valuation process is a study of the corporate environment that the valued firm operates in (Benninga and Sarig, 1997). In order to analyse the corporate environment a three stage structure suggested by Hollensen (2007) is applied. The three stage structure divides the analysis of the corporate environment into macro, meso and micro levels (Hollensen, 2007). At the macro level the external macroeconomic factors that affect ISS are examined, for this purpose a PESTEL analysis is used. At the meso level ISS interaction

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with its environment is analysed by applying Porters five forces analysis. Finally, at the micro level ISS core competences are identified. Additionally, in order to give an overview of the different aspects of the external and internal corporate environment a SWOT analysis for ISS is conducted.

11.1 PESTEL analysis The purpose of the PESTEL analysis is to examine various macro-environment aspects that can have an influence on a companys business. Specifically, the factors analysed in this model are the political, economic, social, technological, environmental and legal (Kotler and Keller, 2006). The most important factors of the macroeconomic environment that ISS operates are discussed below. Political and legal The political and legal parts are often combined into one section in a PESTEL analysis due to the similarities of these two factors (Hollensen, 2007). The points mentioned in this part are considered to be relevant for both the political and legal aspects, and it is therefore decided to combine the two sections. Being a multinational company, ISS has to operate under legislations of 53 different countries. The different legislations can set some limitations for ISS development of its global business activities and cause economic losses if any legislation is violated. An example of limitations that ISS can experience due to legislation is the restrictions on how many acquisitions ISS can make in a country, where they already have strong market presence without violating the competition law (ISS, 2011, 3). Making sure that national and international legislations are followed in the different locations requires a lot of resources from ISS and is thus very costly (ISS, 2011, 1). Another issue that most multinational companies have to deal with is the tax issue. According to Fischer (2006), it has been shown in many studies that multinational companies are sensitive to differences in the income taxes of the different countries. Since ISS operates in 53 countries they also have to use many resources on following the different tax rules. ISS recognizes that changes in tax levels and tax rules are important factors that can affect their business, especially given their high activity level in emerging markets where legislation and politics are often less stable than in Europe (ISS, 2011, 3).

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The issue of differences in legislation and trade restrictions becomes much less significant when a company operates across EU countries. The European Union has created favourable conditions of free movement of people, products, services and capital that make it easier and cheaper for multinational companies to operate across several EU countries and to enter new EU markets (Hollensen, 2007). The EU policy is very beneficial to ISS because Western Europe is their largest market where ISS generates 53% of its revenue (ISS Annual report, 2010). Economic An economic crisis in either one of the countries that ISS operates in, or a global economic crisis would affect ISS negatively (ISS, 2011, 3). During an economic crisis, customers are less inclined to purchase facility services, and ISS risks suffering operating losses, this is discussed further in section 11.4. As a multinational company, ISS is exposed to exchange rate risks, interest rate risks and inflation rate risks. ISS has mainly local transactions in the different countries and it carries out its local transactions in local currencies, which protects the different subsidiaries from exchange rate risk on a daily basis. However, the consolidated financial statements are completed in DKK and ISS is thereby exposed to exchange rate risks because 95% of ISS revenue is generated in other currencies than DKK (ISS, 2011, 3). Furthermore, ISS local business units obtain the necessary loans in local countries and ISS is thereby exposed to changes in interest rates in 53 countries. Finally, ISS is exposed to changes in inflation rates in all the countries that they operate in. In general exchange rates, interest rates and inflation rates are more volatile in emerging markets so ISS increasing investments in emerging markets makes them more sensitive to these factors (ISS, 2011, 3). Social In order to withstand competition and be able to get large contracts within the private and public sector, it is important for ISS to maintain a good reputation and brand name. In order to maintain a good reputation ISS has to deliver services at expected quality levels, fulfil their contractual obligations, make sure that the salaries they pay to their staff are in accordance with the local requirements and respond to eventual customer complaints in order to ensure customer satisfaction (ISS, 2011, 3).

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The success of ISS depends on the demand for facility services that ISS offers. According to one of ISS managers at the investor meeting,12 increasing welfare in the world leads to increasing demand for facility services (ISS investor meeting, Aarhus, 2011). Increasing welfare is therefore an important social factor for ISS. Technological 52% of ISS revenue is generated through the cleaning services (ISS, 2010, 4). Cleaning often requires a lot of manual labour; however, in order to make the cleaning process more effective advanced technologies are also used. For example in 2010 ISS started using a special environmentally friendly technology named ec-H2O which eliminates the use of chemicals and reduces the amount of water used in daily cleaning (ISS, 2010, 4). Another technological factor that is important to ISS is advanced IT systems which allow them to have an overview of all their operations in the 53 countries, and to align the various reporting procedures from all their subsidiaries (ISS, 2011, 3). Environmental The problems of using too much energy from non-sustainable energy sources such as coal13 or gas, and the effect on the environment from extensive use of various chemicals which can lead to problems such as global warming14 are general environmental problems that have received a lot of attention in the media. The mentioned environmental issues are all relevant to ISS because they for example need to use many different chemicals in their cleaning service (ISS, 2010, 4), and energy is always used for all types of activities, especially cleaning during night time. In order to minimize the negative effects on the environment, ISS is following an environment policy which amongst other things includes energy saving programs, minimization of cleaning chemicals and water used, and reduction of waste (ISS, 2011, 3). Furthermore, ISS is offering their customers ISS Green Cleaning where environmentally friendly chemicals are used, and the cleaning is done during the day hours in order to save energy otherwise needed for lighting up the buildings during the evenings and nights (ISS, 2010, 4).

12

The investor meeting with ISS took place in Aarhus on the 08.03.2011. The purpose of the meeting was to tell potential investors about ISS and their upcoming IPO. 13 http://www.ucsusa.org/clean_energy/coalvswind/c02c.html 14 http://www.globalwarming.org/

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Summary of the PESTEL analysis The external environmental factors which are mostly relevant for ISS operations have been identified and examined in this analysis. The factors that are most uncontrollable for ISS are considered to be the political and economic factors, because ISS is not able to affect a countrys politics, changes in legislation or what is happening to the macro economy. For the social factors, it is for example possible for ISS to affect their reputation in the market by working in accordance with the standards that they set. For the technological factors, it is possible for ISS to invest in new technologies and thereby achieve more efficiency, because technology is under constant development. And finally for the environmental factors, it is possible for ISS to focus on doing their business in an environmentally friendly way.

11.2 Porters five forces analysis According to Porter (1985), a companys profitability is mainly determined by the attractiveness of the industry in which it operates. Porter (1985) suggests five forces for evaluating the potential for profitability in an industry. These are: the competitive rivalry among existing firms, the bargaining power of suppliers, the bargaining power of buyers, the threats of substitute products and services and the threat of new entrants. The combined strengths of the five forces determine a firms ability to generate rates of return on investments above the cost of capital (Porter, 1985). ISS operates in many countries and in different industries such as commercial cleaning, security services and the catering industry. For this reason, ISS main competitors can be divided into three groups: the small local companies that offer one or more facility services to the local customers, the international facility service companies such as Compass, Sodexo, G4S, Securitas (ISS, 2011, 3) Ecolab Inc and ABM Industries Incorporated (see appendix B), and companies that handle their facility services internally. In order to determine the attractiveness of the facility services industry for ISS, Porters five forces analysis is applied. The competitive rivalry among existing firms Due to the fact that the facility services industry includes many different types of services, the rivalry between the different competitors is less intense, because the different companies have different facility services as their primary operations. For example ISS main areas: cleaning and property services generated 52% and 20 % of the revenues in 2010, respectively, with the rest of the services (catering, support, security and facility management) accounting for the remaining 28% of Page 49 of 112

the revenue (ISS Annual report, 2010). In comparison, Compass mainly offers food and support services, Sodexo primarily focuses on food and facility management services, Rentokil mostly generates revenues from its hygiene services and products, while G4S and Securitas are security service companies. ABM generates most of its revenues from cleaning services, but it mainly operates in the countries, where ISS has either no or a low presence (see appendix B). Additionally, the intensity of competitor rivalry is reduced for ISS because the company has longterm contracts15 with its customers (ISS investor meeting, Aarhus, 2011). This way, the customers incur costs if they decide to switch service suppliers before the end of their contract. However, ISS is also subject to penalty costs if it does not fulfill the agreed contracts with its customers and suppliers and this can be considered as an exit barrier. In general, however, the facility services industry does not involve high investments in fixed assets such as (plants or machinery) (ISS, 2011, 3), thus there are low exit barriers and competitors will engage in more rivalry. The global facility services market has grown with about 6% per year from 2001 to 2006, and then the growth rate has decreased from 2006 to 2009 due to the global economic downturn. The growth rates depend on the geographical area with higher growth rates in Asia, South America and Eastern Europe and lower growth rates in Western Europe, the Nordic, the Pacific and North America (www.issworld.com). This development is also reflected in the development of the revenues generated by ISS services in the period 2006 to 2010, for example the percentage of the revenues from cleaning services, property services, and facility management out of the total revenue have decreased by 5%, 2% and 3%, respectively, in this period (Annual reports, ISS, 2006 2010) (see appendix C). In order to grow in this period, ISS has been acquiring other companies and so has its competitors. An increasing level of growth through acquisitions instead of organic growth may indicate that rivalry in the facility services industry is intense. In summary, ISS operates in different markets worldwide and there is no other company offering exactly the same combination of services. However, ISS still faces competition both at the national and international levels in the different markets.

15

According to Jakob Stausholm (CFO), ISS has long term contracts up to 10 years with some customers, and 80% of the companys revenue depends on long term contracts (ISS investor meeting, Aarhus, 2011). For example in 2011 ISS, signed a 5 year contract with telecoms operator TDC (www. issworld.com )

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The bargaining power of suppliers When the suppliers in a given industry have high bargaining power, the industry is assumed to be less attractive to operate in (Porter, 1985). ISS uses about 5500 suppliers every year for providing items such as cleaning products and vehicles, and in 2009 the company purchased products for DKK 1.3 billion from the different suppliers (Innologics, 2009). Due to the fact that ISS is a large and thereby attractive customer to the suppliers, it is assumed that it is relatively easy for ISS to find new suppliers. On the other hand, ISS may incur penalty costs in case it switches suppliers before a contract is fulfilled. In conclusion, the suppliers have low bargaining power over ISS and the industry is attractive for ISS to buy its supplies. The bargaining power of buyers ISS customers range from multinational companies such as The UK Foreign Commonwealth office, Hewlett-Packard and Sony Erikson that request integrated facility services, to small customers that demand single services. The companys 10 largest customers accounted for about 6% of the revenues in 2009 (ISS, 2011, 3). The bargaining power of ISS buyers is assumed to be low especially for buyers, who mainly demand single services. On the other hand, the buyers who demand integrated facility services in one or several countries may have some bargaining power and for example demand a discount due to their larger purchase of services. Overall, ISS has a relatively high bargaining power compared to the buyers due to the companys large customer base. The threats of substitute products and services The existence of substitute products can lower the attractiveness of a given industry by limiting price levels (Porter, 1985). In the facility services industry, there is currently no real substitute for the services that ISS offer because they require human involvement. However, in an economic recession companies may choose to perform activities such as cleaning and catering themselves to cut the costs down on their non-core activities. The threat of new entrants New entrants in an industry can increase the level of competition, thus reducing its attractiveness (Porter, 1985). The basic facility services such as cleaning services can be delivered with a few resources, this means that the entry barriers are low, and as a result there will always be small, local companies that enter this market. On the other hand, it requires more resources to deliver integrated

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facility services in several countries, and the threat of potential entrants at an international level, that offer various facility services, is therefore significantly lower (ISS, 2011, 3). Conclusion of the five forces Based on the above analysis, it can be concluded that the competition in the facility services industry and the threat of new entrants is relatively high, while the threat of substitutes and the bargaining power of suppliers and buyers is relatively low. Thus, it is moderately attractive for ISS to operate in the facility services industry.

11.3 Core competencies Core competencies arise from a companys technical and production expertise within its area of business. A combination of a firms core competencies and distinct capabilities such as unique business processes leads to competitive advantage (Kotler, 2000). Hamel and Prahalad (1990) suggest three characteristics for identifying a companys core competencies: that is, whether a companys skills: 1) create a significant contribution to the perceived customer benefits 2) are difficult to imitate and 3) have a breadth of applications to different potential markets. In order to identify ISS core competences, these characteristics are discussed below. The perceived customer benefits for ISS customers lie in the fact that the company offers customized integrated facility services. This way ISS makes its customers non-core jobs its main business and the customers can achieves benefits such as cost reductions16 and deal with one supplier of services. Additionally, ISS strategy, The ISS Way is difficult to imitate for competitors because it includes a unique delivery of services through an integration of people, processes and management (ISS, 2011, 5). ISS claims that the implementation of its strategy is supported by business growth; either organic or through acquisitions of different companies. Business growth has helped ISS to achieve a great customer base, knowledge, and an increase in its service capabilities and capacity (such as trained employees and consistent quality). This has then led to satisfied customers, who renewed their long-term contracts with ISS (issworld.com).

16

E.g. reception services can be combined with security services when an employee switches roles from the front desk to guard (www. issworld.com). A cleaning employee can also perform tasks such as watering plants, filling up vending machines or assist at the reception at peak hours (ISS, 2011, 5).

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Lastly, ISS skills can be applied in a wide variety of markets because they are centered on facilitating the customers needs. The services ISS provides, such as cleaning, security and food services are not related to the core activities of their customers, but are still necessary for all companies (www.issworld.com). In conclusion, the company has achieved its core competences through customization and an integration of the different facility services as well as its great emphasis on management of people and employee training. Furthermore, it is concluded that ISS strategy The ISS Way is a differentiation and growth strategy.

11.4 SWOT analysis SWOT analysis is an overall evaluation of a companys internal environment (strengths and weaknesses) and external environment (opportunities and threats). This simple marketing analysis can help a company identify ways for matching its strengths with its opportunities, converting its weaknesses into strengths as well as respond to the threats in the external environment (Kotler and Keller, 2006). For a large, multinational company like ISS numerous factors can be mentioned for each of the categories in this analysis, however, due to space limitations and the fact that this thesis focuses on the financial valuation of ISS, only the factors that are most important to company valuation are included in this section. Strengths ISS specializes within different types of services which are all described in section 2, and is thereby able to offer its customers individual contracts with the required service mixture, all delivered from ISS and managed by one person. This solution is often cheaper for customers compared to receiving all the services from individual suppliers as mentioned in section 11.3. ISS offers single services, a selection of two or more services which they call multi services, or the company can be in charge of all or most of the facility functions for a customer, which they call Integrated Facility Services. The fact that ISS can offer this flexibility of different service products to match their customers needs is recognized as a major strength and competitive advantage by the company (ISS, 2011, 1; ISS, 2011, 2). By being a multinational company, ISS is able to offer their multinational customers the same services in different countries. This way ISS multinational customers are able to centralise their

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service purchases and use the same supplier in various countries, while ISS gets major international contracts and thereby outcompetes the local service providers (ISS, 2011, 1). Weaknesses ISS is a very large and diverse multinational company which operates within different industries, this make ISS organizational structure very complex. Additionally, ISS is exposed to different types of risk in the different industries as mentioned in the PESTEL analysis. It is therefore a challenge to manage this very complex organization so that the different business units create synergy, and also to manage all the different risks that the company as a whole is facing (ISS, 2011, 1). Another weakness in relation to the organizational structure of ISS is the decentralisation, where the managers of the different subsidiaries are responsible for their subsidiarys performance. Even though ISS has many rules and guidelines regarding how their subsidiaries are expected to operate, it is difficult to fully control operations in 53 countries. Therefore, ISS depends on the managers ability to manage the subsidiaries that they are responsible for in a satisfying way. Due to large cultural differences especially between European markets and emerging markets, ISS can be subjected to for example lower quality performance or violation of local legislation in some countries which can affect the companys results negatively (ISS, 2011, 3). Since 2000 ISS has been buying and selling companies, and it has bought 660 companies in 48 countries, that it integrates in its organization. The sale of companies has mainly occurred in areas that ISS considers to be unfit with its strategy (ISS, 2011, 3). By achieving growth through acquisitions, ISS has been aggressively pursuing an inorganic growth strategy17 in the past years. The fast inorganic growth has led to the fact that ISS faces challenges related to integrating the various businesses as well as challenges in decreasing operational costs (RocSearch, 2011). As shown in appendix F ISS has very large amounts of debt. In fact the debts are so high that ISS has difficulties paying them off. If the company is not able to change the contract terms for its debts or refinance it in some way it will lead to major financial problems for ISS (ISS, 2011,1). Opportunities ISS has achieved high growth partly due to many acquisitions of smaller companies in the different countries as stated in Porters five forces analysis. According to ISS there is an opportunity to
17

http://www.marketresearch.com/product/display.asp?productid=1585206 (23.06.2011)

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continue with the growth strategy through acquisitions; however, their main focus is now on acquisitions in emerging markets18 (ISS, 2011,1). Additionally, ISS has very high debt levels which can be seen in appendix F and in an article published in June 201119 ISS informs about their request for an extension of their debt maturities. The largest lenders have already agreed to extend the debt maturities, which will give ISS some financial flexibility and thereby some opportunities to adjust their capital structure before launching their second time IPO. This way ISS hopes to get a better share price than the one offered in 2011 and also raise more capital to pay off some of the debt. Threats As mentioned in section 2, ISS offers services such as cleaning services, catering services etc. However, when the economy is going bad, as has been experienced during the financial crisis which started in 200720, services like those that ISS offer are often what companies cut down on first (Hollensen, 2007). Thus a weakening economy in a single country where ISS operates or a globally distressed economy is a major threat to ISS (ISS, 2011, 1). The fact that another financial crisis is a threat to ISS was also mentioned at the investor meeting with ISS (ISS investor meeting, Aarhus, 2011). Since ISS is a global company that operates across 53 countries, its overall financial results are very sensitive to changes in the exchange rates, interest rates and inflation rates, as described in the PESTEL analysis. According to ISS, large and unpredicted changes in any of these factors can affect their business very negatively and are therefore another significant threat (ISS, 2011, 1). Since the entering barriers are low within the service sector that ISS operates in, as discussed in Porters five forces analysis, ISS is subjected to heavy competition. ISS is therefore constantly threatened by losing contracts to competitive firms or by losing contracts if ISS customers decide to take care of the facility services themselves without using external suppliers (ISS, 2011, 3).

18

Emerging markets are defined by ISS as: Asia, East Europe, Latin America, Turkey, Israel and South Africa (ISS, 2011, 1) 19 http://www.issworld.com/press/press_releases/archive2011/Pages/ISS_Announcement_Amend_Extend.aspx 20 http://www.globalissues.org/article/768/global-financial-crisis

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Summary of the SWOT analysis In this section the most important aspects of ISS internal and external marketing environment were evaluated. ISS is good at differentiating themselves by offering a selection of services and customized offers, but are threatened by major competition. Thus, to facilitate its strengths of providing consistent high quality services worldwide, ISS can work on making their employee management policies and worldwide operations more effective and thereby outperform competitors. Additionally, by being multinational ISS has an advantage of servicing their multinational customers in different countries, but is on the other hand threatened by both global and local economic risk factors in all the markets. To deal with some of these risks the company can thoroughly examine the tradeoffs associated with operating in each country. Finally, an important negative factor that is currently very relevant for ISS is their major debt levels, which they have difficulties paying off. Besides extending the debt maturities, the company can raise more capital to decrease the debt by becoming listed on the stock market and divesting in unprofitable operations.

12. Valuation of ISS using the DCF model The DCF method for a company that offers one type of business in one industry can be set up by using the four steps that are discussed in section 7.1. Due to the fact that ISS is a multibusiness and a multinational company, it has been decided to add two additional steps to the DCF method: These are: the choice between using aggregated or disaggregated numbers and the currency choice. The following sections include a DCF analysis of ISS using the six steps. 12.1 Step 1: Choice between using aggregated or disaggregated numbers As the first step in valuing a multibusiness, multinational company Damodaran (2009 2) suggests to choose between valuing the company as a whole using consolidated financial statements or valuing the different business units separately. The first determinant of the decision is the availability of information for the company. ISS provides consolidated financial statements for the whole corporation in the annual report for 2010, there is however no accounting information available for the different subsidiaries. The second point that is important to consider is how different the various business units are. If the differences in terms of for example risk and growth are not very big, the company should be valued as consolidated (Damodaran, 2009 2). Even though, there are some differences in terms of risk and growth in the business units located in

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developed and developing countries, ISS revenues from developing countries are at a relatively low level compared to the revenues generated from businesses in developed countries. For this reason country specific risk and growth are assumed not to have a significant effect on firm value. Additionally, there is insufficient information to determine risk and growth rates for each country. Lastly, it should be considered how many business units the company has and how many countries it operates in. If this leads to an unreasonably high number of valuations, it is more beneficial to value the overall company. ISS offers 6 different services, as described in section 2, and operates in 53 countries. Not all services are provided in all countries, but if each service in each country is treated as a separate business unit it amounts up to 644 business units21 that need to be valued. Due to the fact that there is no financial information available for the different subsidiaries and that valuing 644 business units requires too many resources compared to the potential gain. Based on the discussion above, it is decided to value ISS using consolidated financial statements. 12.2 Step 2: Currency choice The second step in the multinational, multibusiness company valuation is the choice of currency. It is necessary to choose one currency to work with when the company is valued as a whole. In practice, it is often chosen to use the currency in which the companys consolidated financial statements are reported (Damodaran, 2009 2). ISS consolidated financial statements are reported in DKK, and it is therefore decided that the valuation of ISS will be carried out in DKK in this paper. 12.3 Step 3: Calculation of free cash flow As mentioned in section 7.1.1, the main drivers of a companys value: the return on invested capital (ROIC)22, the growth rate and free cash flow cannot be directly determined from a companys annual report. Thus, it is necessary to reformulate these statements so as to identify a companys operating items, non operating items and financial structure (Koller et. al, 2005). The reformulated statement of shareholders equity provides the overall profitability measure: the return on shareholders common equity (ROCE) which together with growth determines the companys value. The reformulated balance sheet and income statement provide more details about

21 22

Based on the information provided on p. 163 in ISS Annual report, 2010 Also known as: return on net operating assets (RNOA), which is the notation used by Penman (2010), and which will also be used throughout this paper

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the sources of profitability and growth, i.e. the drivers of ROCE and growth, which will be used for forecasting the free cash flow and valuing the company (Penman, 2010). The quality of financial statements ISS consolidated financial statements, which are used in the analysis of the company, are prepared according to International Financial Reporting Standards (IFRS) in the analyzed period. Even though, ISS switched from Danish accounting policies to IFRS in 2005, the information that was stated according to the Danish accounting policies has been changed to comply with IFRS (ISS, Annual report, 2005). The financial statements are assumed to be reliable (provide a true and fair view of the companys financial position) because they are signed by the board of directors, the executive group management and an independent auditor (KPMG) (ISS, Annual report, 2005). 12.3.1 The reformulated statement of shareholders equity (SE) The reformulated statement of shareholders equity shows all the transactions that affect equity in a company. This statement also corrects the fact that the earnings in the reported income statement are not complete, by identifying comprehensive income (Penman, 2010). Furthermore, the profitability of the owners investment for the period (ROCE) and the growth in equity from business activities can be calculated from the data in the SE statement (Penman, 2010). The formula for ROCE for the current year (period t) can be stated as:

Where:

is the average common shareholders equity for the year.

The analysis of the drivers of ROCE is called the profitability analysis, and it is discussed further in section 12.3.5. The original statements of shareholders equity for the years 2005-2010 are enclosed in appendix D and the reformulated statements of shareholders equity are enclosed in appendix E. 12.3.2 The reformulated balance sheet According to Penman (2010), the balance sheet is reformulated by categorizing the different balance sheet items into operating assets (OA), financial assets (FA), operating liabilities (OL) and financial obligations (FO). Afterwards, the net operating assets (NOA) are calculated as: NOA = OA OL

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And the net financial assets/obligations (NFA/NFO) are calculated as: NFA = FA FO or NFO = FO FA Finally, common shareholders equity (CSE) is found as: CSE = NOA NFO minority interest It is decided to analyse the financial statements of ISS for the years 2005-2010, because ISS was acquired in 2005 and as a consequence its financial structure has changed since 2005. The original balance sheets for the years 2005-2010 are enclosed in appendix F and the reformulated balance sheets are enclosed in appendix G. As it can be seen from the reformulated balance sheets, ISS has net financial obligations rather than net financial assets for all the years. This means that ISS is financing its operations mainly through debt rather than equity. For example in 2010 the company had DKK 32,955 million in net operating assets, DKK 30,329 million (92%) were financed through debt (NFO) and DKK 2,626 million (8%) were financed through equity. In general for the period 2006-2010 over 80% of NOA were financed by NFO. The main part of operating assets for ISS are the intangible assets (e.g. goodwill, brands, customer contracts), which account for DKK 35,358 million (69%) out of the total DKK 51,520 million in 2010. In comparison, fixed tangible assets (property, plant and equipment) account only for a small share DKK 2,055 million (4%). This finding is consistent with the strategic analysis of ISS in section 11, which stated that there are no requirements for major investments in tangible fixed assets in the facility service industry. The intangible fixed assets are specified in note 15 in ISS annual report from 2010, and it can be seen that DKK 27,747 million is goodwill; this means that most of the intangible fixed assets are generated from acquisition of other companies. This confirms the fact stated in section 11 that ISS has been focused on growth through acquisitions. The last noticeable item in the operating assets is the trade receivables, which account for DKK 10,896 million (31%) in 2010. This means that ISS sells a large amount of services on credit to its customers; compared to the total revenue from 2010 which was DKK 74,073 million, 15% of services are sold on credit. According to the annual report (2010), DKK 241 million (2%) of the trade receivables are written off as uncollectable receivables. Having such high trade receivables makes the company more risky, because there is always a risk that the receivables will be uncollectable, and it also reduces the cash flow to the firm. The trade payables are low relative to trade receivables. Trade payables account for DKK 2,830 million (15%) of the total operating liabilities, which are DKK 18,565 million. This shows that ISS does not purchase nearly as much on credit as it sells. It is not very good for the shareholders, because it means that more purchases have

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to be financed through either debt or equity, and it also reduces the cash flow to the firm. If the money was not paid to the suppliers immediately, it could have been temporary invested in e.g. financial securities to generate more income. 12.3.3 The reformulated income statement Penman (2010) states that it is necessary to reformulate the companys income statement by grouping the different items presented in the original income statement into operating items and financing items. The operating items are divided into operating income from sales and other operating income in order to identify the profitability from trading with customers. Furthermore, the reformulated income statement includes items from the reformulated statement of owners equity and the obtained result from the reformulated income statement is therefore comprehensive income. A last important change in the reformulated income statement is the allocation of taxes. Taxes are allocated to the operating and financing items, so that the operating income from sales after taxes is not affected by the tax shield that financial expenses generate. Penman (2010) recommends using the marginal tax rate rather than the effective tax rate for the tax allocation purposes. For ISS, the marginal tax rate is the Danish corporate tax rate, which was 28% in the years 2005-2006 and 25% in the following years. The reformulated income statement for ISS in appendix I, shows the companys operating income from sales after taxes which is DKK 3,318 million. After accounting for other income and expenses which are not related to trade with customers, the after tax result is DKK 2,133 million. This income is reduced by ISS net financial expenses of DKK 2,368 million (DKK 1,776 million after tax) which are caused by the large net financial obligations, identified in the reformulated balance sheet, amounting up to DKK 34,244 million. This leaves the company with a comprehensive income of DKK 357 million at the end of 2010. 12.3.4 Trend analysis Penman (2010) suggests performing a trend analysis of the valued companys historical financial statements in order to have an overview of how the different items have changed over time. Thus, a trend analysis is made for ISS for the years 2005-2010 with 2005 as the base year. A deeper analysis of the changes is performed in section 12.3.5. The trend analysis for selected items from the reformulated income statement is shown in table 12.1.

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Table 12.1 Trend analysis of selected items from the reformulated income statement
2010 Operating revenues Gross margin Operating income from sales (before tax) or Core operating income Operating income from sales (after tax) Operating income (after tax) Financial income Net financial expense 233.37 236.16 214.73 2009 217.40 217.66 198.99 2008 216.85 221.97 206.88 2007 201.39 207.26 196.39 2006 175.71 174.53 166.97 2005 100.00 100.00 100.00 Base: 2005 in DKK million 31,741 8,352 2,383

229.54 784.58 215.22 143.33

206.10 162.06 242.39 139.70

231.98 35.37 263.04 165.30

243.34 606.99 216.30 182.61

177.80 334.31 250.00 136.61

100.00 100.00 100.00 100.00

1,445 272 92 1,239

Source: Authors, 2011, based on the reformulated income statement

It can be seen from table 12.1 that operating revenues have grown in all the years in the analyzed period, and the total growth in operating revenues from 2005 to 2010 is 133.37%. The gross margin has in general grown at a rate that is close to the growth rate of operating revenues, which means that cost of sales have been relatively stable over the years. Operating income has grown substantially over the years, with an increase of 684.58% from 2005 to 2010, however, this positive trend has been reduced by the high net financial expenses, resulting in a negative comprehensive income in 2010 (see appendix I). Looking at the trend analysis for the reformulated balance sheet presented in table 12.2, an increasing level of trade receivables can be observed, this means that ISS have been allowing its customer an increasing level of credit, which is not very good for the company as it reduces the FCF to shareholders.

Table 12.2 Trend analysis of selected items from the reformulated balance sheet
2010 2009 2008 2007 2006 2005 Base: 2005 in DKK million 7564 1952 29362 1804 2097 24685 22588 6714

Trade receivables 144.05 133.92 133.49 Trade payables 144.98 134.43 145.24 Net operating assets 112.32 111.83 111.49 Cash and cash equivalents 199.89 186.47 164.14 Total financial assets 186.70 178.21 156.65 Total financial obligations 138.72 139.19 131.61 Net financial obligations 134.27 135.57 129.29 Common shareholders' equity 39.11 32.62 52.10 (CSE) Source: Authors, 2011, based on the reformulated balance sheet

133.71 140.88 117.66 143.07 137.96 129.31 128.51 81.31

122.70 132.94 109.35 122.84 119.89 116.02 115.66 88.13

100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

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Trade payables have been increasing with almost the same percent rate as trade receivables; however, given the substantially lower base amount in 2005 for the trade payables, the actual increase in trade payables is much lower than the actual increase in trade receivables, therefore the FCF to shareholders has not increased that much. Net operating assets and net financial obligations have both increased in the 5 years period, however NFO have increased at a higher rate than NOA. The growth in the NOA indicates that ISS is investing in its operations over the years, and the high growth in net financial obligations indicates that the company is mainly financing its operations through loans. Common shareholders equity has been decreasing over the years, and in total from 2005 to 2010 the CSE has decreased by 60.89%. This indicates that the owners have reduced their investment in the company significantly since the acquisition in 2005, probably due to the planned sale of the company. Moreover, total financial assets are increasing continuously over the years, with a total increase of 86.7% from 2005 to 2010. This means that ISS has also been focusing on generating income by investing in financial assets; this is reflected in the income statement because the financial income increases overall during the period, with a total increase of 115.22% in 2010 compared to 2005. 12.3.5 Profitability analysis According to Penman (2010), the analysis of the drivers of ROCE, i.e. the profitability analysis can be performed at three levels: 1) the analysis of financial and operating liability leverage, 2) the analysis of the drivers of operating profitability and 3) the analysis of the profit margin and turnover drivers (see appendix J). Through the profitability analysis, it can be determined where the firm is now financially, and by understanding the present ROCE of the firm, the analyst can predict whether the future ROCE will be different from the current ROCE (Penman, 2010). The profitability analysis is based on the years 2006 - 2010 because some of the formulas for the ratios involve using prior years and for 2005, the prior year 2004 is not comparable to the other years, because ISS was a public company in 2004 and it had amongst other things a different capital structure.

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Level 1: The analysis of financial and operating liability leverage The first level break down of ROCE separates the profitability from operating activities and financing activities. Additionally, the effect of leverage, that levers ROCE upwards or downwards through liabilities is also analyzed at this level (Penman, 2010). Financial leverage Financial leverage (FLEV) refers to the degree to which a business finances its net operating assets (NOA) with net financial obligations (NFO) or by common equity. As shown in appendix J, ROCE can also be stated as (Penman, 2010):

The formula above implies that ROCE depends on the return on net operating assets, financial leverage and net borrowing costs (NBC23). If a company does not have financial leverage, then ROCE is equal to its return on net operating assets (RNOA24). Moreover, favorable leverage is achieved when a company generates a RNOA higher than its after tax NBC (Penman, 2010). As mentioned in section 12.3.2, ISS is financing its net operating assets mainly through debt rather than equity. The effect from the use of debt financing can be seen in table 12.3, which shows that in the period 2006 2009, the debt had a negative influence on ROCE, and during this period ISS was not able to generate a RNOA higher than its net borrowing cost, which led to an unfavourable leverage and a negative spread, with a huge impact especially in 2009 and 2008. However in 2010, ISS RNOA increased from 1.35% in 2009 to 6.49% in 2010 (an increase of 5.14%), and in the same period the company achieved a positive spread. This improvement in RNOA resulted in a positive ROCE of 14.84%25. The reasons for this development will be discussed in the level 2 and level 3 breakdowns below.

23 24

NBC = NFE (after tax) / NFO RNOA = OI (after tax) / NOA = OI after tax / (OA OL) 25 The results for the same ratio using different formulas might not be identical due to rounding errors

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Table 12.3 ROCE first level break down, financial leverage

2010 30,476 2,408 12.66 1,754 6.49% 5.83% 0.66% 14.84% 2009 29,913 2,844 10.52 1,890 1.35% 5.79% -4.44% -45.37% 2008 29,116 4,479 6.50 2,156 0.29% 7.03% -6.75% -43.59% 2007 27,577 5,688 4.85 1,978 4.96% 8.21% -3.25% -10.80% 2006 24,357 6,316 3.86 1,466 2.96% 6.95% -3.99% -12.43%

Average (NFO) Average equity Financial leverage (FLEV) Net financial expense after tax (NFE) RNOA Net borrowing cost (NBC) SPREAD (RNOA-NBC) ROCE Source: Authors, 2011

As shown in table 12.3 under FLEV, ISS is highly leveraged with an increasing financial leverage in the period 2006-2010 and the higher leverage a company has the higher is its risk. As seen in appendix H, ISS has been making losses in all the years partly due to the high financial expenses in table 12.3. To compensate for the losses, the owners have been borrowing more money, and this is illustrated by the increasing amounts of NFO in table 12.3. RNOA shows how efficient a firms management is at using its operating assets to generate profit (Penman, 2010). Table 12.3 shows that the RNOA decreased from 4.96% in 2007 to its lowest level of 0.29% in 2008 and then it started increasing until the year 2010 as mentioned earlier. An increase in the RNOA can be due to higher profit margins or a more efficient use of operating assets and operating liabilities in generating revenue. The RNOA is discussed further in the level 2 breakdown. Operating liability leverage Operating liability leverage (OLLEV) refers to the degree to which a firm applies operating liabilities (OL) to lever up the RNOA through a reduction in net operating assets (Penman, 2010). As mentioned in section 11.4, there was a financial crisis that started in 2007. The financial crisis may be the main reason for the downturn development for ISS operating income from DKK 1,652 million in 2007 to DKK 96 million in 2008, which is a decrease of 94% as shown in table 12.4. In this period ISS also had huge losses on hedges and foreign exchange adjustments of subsidiaries and non-controlling interests and its lowest RNOA 0.29%.

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Table 12.4 ROCE first level break down, operating liability leverage
2010 Total operating income (OI) after tax Total operating assets Total operating liabilities Net operating assets ( OA-OL) RNOA (OI after tax/ average NOA) Operating income from sales (after tax) or core OI RNOA from sales or core RNOA OLLEV Source: Authors, 2011 2,135 50,617 18,540 32,908 6.49% 3,318 10.08% 55.19% 2009 441 50,320 17,782 32,786 1.35% 2,979 9.09% 53.93% 2008 96 52,455 17,583 33,642 0.29% 3,353 9.97% 52.75% 2007 1,652 49,739 17,909 33,326 4.96% 3,517 10.55% 53.32% 2006 910 44,359 17,633 30734 2.96% 2,570 8.36% 53.08%

Despite the economic downturn, ISS managed to gradually improve its operating income from DKK 441 million in 2009 to DKK 2,135 million in 2010 (an increase of 384%). Looking at ISS core OI in table 12.4, ISS has generally been able to generate a higher operating income from sales in the period 2006-2010, with an increase of 29 % from 2006 to 2010, despite a 15% decrease in core operating income from 2007-2009. This has lead to a higher core RNOA relative to RNOA. However, ISS has also incurred high operating expenses over the years, which reduced its total operating income. These expenses have resulted in relatively low RNOA levels, which are lower than the net borrowing cost, and thus wealth was not created for ISS shareholders in the period 2006 -2009. In general, ISS NOA are high relative to its operating liabilities as shown in table 12.4 in the years 2006 to 2010, which results in relatively high OLLEV over 50%26. This means that it has been necessary for ISS to invest a lot of capital in operating assets as discussed in section 12.3.2. By investing a lot of cash in operating assets, ISS does not create value for the shareholders because the company could for example put the money to an alternative use by letting the suppliers carry the investment in e.g. inventory. Level 2: The analysis of the drivers of operating profitability At this level the RNOA, is analyzed further. The two drivers of RNOA are the operating profit margin (PM) and the asset turnover (ATO). The PM measures how much a company makes on each DKK of sales, and it is calculated as: (Penman, 2010)
26

According to Penman (2010) a typical OLLEV is around 40%

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PM = OI (after taxes)/sales The ATO measures the amount of sales generated for every DKK of NOA. The ATO is determined as: ATO = Sales/NOA

In general, there is a tradeoff between ATO and PM, companies with businesses that require low investments tend to yield a high ATO and a low PM (Penman, 2010). As table 12.5 shows, ISS PM has been relatively low throughout the period, with 2010 showing the best results. Table 12.5 ROCE second level break down, operating profitability analysis
2010 Operating revenues Operating income (after tax) PM Average NOA ATO Inverse value ATO 74,073 2,135 2.88% 32,908 2.25 0.44 2009 69,004 441 0.64% 32,786 2.10 0.48 2008 68,829 96 0.14% 33,642 2.05 0.49 2007 63,922 1,652 2.58% 33,326 1.92 0.52 2006 55,772 910 1.63% 30,734 1.81 0.55

Source: Authors, 2011, based on the financial statement analysis

The PM increased from 2006 to 2007, then it decreased in 2008 due to the financial crisis and the costs incurred during this period. The generally low PM implies that ISS operates in competitive markets. A low PM also indicates that there is a possibility for making high ATO and there is a low investment requirement to enter a given market. Due to the low entry barriers in the facility services industry as mentioned in section 11.2, this will attract competition and ISS may be forced to lower its sales prices in order to maintain the turnover. Furthermore the asset turnover measures a firm's efficiency at using its assets in generating sales or revenue, the higher the number the better. ISS ATO has increased by 24% from 2006 to 2010; this is possibly due to the increase in revenues over the period. This may imply a slight improvement in the ATO, that can also be seen in ISS decreasing inverse value of ATO, which shows how much money is tied up in operating assets in order to generate 1 DKK of revenue; for example in 2006 ISS used 0.55 per DKK for every 1 DKK of revenue, but in 2010, ISS used a lesser amount of DKK 0.44, (a decrease of 20%). Level 3: The analysis of the profit margin and turnover drivers Level three involves an analysis of the drivers of the profit margin and turnover.

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The profit margin drivers The profit margin consists of the sales profit margin and other items profit margin. The sales profit margin is increased by reducing a companys costs of sales, by adding income from other items and by reducing costs per dollar of sales (Penman, 2010). For ISS cost of sales consist of staff cost and consumables. Table 12.6 shows that the consumables account for a relatively low percentage of revenue which has been stable from 2006-2007 and thereby not improved the PM ratio. Table 12.6 ROCE third level break down, PM and ATO drivers
2010 Profit margin drivers Operating revenues Staff cost (% of revenue) Consumables (% of revenue) Other operating expense (% of revenue) Turnover drivers Total operating working capital Operating working capital / Sales Total long-term NOA Long-term net operating asset / Sales 74,073 64.79% 8.58% 19.72% 2009 69,004 64.90% 8.76% 19.47% 2008 68,829 64.15% 8.91% 19.77% 2007 63,922 64.14% 8.78% 19.76% 2006 55,772 65.06% 8.81% 19.00%

-1,378 -0.019 34,358 0.46

-1,584 -0.023 34,419 0.50

-2,307 -0.034 35,044 0.51

-1,617 -0.025 36,163 0.57

-2,291 -0.041 34,397 0.62

Source: Authors, 2011, based on the financial statement analysis

Moreover, ISS staff costs account for the largest part of its cost of sales, and these costs have also not changed considerably from 2006-2010. According to ISS (2011, 3) one of the reasons for the lack of reduction in staff costs is the fact that employment in the facility services industry is often considered as a temporally job or a second job by many people, and ISS incurs recruitment and training costs every time a new employee is hired. ISS has been trying to reduce staff costs by for example providing varying work tasks and training courses, in hope that the employees can become more efficient (ISS, 2011, 3). Additionally, the staff costs are also related to the revenue in the sense that when the company gets a new contract they can hire new employees and thereby also increase their revenue. ISS can also fire the employees if they for example lose a big contract or do not have work for them. Overall, there has been no great decrease in these costs and thereby no added improvement to the PM.

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Furthermore, another reason for the low PM ratio is the fact that ISS has high other operating expenses during this period. The turnover drivers The turnover drivers can be grouped into the operating working capital27 driver and the long-term net operating asset driver28 (Penman, 2010) (see the electronic appendix 1, working capital & longterm NOA). As table 12.6, illustrates, ISS operating working capital was negative from 2006-2010, this means that during the whole period ISS was unable to meet its short-term liabilities with its current assets. This may indicate that ISS was not operating in the most efficient way because e.g. money that is tied up in current assets e.g. accounts receivables cannot be used to pay off the company's obligations as discussed in section 12.3.2. The long-term net operating assets to sales ratio has decreased over the years from 0.62 in 2006 to 0.46 in 2010 (a reduction of 26%), this means that ISS has improved at using its long-term NOA in generating sales. 12.3.6 Summary of the financial statement analysis The financial statement analysis has shown that ISS finances its operations through debt rather than equity, and this has had a negative effect on the companys ROCE. This is because ISS was not able to generate a RNOA higher than its net borrowing cost in the years 2006 to 2009. Additionally, there was a downward development in ISS performance in the years 2008 and 2009 mainly due the financial crisis; however ISS has managed to improve its performance in the year 2010. For all the years, ISS net operating assets have been high relative to its operating liabilities, and this means that it has been necessary for ISS to invest a lot of capital in operating assets, and thereby not create a lot of value for the shareholders. ISS relatively low PM ratios over the years are mainly due to intense competition in the industry and high operating costs, which have not been reduced considerably in the period 2006-2010. Despite the slight improvement in the assets turnover over the years, ISS has not been operating in the most effective way over the years, this may be due to the challenge of integrating the operations of the different acquired businesses as mentioned in section 11.4.

27 28

Operating working capital = operating current assets operating current liabilities Long-term operating assets usually consist of property, plant and equipment, intangibles and investments in equities

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12.3.7 The amount of free cash flow In order to achieve a correct result from the DCF analysis, it is necessary to obtain the free cash flow (FCF) from the reformulated financial statements. This can be done in three different ways: 1) FCF = operating income change in NOA where: operating income is gathered from the reformulated income statement and change in NOA is calculated from the reformulated balance sheet for the last two years. 2) FCF = net financial expense change in NFO + net dividends + minority interest in income change in minority interest in the balance sheet where: net financial expense is obtained from the reformulated income statement, the net dividends are from the reformulated statement of owners equity and the last three items are obtained from the reformulated balance sheets. 3) Find FCF by reformulating the cash flow statement If one of the first two methods is used to obtain the FCF, it is not necessary to reformulate the cash flow statement. Furthermore, it is more useful to forecast the expected free cash flows that are necessary for the DCF valuation by forecasting reformulated balance sheets and income statements, instead of forecasting the reformulated cash flow statements (Penman, 2010). Therefore it is decided to use method 1 to calculate the FCF for the DCF model, and to forecast the FCF in section 12.3.8. The FCF for the years 2006-2010 calculated using method 1 is illustrated in table 12.7. Table 12.7 ISS FCF in the years 2006-2010 (numbers in DKK million)
2010 Operating income NOA FCF 2135 32,980 1,990 2009 441 32,835 343 2008 96 32,737 1,905 2007 1652 34,546 -788 2006 910 32,106 -1,834 2005 272 29,362

Source: Authors, 2011, based in the reformulated financial statements

Table 12.7 shows that the FCF for ISS has been negative in the years 2006-2007 and positive in the period 2008-2010. 12.3.8 Forecasting free cash flow In order to forecast FCF, it is necessary to forecast its elements first. Therefore NOA and operating income are forecasted and used to calculate the FCF. The forecasts are made for a ten year period from 2011-2020, as recommended by Koller (2005). Selected forecasts up to year 2018 are

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presented in the following sections whilst the full forecasts can be found in the electronic appendix 1, valuation of ISS. It is decided only to include forecasts up to year 2018 in the presented tables due to the limited table space. Forecasting sales In order to forecast sales for ISS three main areas that are suggested in Penman (2010) are investigated, these are: the companys strategy, the market conditions and the companys marketing plan. In order to discuss and evaluate the effect of the different factors on sales, the strategic analysis performed in section 11 is used. In relation to the companys strategy, ISS follows a differentiation strategy where it focuses on creating a unique delivery of services which is difficult for the competitors to imitate, as discussed in section 11.3. Furthermore, ISS is following a growth strategy. The company has grown mostly through acquisitions and partly organically over the past years, and their strategy involves continuing growth through acquisitions mainly in the emerging markets, and increasing organic growth. The strategic analysis shows that business growth helps ISS to increase its capacity and service capabilities which enable the company to serve more customers and to achieve higher customer satisfaction which for example leads to renewals of long-term contracts as mentioned in section 11.3 According to ISS (2011, 3) the key factors for sales increase are organic growth and growth through acquisitions, whilst an important factor that can reduce sales is divestment in subsidiaries. In relation to the market conditions for the facility services, it is expected that the demand for these services increases in an upward economic development as discussed in section 11.1. Gross domestic product (GDP) is an indicator of the level of the economic activity, e.g. ISS states that when GDP is growing in the countries where ISS operates, the demand for ISS products also grows. According to Eurostat the GDP in EU, which is the main market for ISS as mentioned in section 11, is expected to increase in the coming years, which is beneficial for ISS. The development in the GDP in the EU is presented in table 12.8.

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Table 12.8 Real GDP growth rate in EU

2006A European Union (25 countries) Source: Eurostat
29

2007A 2.90%

2008A 0.40%

2009A -4.20%

2010A 1.90%

2011E 1.80%

2012E 1.90%

3.20%

Furthermore, ISS is investing in emerging markets and as these markets pick up economically, the demand for ISS services is expected to increase accordingly (ISS, 2011, 3). However, in 2010 ISS only generated 18.3% of their revenue from emerging markets (ISS, 2011, 3) and the rest was generated from established markets (Europe and North America), so the impact from emerging markets is considered to be relatively low. In general, economic conditions mainly affect the single services that ISS offers, whilst the integrated facility services (IFS) are less sensitive to economic crises, this trend was experienced by ISS during the financial crisis which started in 2007. However, single services accounted for 64.8% of the total revenue in 2010, whilst IFS accounted for 18.7% and the remaining 16.5% was generated by multiservices (ISS, 2011, 3), therefore overall, ISS is evaluated to be sensitive to economic crises. ISS marketing plan is a part of their The ISS way strategy, where the company amongst other things focuses on increasing their sales of integrated facility services which is one of their major strengths (section 11.4), and which is expected to generate more profit than single services in the future. In order to forecast ISS sales in the future, historical growth levels in sales are analyzed first. From 2005 to 2010 the sales have increased continuously except for year 2009, the growth in sales is illustrated in table 12.9.

Table 12.9 Annual growth in sales for ISS

2010 Operating revenues (in million DKK) Annual growth Source: Authors, 2011 74.073 7.35% 2009 69.004 0.25% 2008 68.829 7.68% 2007 63.922 14.61% 2006 55.772 75.71% 2005 31.741

The major growth in sales in 2006 is most likely caused by the fact that ISS was acquired in 2005 and the growth and differentiation strategies discussed above started to be implemented by the new owners. 2008 and 2010 show a lower and more stable level of growth compared to the first years
29

http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/ (Real GDP growth rate)

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after acquisition. The low growth in 2009 is most likely caused by the financial crisis that started in 2007. In 2010 the growth in sales picked up again, probably due to the diminishing effect of the financial crisis. As the financial crisis is fading away, ISS level of sales is expected to continue increasing in the coming years. ISS differentiation and growth strategies that have lead to increases in sales in the past years are expected to increase the sales further in the future, assuming that there is no second financial crisis. Overall, it is expected that ISS sales will grow in the coming years, but the growth rate is expected to decrease slowly towards a stable long-term growth rate by the end of the forecast period. ISS experienced a growth in sales of 8% in the first quarter of 2011 compared to the first quarter of 2010, but for the whole 2011 the expected growth in sales is 4% (www.issworld.com). As mentioned in section 11.2, the global market for the facilities services has grown with approximately 6% per year in the period 2001-2006, and then at a slower rate in the period 20062009 mainly due to the economic downturn. Even though, the financial crisis temporarily reduced growth rates in the facility service industry, it is expected that this industry will improve with the recovery in world economy. This is because an economic downturn enforces the need for companies to reorganize their business operations in a cost-effective way in order to remain competitive in the market. The facility service industry is expected to increase at a moderate level in mature markets such as Europe and United States, and at a higher rate in emerging markets as the standard of living increases (Global Industry Analysts, Inc, 2011). As illustrated in table 12.10, it is decided to set the growth rate for 2011 to 4% to follow ISS expectations.

Table 12.10 Forecasted operating revenues

2010A Operating revenues (in DKK million) Revenue growth Source: Authors, 2011 74,073 7.35% 2011E 77,036 4.00% 2012E 81,658 6.00% 2013E 88,191 8.00% 2014E 93,482 6.00% 2015E 99,091 6.00% 2016E 104,541 5.50% 2017E 109,768 5.00% 2018E 114,708 4.50%

In 2012 the growth in sales is mainly expected to be due to the companys organic growth and partly due to acquisitions in the emerging markets. In 2013 the growth is expected to increase up to 8% due to improved operational efficiency and continued organic growth. In 2014 and 2015 the growth rate is set to 6% due to increased competition and a stabilized, lower level of organic

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growth. From 2016 the growth rates are expected to decrease slowly until they reach a stable level of 3.5% in 2018 (electronic appendix 1, valuation of ISS).

Forecasting ATO and calculating NOA When forecasting the NOA, Penman (2010) suggests first to forecast the ATO and then to calculate the NOA as: NOA = Sales/ATO An accurate estimate of the ATO is achieved by forecasting the different elements of ATO individually (Penman, 2010). In order to determine which elements of ATO should be forecasted separately for ISS, the ratios of all the different OA to sales and OL to sales are calculated for the years 2006-2010, selected items are presented in table 12.11, whilst the full dataset can be found in the electronic appendix 1, ATO drivers. Table 12.11 1/ATO drivers
2010 Average Intangible assets/sales Average PPE/sales Average trade receivables/sales Other average OA/sales Average deferred tax liabilities/sales Average trade payables/sales Average other liabilities/sales Other average OL/sales 1/ATO (OA/sales - OL/sales) Source: Authors, 2011 47.80% 2.74% 14.19% 4.21% 3.15% 3.68% 14.46% 3.23% 44.43% 2009 51.77% 3.10% 14.66% 3.61% 3.52% 3.96% 15.17% 2.98% 47.51% 2008 53.14% 3.27% 14.68% 3.57% 3.84% 4.06% 15.22% 2.66% 48.88% 2007 57.24% 3.43% 15.17% 4.09% 4.66% 4.18% 16.08% 2.88% 52.14% 2006 61.59% 3.69% 15.10% 3.97% 5.80% 4.08% 16.30% 3.08% 55.11%

It is decided to forecast the ratios that are higher than 2% separately, whilst the ratios that are lower than 2% are summed up and forecasted together as other average OA/sales. Based on the figures presented in table 12.11, it can be seen that the ratios with: intangible assets, property, plant and equipment and trade receivables are higher than 2%. Similarly, for operating liabilities: deferred tax liabilities, trade payables and other liabilities are forecasted individually

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and the rest are forecasted together as other operating liabilities. All the forecasts are enclosed in the electronic appendix 1, valuation of ISS, whilst the resulting 1/ATO, and the calculated ATO and NOA are presented in table 12.12. Table 12.12 Forecasted 1/ATO and calculated NOA
2010A 1/ATO ATO 44.43% 2011E 42.80% 2.34 32971 2012E 41.67% 2.40 34027 2013E 40.45% 2.47 35673 2014E 39.35% 2.54 36785 2015E 38.50% 2.60 38150 2016E 37.70% 2.65 39412 2017E 37.90% 2.64 41602 2018E 37.90% 2.64 43474

2.25 NOA = sales/ATO 32908 Source: Authors, 2011

The ATO drivers in the electronic appendix 1, valuation of ISS are forecasted based on a combination of their historical performance, available published information about ISS and the authors future assumptions about the given drivers. For example ISS, is planning to continue growing through acquisitions, but only to a limited extent (section 11). Intangible assets are mainly affected by acquisitions because 77% of intangible assets consist of goodwill (ISS Annual report, 2010), since no major acquisitions are planned by ISS, it is expected that the decreasing trend of intangible assets/sales ratio will continue. With regard to PPE in the years 2011-2020, it is decided to increase the PPE for the years 2012-2013 because additional PPE might be needed when the level of operations increases. Some of the items such as deferred tax liabilities/sales, other OA/sales and other OL/sales, which have not been subject to major changes in the past years, are set to constant growth rates. As it can be seen from table 12.12, ATO and NOA are calculated to increase gradually up to year 2018 based on the forecasted ATO drivers. After 2018 the growth is expected to stabilize, this effect will be captured by the continuing value which is calculated in section 12.5. Forecasting operating income In order to forecast operating income which is needed for the FCF calculation, it is necessary to forecast the different parts of operating income, these are: core operating income and other operating income/expense. The operating income is forecasted through the operating PM from both the core OI and other OI, using the formula (Penman, 2010):

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OI = sales * operating PM Table 12.13 contains the different components of the operating PM for ISS. As it can be seen from the table, all the costs directly related to sales have been quite stable in the period 2006-2010 as discussed in section 12.3.5. Thus, it is assumed that these costs will continue to be stable in the future. The costs which are directly related to sales, i.e. staff costs, consumables and operating expenses are forecasted as an average of the historical costs, and the rates are set to be constant for the whole forecast period due to the very small historical changes. The calculated forecasts for year 2011 are shown in table 12.13, and the full forecasts can be found in the electronic appendix 1, valuation of ISS. Table 12.13 Operating income to sales ratio and its components
2006A Operating revenues Staff cost/sales Consumables/sales Gross margin/sales Operating expenses/sales Core operating income (before tax)/sales Tax on operating income/sales Core operating income from sales (after tax)/sales Other operating expense (after tax)/sales Other operating income without tax effect/sales Total operating income (after tax)/sales 55,772 65.06% 8.81% 26.14% 19.00% 7.13% 2.53% 4.61% 2007A 63,922 64.14% 8.78% 27.08% 19.76% 7.32% 1.82% 5.50% 2008A 68,829 64.15% 8.91% 26.93% 19.77% 7.16% 2.29% 4.87% 2009A 69,004 64.90% 8.76% 26.34% 19.47% 6.87% 2.55% 4.32% 2010A 74,073 64.79% 8.58% 26.63% 19.72% 6.91% 2.43% 4.48% 2011E 77,036 64.78% 8.65% 26.57% 19.42% 7.15% 2.43% 4.72%

3.02% 0.05%

2.65% -0.26%

2.81% -1.92%

4.17% 0.49%

2.80% 1.20%

2.70% 1.00%

1.63%

2.58%

0.14%

0.64%

2.88%

3.02%

Source: Authors, 2011, based on the financial statement analysis

Additionally, other operating income for ISS consists of other operating expenses and other operating income without the tax effect. These ratios are also illustrated in table 12.13. The forecasted rate for other operating expense (after tax)/sales is set to 2.70% from 2011 to 2013, which is slightly lower than in 2010, and then this ratio is expected to decrease gradually as Page 75 of 112

illustrated in the electronic appendix 1, valuation of ISS. The ratio is forecasted in this way because the main part of these expenses is caused by goodwill impairment and amortization of brands (electronic appendix 1, PM drivers) and ISS expects to be able to lower these costs, partly because fewer acquisitions are expected in the coming years (ISS, 2011, 3). The forecasted rate for other operating income without tax effect/sales is set to 1% because this ratio has been increasing and decreasing over the years as illustrated in table 12.13, and since the main part of this income is caused by foreign exchange rate adjustments which will continue to exist due to ISS international operations, it is expected to have an effect in the future. As illustrated in table 12.14, the resulting operating PM is 3.02% in the years 2011-2013, 3.12% in the years 2014-2016 and then slowly increasing up to the long-term rate of 3.72% (electronic appendix 1, valuation of ISS). In general, the forecasted PM is slightly higher than in the past years, however it matches well with ISS expectations to increase its profit margin in the future (ISS, 2011, 3). Based on the forecasted operating PM and operating revenues, expected operating income is calculated for ISS, and the results up to year 2018 are presented in table 12.14. Table 12.14 Forecasted operating income
2010A Operating revenues Operating PM OI Source: Authors, 2011
30

2011E 77,036 3.02% 2,328

2012E 81,658 3.02% 2,468

2013E 88,191 3.02% 2,665

2014E 93,482 3.12% 2,918

2015E 99,091 3.12% 3,094

2016E 104,541 3.12% 3,264

2017E 109,768 3.32% 3,646

2018E 114,708 3.32% 3,811

74,073 2.88% 2,135

Calculating future FCF Based on the forecasted NOA and OI, it is possible to calculate the expected FCF for the forecast period. The expected FCF is calculated using the first method described in section 12.3.7. The resulting FCF up to year 2018 is presented in table 12.15, and the full forecasts up to year 2020 are enclosed in the electronic appendix 1, valuation of ISS.

30

Operating PM = Total operating income (after tax)/sales

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Table 12.15 Future FCF (in DKK million)

2010A 2011E 2012E 34,027 2,468 1,412 2013E 35,673 2,665 1,019 2014E 36,785 2,918 1,806 2015E 38,150 3,094 1,729 2016E 39,412 3,264 2,002 2017E 41,602 3,646 1,456 2018E 43,474 3,811 1,938

NOA 32,980 32,971 OI 2,135 2,328 FCF 1,990 2,337 Source: Authors, 2011

12.4 Step 4: Estimating the weighted average cost of capital According to Damodaran (2009 2), it is often necessary to adjust the risk levels for multinational companies that are incorporated in a developed country located in e.g. Europe or United States and operate in emerging markets. This is because the risk of operating in an emerging market is usually higher compared to operating in a developed market, discount rates assigned to the multinational company based on where it is incorporated do not represent the actual operating risk, and this will lead to an overvaluation of the company. ISS headquarter is in Denmark as mentioned in section 2 and the company does operate in developing countries, however ISS revenue from emerging markets accounts for only 18% of the total revenue (ISS Annual report, 2010) and this issue is therefore considered to be insignificant in case of ISS and will not be taken into account in the valuation process. The weighted average cost of capital (WACC) for ISS As stated in section 7.1.2, WACC can be calculated by determining its three components: the aftertax cost of debt, the cost of equity and the companys target capital structure (Koller et. al, 2005). Thus, the formula for WACC is (Brealey & Myers et al., 2007): WACC = Determining the risk free rate As mentioned in section 7.1.2, it is common practice to use the YTM from the German Eurobond as the risk free rate for European firms, because it is assumed to have higher liquidity and lower credit risk compared to bonds of other European countries. The 10-year German Eurobond with maturity

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in 2021 has currently a YTM of 2.8%31 and this rate is used as the risk free rate in the WACC calculation. ISS cost of debt As mentioned in section 7.1.2 a companys cost of debt can be determined by the following three factors: the risk free rate, the default spread and the tax rate. As stated above, ISS risk free rate is 2.8%. The default spread will be determined by using option a) from section 7.1.2 i.e. using the market interest rate on ISS long-term bonds. According to ISS annual report (2010) the companys market interest rate on long-term bonds is 5.01%. Thus, the default spread is determined as:

By using ISS marginal tax rate of 25%, the companys after tax cost of debt is determined as
After tax cost of debt = (Risk free rate + Default spread) (1- marginal tax rate) = 2.8%+2.21%*(1-25%) =3.76%.

The after tax cost of debt of 3.76% is used in ISS WACC calculation below. ISS cost of equity ISS cost of equity can be determined by the CAPM, which is discussed in section 7.1.2. The inputs to the CAPM: the risk free rate, beta and the market risk premium for ISS are determined in this section. ISS risk free rate is already determined to 2.8%, the beta and the market risk premium are determined below. Estimating beta for ISS As mentioned in section 7.1.2, the beta for private firms can be estimated by using: 1) accounting earnings, 2) using a private firms ratios to get fundamental betas or 3) using average betas for similar public firms to get bottom up betas. Due to the fact that ISS has negative earnings in the analyzed period, option 1 is not used. According to Damodaran (2009), fundamental betas often have a low R2, therefore option 2 is not used. It has been decided to apply option 3, whereby bottom
31

http://www.bloomberg.com/markets/rates-bonds/government-bonds/germany/ ( 13-07-2011)

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up betas are determined by using the market model regression that is stated in section 7.1.2. In order to determine the bottom up beta, returns from ISS competitors are regressed against the returns from the market. Five competitors32 are chosen for the regression, these are specified in table 12.16, and the market returns are determined based on MSCI world index. The regression results from the market model are stated in appendix K and table 12.16 shows ISS resulting bottom up beta (the calculations for table 12.16 can be seen in the electronic the electronic appendix 1, ISS bottom up beta). Table 12.16 Calculations for ISS bottom up beta
Levered Beta (Market model) Compass Sodexo Rentokil Ecolab ABM Average beta 0.92 0.92 1.68 0.71 0.91 1.028 51% 29% 53% 49% 34% 43% 0.06 0.09 0.58 0.05 0.02 0.16 Debt/Equity 0.59 0.88 0.87 1.19 0.69 0.90 0.90 Levered beta 1.30 R2 Debt/Equity Unlevered beta

ISS

Average unlevered beta 0.90

Source: Authors, Datastream, 2011

Table 12.16 shows the levered betas, the debt/equity ratio and the unlevered betas for the chosen peer group companies. In order to consider the differences in financial and operating leverage between ISS and the other firms in the market, the unlevered beta is adjusted so as to get a more accurate beta estimate. The adjustment can be made by using the average peer group D/E ratio or the private firms D/E ratio if it is stated by the management (Damodaran, 2009). Due to the fact that ISS has a high leverage compared to the peer group, it is decided to use the firms target D/E ratio of 0.59.

32

Due to the fact that the authors want to focus on companies that offer a wide variety of services like ISS in the regression analysis, it is decided not to include the companies G4S and Securitas because they offer security services.

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Thus, ISS levered beta is determined as (Damodaran, 2009):

Levered beta = Unlevered beta * (1 + (1 Tax rate) * (Debt / Equity))

= 0.90*(1+ (1- 0.25)*(0.59) =1.30 ISS has a rather high beta compared to the market, this means that the company is sensitive to market fluctuations and thereby has more operational and financial risk than the average firm in the market. This may be due to the companys high leverage. Additionally, table 12.16 shows that the average R2 from the regression analysis is relatively low (43%), which means that on average only 43% of the variation in the peer group's returns is explained by the market, while the rest is due to firm specific factors. This fact confirms the discussion in section 7.1.2, which states that the CAPM does not explain a lot of the variation in stock returns. Therefore, the results should be interpreted with caution. Calculating the market risk premium (MRP) As stated in section 7.1.2, the extra return that investors demand for taking on risk i.e. the risk premium, depends on the risk measure, beta, and the market risk premium .

In order to calculate the MRP, the historical return index for the MSCI world was retrieved from Datastream for the period 1970 2010 as shown in the electronic appendix 2, MSCI historical Rm. Additionally, the historical risk free rate for the same period was retrieved from www.forecastchart.com and afterwards the MRP was calculated by using the arithmetic average (Koller et al., 2005) as shown in the electronic appendix 2, market risk premium. As shown in this appendix, the resulting MRP is calculated to be 5.86%. However, according to a report by PriceWaterHouseCoopers (2010) about corporate valuation methods in practice and the level of MRP used by companies, it is concluded that companies use an MRP within the interval 4.0% to 7.2% with the average MRP of 4.9%. The calculated MRP of 5.86% is considered to be high relative to the average MRP of 4.9% presented in the report. The calculated MRP is based on 40 observation which might not be a long enough period, because Koller et al. (2005) suggest analyzing the past 75 years. However, the data on Datastream only reported observations for the past 41 years. Therefore, there is no reason to believe that the calculated MRP is more correct than the MRP reported by

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PriceWaterHouseCoopers (2010). Since changes in MRP have direct effect on the resulting WACC, and small changes in WACC can have a large effect on the resulting company value, as illustrated in section 12.8, it is decided to use a MRP of 4.9%. Calculating the cost of equity for ISS Having calculated the inputs for the CAPM formula, ISS cost of equity can now be determined as:

ISS cost of equity will be used in the WACC calculation. ISS target capital structure After estimating the cost of equity and the cost of debt, the next step towards calculating ISS WACC is to identify the target weights of debt and equity by using market values as mentioned in section 7.1.2. Estimating ISS target capital structure In order to identify ISS target debt and equity level, the companys NFO and equity are forecasted in the period 2011 to 2020. Table 12.17 shows the forecasts for the period 2011-2018, and the forecasts for the last two years can be seen in the electronic appendix 1, WACC and CAPM. Table 12.17 Forecasts of ISS NFO33 and equity
2011E NFO (debt) Percentage change NFO Equity Percentage change equity Source: Authors, 2011. 30,632 1.00% 2,651 0.00% 2012E 17,332 -43.42% 15,951 501.70% 2013E 16,639 -4.00% 19,141 20.00% 2014E 16,140 -3.00% 21,055 10.00% 2015E 15,817 -2.00% 22,108 5.00% 2016E 15,501 -2.00% 22,550 2.00% 2017E 15,191 -2.00% 23,001 2.00% 2018E 14,887 -2.00% 23,461 2.00%

As mentioned in section 12.3.5, ISS current capital structure consists mainly of debt financing and this has resulted in high financial costs and less value created for the shareholders. Thus, ISS is planning to go public in order to obtain cash to pay off some of the debt (ISS, 2011,3).

33

ISS book value of debt is assumed to be approximately equal to the market value of debt.

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Table 12.17 shows that in 2011, ISS NFO are assumed to increase by 1% from the 2010 debt level, due to the costs associated with extending the maturities on loans due in 2012 and 2013 by two years (Javed, 2011). For the rest of the forecast period, ISS debt levels are expected to decrease with the largest decrease occurring in 2012, because it is assumed that in this year ISS will go public, and use all of the proceeds from the IPO to reduce its debt level34 (this leads to a reduction of 43.42% of debt). In the following years, ISS debt is expected to decrease gradually at lower percentages as the principal is being paid off. In relation to the forecasts for the equity level, ISS is expected to issue shares worth DKK 13,300 million, and this will result in a market value of equity of DKK 15,951 million in 2012 (an increase of 501.70%) as shown in table 12.17. In 2013, it is assumed that ISS will issue more shares, in order to get more money to improve operations e.g. by integrating companies in order to grow organically and acquire companies, and this will result in a 20% increase in equity. Additionally, in 2014, it is assumed that the share price will increase or more shares will be issued and this will result in a 10% increase in equity value. For the rest of the years, it is assumed that the equity value will generally increase at lower percentages up to 2020. In conclusion, ISS is expected to have a target debt level of DKK 14,297 million and target equity level of DKK 24,409 million in 2020, as shown in the electronic appendix 1, WACC and CAPM. These levels are used in the WACC formula. Calculating ISS WACC After determining the inputs of WACC in the previous sections, WACC can be calculated as:
WACC = (D/V*rdebt) + (E/V*requity) = (14,297/38,706 )* 3.76% + (24,409 /38,706 )* 9.19% = 7.18%

According to Penman (2010), there is a lot of uncertainty and speculation related to estimating the WACC inputs, thus a sensitivity analysis of the WACC can help in analyzing how this uncertainty affects the valuation results. For this reason a sensitivity analysis is performed in section 12.8.

34

By reducing the debt level, it is expected that ISS will achieve a better credit rating in the future and this will make it possible for ISS to borrow money at lower interest rates (ISS, 2011, investor meeting). ISS current credit rating is B2 by Moodys and BB- by S&P which is a junk bond, and thereby not worth investing in (http://www.business.dk/service/kreditbureauer-overvejer-hoejere-karakter-til-iss).

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12.5 Step 5: Calculating the continuing value The continuing value for ISS is calculated by using the constant-growth formula, which is discussed in section 7.1.3 To apply the constant-growth formula, it is assumed that ISS will go concern and grow at a constant, long-term rate after the horizon year. In order to determine a reasonable longterm growth rate for ISS, the growth rate for the world economy is analyzed. In table 12.18 the growth rate for the world economy in the years 2005A-2011E is presented, and an average growth rate of 3.91% is calculated. Table 12.18 Real GDP growth rate for the world economy
2005A World 4.90%
35

2006A 4.70%

2007A 5.30%

2008A 5.20%

2009A 3.10%

2010A -0.70%

2011E 4.90%

Average 3.91%

Source: Indexmundi

In order for a companys long-term growth rate to be sensible it should be below the growth rate of the world economy, otherwise the company will outgrow the world at some stage which is not a realistic assumption (Koller et al., 2005). The long-term growth rate for ISS is thus set to be 3.5% which is assumed to be a reasonable long-term growth rate under which the company will not outgrow the world economy. The FCF for year (H+1) i.e. 2021 is calculated in the electronic appendix 1, valuation of ISS, to be DKK 3,119 million, and the r is the WACC that is calculated in section 12.4. Thus, the present value of ISS continuing value at the horizon year i.e. year 2020 can be determined as:

Afterwards, the obtained continuing value is discounted back to the end of 2010 by 10 years:

12.6 Step 6: Calculating the company value As stated in section 7.1.4, the firm value can be calculated as:

35

http://www.indexmundi.com/g/g.aspx?c=xx&v=66

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The PV of ISS FCF in the forecast period up to the horizon i.e. 2011-2020 is DKK 12,735 million and the PV of the companys continuing value is DKK 42,438 million, and these result in a firm value of DKK 55,173 million. Additionally, ISS equity value can be calculated by subtracting debt36 and minority interest (MI) from the company value as stated in section 7.1.4. Equity value = firm value debt - MI =55,173 16,100 - 25 = 39,049 ISS market value of equity is thus DKK 39,049 million. The companys share price of DKK 167.59 is then determined as: the equity value of DKK 39,049 million divided by the number of shares of 233 million37 (ISS company value calculation is shown in the electronic appendix 1, valuation of ISS). Furthermore, since forecasting involves making assumptions about the companys future, and predicting the future involves uncertainty as discussed in section 7.1.4, a scenario analysis is performed in section 12.7. The scenario and sensitivity analysis will help to analyze the uncertainty related to the valuation results. 12.7 Scenario analysis According to Damodaran (2007), it is a good idea to perform a scenario analysis in order to see how the estimated value of the asset changes under different scenarios. Since it is not possible to predict the future, a scenario analysis can give an idea of e.g. how low or how high the asset value can become based on different possible future cash flows. It is then possible to determine the expected value of the asset by either applying weights to the different scenarios and estimate a weighted average value, or by choosing one of the scenarios as the expected outcome. It is decided to perform a scenario analysis to analyse how ISS firm value and the corresponding share price change depending on different assumptions about the future growth rates. The scenario analysis contains a base case, a best case and a worse case scenario. All the calculations for the
36

As mentioned in section 12.4 ISS is expected to go public in 2012, thus it is assumed that there will be a major change in the capital structure whereby ISS debt level will be reduced. For this reason the 2012 debt level (NFO) have been discounted back (using the cost of debt) to 2010 in order to get the debt level, which is relevant for the equity value and the share price calculations i.e. 17,332/ (1+ 3.76%)2 = 16,100
37

ISS has 100 million existing shares and it plans to issue 133 million new shares, and these result in 233 (100+133) million shares (ISS, 2011, "3").

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different scenarios can be found in the electronic appendix 1. The base case is the expected outcome which is used to estimate the firm value of ISS in section 12.6, and is therefore not discussed further here. The best case and worse case scenarios are discussed below. Best case scenario In the best case it is assumed that the economy will grow in all the markets that ISS operates in, which will affect the companys growth positively. ISS will therefore achieve its goal of at least 6% organic sales growth (ISS, 2011, 3) in the forecast period, and grow at a rate that is higher than 6% in the years 2012-2018 for example due to growth through acquisitions, improved operations and successful integration of the acquired subsidiaries. The expected growth rates and corresponding operating revenues until year 2018 are presented in table 12.19; the full forecasts are enclosed in the electronic appendix 1, scenario analysis best. Table 12.19 Expected growth in the best case scenario
2010A Operating revenues (in DKK million) Revenue growth Source: Authors, 2011 74,073 7.35% 2011E 78,517 6.00% 2012E 84,014 7.00% 2013E 90,735 8.00% 2014E 97,812 7.80% 2015E 105,148 7.50% 2016E 112,298 6.80% 2017E 119,710 6.60% 2018E 127,251 6.30%

Furthermore, in the best case scenario the growth rate until infinity is expected to be 3.80%, this is slightly below the average growth in the world economy of 3.91% as discussed in section 12.5. Worse case scenario In the worse case it is assumed that the economy will grow slowly, and ISS will not reach its goal of a 6% organic growth rate at any stage. Furthermore, already in year 2018 ISS will reach its longterm growth rate of 2% due to strong, increasing competition in all the markets that ISS operates in. The annual growth rates and corresponding operating revenues under the worse case scenario are outlined in table 12.20, whilst the full forecasts can be found in the electronic appendix 1, scenario analysis worse.

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Table 12.20 Expected growth in the worse case scenario

2010A Operating revenues (in DKK million) Revenue growth Source: Authors, 2011 74,073 7.35% 2011E 77,036 4.00% 2012E 80,503 4.50% 2013E 84,528 5.00% 2014E 88,754 5.00% 2015E 92,304 4.00% 2016E 95,073 3.00% 2017E 97,450 2.50% 2018E 99,399 2.00%

Table 12.21 summarizes the resulting enterprise value, equity value and share price under the different scenarios. The resulting values in the best case scenario are also affected by minor changes in the forecasted other operating expenses and other operating income, these changes are specified in the electronic appendix 1, scenario analysis best. In the worse case scenario other operating expenses are set at constant rate of 2.70% and other operating income is set at a constant rate of 1% as illustrated in the electronic appendix 1, scenario analysis worse. Table 12.21 Company value of ISS under the different scenarios
PV of FCF up to 2020 12,721 12,735 14,919 PV of continuing value 55,212 42,438 23,230 Enterprise value 67,993 55,173 38,149 Market value of equity 51,808 39,049 22,024 Price per share 221 167 94

Best case Base case Worse case

Source: Authors, 2011

As illustrated in table 12.21, in the best case scenario, the increased growth results in a price per share of DKK 222, which is 32% higher than in the base case. In the worse case scenario the share price is estimated to be DKK 94, which is 44% lower than in the base case. This shows that the company value of ISS and the corresponding share price are sensitive to changes in growth rates and costs. In case ISS achieves a performance level similar to the one forecasted in the best case scenario, the share price will increase significantly compared to the IPO price, which is of course very beneficial for investors. However, in case ISS does not manage to do so well and will grow at a level similar to the worse case scenario, the investors can risk that the share price drops below the lowest IPO price of DKK 100, and investors will thereby suffer a loss. 12.8 Sensitivity analysis Koller et al., (2005) and Brealey and Myers et al., (2007) suggest performing a sensitivity analysis in order to evaluate the forecast models robustness under different assumptions, for example by stating optimistic and pessimistic values for WACC and revenue growth. The changes in revenue Page 86 of 112

growth are discussed in section 12.7, thus this section will include a discussion of the optimistic and pessimistic values for the WACC. Optimistic and pessimistic values for WACC In order to evaluate the effect of changes in ISS expected WACC of 7.18% on the enterprise value, it is assumed that the optimistic value represents a 1% decrease in WACC and the pessimistic value represents a 1% decrease in WACC as shown in table 12.22 (the calculations can be seen in the electronic appendix 1, sensitivity analysis). Table 12.22 Optimistic and pessimistic values for WACC
Expected outcome 7.18% 12,735 42,438 55,173 167.59 Optimistic value 6.18% 13,379 64,033 77,411 263.03 % change -1.00% 5.05% 50.88% 40.30% 56.95% Pessimistic value 8.18% 12,138 30,402 42,540 113.37 % change 1.00% -4.69% -28.36% -22.90% -32.35%

WACC Total PV of FCF up to 2020 PV of continuing value Enterprise value Price per share Source: Authors, 2011

In table 12.22, it can be seen that small percentage changes in ISS WACC have a large effect on the enterprise value, for instance for the optimistic value, a 1% decrease in WACC leads to a 50.88% increase in the PV of the continuing value and a 5.05% increase in the total PV of FCF up to 2020. This results in a 40.30% increase in ISS enterprise value and a 56.95% increase in the companys price per share. Additionally, for the pessimistic value table 12.22 illustrates that a 1% increase in WACC lead to a 22.90% decrease in firm value and a 32.35% decrease in the companys share price. In conclusion, ISS estimated enterprise value is considerably sensitive to small changes in the WACC, thus this value should be interpreted with caution.

13. Valuation of ISS using real options As discussed in section 7.4, using the DCF method alone to estimate the value of a company is too simplistic and it does not capture the value of the companys future options, the value obtained from

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the DCF analysis may therefore be too low. For this reason real options valuation is applied to ISS as an extension of the DCF analysis. ISS focuses on organic growth and growth through acquisitions as discussed in section 11. ISS increase in operating revenue which leads to an increase in firm value is often caused by the companys growth, therefore an option to expand is found to be relevant for ISS. As mentioned in section 11, ISS plans to acquire companies in emerging markets in the future due to the expected high demand in these markets as discussed in section 11. Therefore, it is decided to estimate the value of the flexibility that ISS has in relation to expanding in emerging markets. The companys option to expand is discussed in the next section. Option to expand ISS has an option to expand in the emerging markets; however, emerging markets is a very broad term which covers over many countries on different continents. In order to estimate the value of an option to expand, a more narrow definition of the option is needed. To define a specific option for ISS the countries in the emerging markets where ISS does not currently have any operations are identified first. Next the demand for facilities services in these countries is evaluated. One of the countries that ISS is not currently present in, is South Korea. Based on a market potential index, developed by GlobalEdge, for countries in emerging markets, South Korea is ranked 7 out of 26 countries based on the market size. A list of top 10 countries based on the market size is illustrated in table 13.1. The other rankings for South Korea in table 13.1 are also relatively high compared to other countries in emerging markets, which indicates that South Korea is in general a favourable market to enter.

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Table 13.1 Top 10 countries in emerging markets based on market size

Countries Market Size Market Growth Rate Rank 1 2 26 11 4 22 16 Market Intensity Rank 26 24 20 17 19 8 6 5 18 9 Market Consumption Capacity Rank 13 11 16 23 10 21 1 9 25 4 Commercial Infrastructure Rank 21 25 8 13 20 16 4 15 24 26 Economic Freedom Rank 25 18 24 14 15 9 4 12 11 21 Market Receptivity Rank 23 20 22 25 24 7 9 13 3 26 Country Risk Rank 8 13 15 12 22 11 4 17 14 26 Overall Index Rank 2 9 21 11 12 13 4 10 24 22

Rank China 1 India 2 Russia 3 Brazil 4 Indonesia 5 Mexico 6 Korea, 7 South Turkey 8 10 South 9 19 Africa Pakistan 10 3 Source: GlobalEdge, 201138

Furthermore, ISS is currently present in all the other countries shown in table 13.1, except for Pakistan (ISS Annual report, 2010), which should make it easier for ISS to enter South Korea as the company must have experience in operating in emerging markets. The facilities service market in South Korea is expected to achieve a growth rate of 4%-6% in the years 2012-2016, as South Korean companies choose to outsource their facilities management. And it is expected that it is the foreign facilities management companies that will be providing these services39. This makes South Korea an attractive market for ISS. An option to expand for ISS is therefore defined as an option to enter the South Korean market through acquisition of one or more local companies. The option is expected to expire in five years when the growth rate of the facilities service market in South Korea will slow down. If ISS enters the South Korean market before the option expires, it is assumed that its operating revenues will increase by 0.80% up to year 2016, then by 0.30% in the period 2017-2020 and finally the longterm growth rate will increase by 0.05%. These increases in operating revenues are expected to cause an increase in the enterprise value of 2.33% as shown in the electronic appendix 1, increase in EV with ROV. ISS stated that they are planning to spend around DKK 500 million a year on acquisitions mainly in the emerging markets (ISS, 2011, 3), it is thus assumed that DKK 250

38

39

http://globaledge.msu.edu/resourcedesk/mpi/index.asp?year=2010&sort=1#mpiGrid http://www.reuters.com/article/2011/04/20/idUS18937+20-Apr-2011+BW20110420

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million will be spent on acquisition and integration of a subsidiary in South Korea, which is the cost of the option. 13.1 Step 1: The value of ISS without flexibility As discussed in section 7.4.2, when valuing a whole company with ROV the company value from e.g. the DCF analysis can be used as the value of the underlying asset. The value of ISS without flexibility, which is used in the ROV, is DKK 55,173 million as calculated in the DCF analysis in section 12.6. 13.2 Step 2: Event tree for ISS The second step of the ROV analysis involves determining the up- and downward movements in the geometric event tree using the annual volatility. The annual volatility can be determined in three different ways as discussed in section 7.4.2. Due to the fact that the cash flows from ISS similar expansion options are not provided in the annual report it is decided to use option 3, i.e. the variance in values of similar firms in the industry to determine the variance of the expansion option. This variance is estimated by using the market model, which has already been applied in section 12.4, and is stated as:

Two public, South Korean companies similar to ISS are found in Datastream, these companies are: Korean Environment Technology Co. Ltd and Y-Entec Co. Ltd. A short description of these companies is enclosed in appendix L. Thus, the stock returns for the Korean Environment Technology Co.,Ltd. and the Y-Entec Co., Ltd., are regressed on the MCSI world index in Eviews. The regression outputs for the market model are stated in appendix M. The data for the regressions is retrieved from Datastream and can be seen in the electronic appendix 3. Table 13.2 shows the resulting annual volatility. The betas and standard errors in table 13.2 are obtained from the regression results, calculations of var(ei) and var(Rm) are shown in electronic appendix 4, annual volatility. The monthly variance is determined as (Grinblatt and Titman, 1998):

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Table 13.2 Volatility

Korean Environment Technology 1.31 0.1765 0.0312 Y-Entec 1.44 0.1579 0.0249 Average 1.375 0.1672 0.0280 0.00442
2

std.error var(ei) var(Rm) Monthly variance ( i) Monthly volatility Annual volatility Authors, 2011

0.0364 0.1908 0.6609

The monthly and annual volatility are calculated based on the monthly variance as shown in the electronic appendix 4, annual volatility. The annual volatility is found to be 66.09%, and this is used in determining the up and down movements in the event tree as:

The number of years per upward movement is set to 1 year. By using the calculated factors for the up- and downward movements in the event tree, and the enterprise value from the DCF analysis as the value of the underlying asset, the possible values of ISS for the next five years are modelled in an event tree. The obtained event tree is illustrated in figure 13.1. Figure 13.1 Event tree for ISS expansion option in South Korea
T 0 1 2 3 4 775,933 400,682 206,907 106,844 55,173 28,491 14,712 7,597 3,923 2,026 Source: Authors, 2011 55,173 28,491 14,712 7,597 106,844 55,173 28,491 206,907 106,844 400,682 5 1,502,617

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The probabilities of the up- and downward movements in the event tree are determined as:

where the WACC (7.18%) from the DCF analysis is used as the cost of capital, r. The values in the event tree can thus be verified using the probabilities pu and pd, as mentioned in section 7.4.2. As an example the value in the upper branch in year 4 is calculated as:

The same calculation can be done for all the other values in the event tree, confirming that the tree is correct. 13.3 Step 3: Decision tree for ISS In order to make the decision tree, it is assumed that the cost of expanding in South Korea is DKK 250 million, the expansion is assumed to increase ISS enterprise value by 2.33% and the option can be exercised at any time during the next five years as discussed in the description of the expansion strategy. The decision tree for ISS expansion option is illustrated in figure 13.2. Figure 13.2 The decision tree

4 793,769

5 1,537,378

409,781 211,498 109,121 56,279 28,986 14,903 7,648 3,923 56,246 28,946 14,857 109,097 56,215 211,485

409,768 109,084 28,904 7,597 2,026

Source: Authors, 2011

Looking at for example the uppermost branch in period 5, on the upward limb, the payout without the expansion option is DKK 1,502,617 million as stated in figure 13.2, but with the expansion, it is (1+ 2.33%) *1,502,617 - 250 = 1,537,378. Due to the fact that the value with expansion is higher

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than the value without expansion, ISS would choose to expand. On the other hand, looking at the lowest branch in period 5, the value without expansion is DKK 2,026 million, whilst the value with expansion is (1 + 2.33%) * 2,026 250 = 1,823. In this case the value without expansion is higher, and thus ISS would not choose to expand. These calculations are performed for all the values in year 5 to decide whether or not to expand. When the value with flexibility is higher than the value without flexibility, the company chooses to expand. The values for which ISS would choose to expand in year 5 are marked bold in figure 13.2. 13.4 Step 4: The value of ISS with flexibility In step 4 the value of the real option is determined by working backwards from right to left through the decision tree by using risk neutral probabilities at each node for the remaining 4 years. The risk neutral probabilities are determined as:

For example the value of the option in the uppermost branch in period 4 is determined as:
Option = Max((pu* upper value with flexibility year 5+(1 - pu*) down value with flexibility year 5) / (1

+ rf); value without flexibility year 4)

= Max (793,769 ; 775,933) = 793,769 The rest of the calculations can be seen in electronic appendix 4, event and decision tree. After determining the value for all the nodes, the enterprise value with the expansion option is DKK 56,279 million, subtracting this value from the enterprise value without the option DKK 55,173 million, results in an option value of DKK 1,106 million (56,279 - 55,173). The enterprise value, equity value and share price for ISS with and without the expansion option are summarized in table 13.3.

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Table 13.3 Value of ISS with and without the expansion option
Enterprise value Without expansion option With expansion option Source: Authors, 2011 55,173 56,279 Equity value 39,049 40,154 Share price 167.59 172.34

As illustrated in table 13.3, ISS share price with the real option is DKK 172.34, which is an increase of 2.8% compared to the share price without the option. This shows that the expansion option in South Korea does add value to ISS, and thereby creates value for ISS shareholders. The firm value of ISS is therefore determined to be DKK 56,279 million in this paper. The fair share price for ISS is then DKK 172.34, and is discussed further in section 15.

14. Valuation of ISS using multiples The multiples analysis is performed by determining an average ratio of a given multiple based on comparable firms as mentioned in section 7.5. In section 9, it was decided that the EV/EBITDA and the EV/S multiples are suitable for ISS peer group analysis, and ISS peer group was determined in section 11.2, based on the industry criterion. Table 14.1 shows the EV/EBITDA and EV/S multiples of ISS comparable companies (the calculations can be seen in electronic appendix 5, Peer group). Table 14.1 Peer group analysis
EV/EBITDA 2011E 2012E 8.60 8.32 5.65 7.95 7.62 6.91 10.41 7.92 7.63 7.43 4.98 6.89 6.89 6.12 9.06 7.00 EBITDA margin 2010A 2011E 2012E 8.53% 4.46% 18.11% 6.63% 8.90% 7.39% 19.08% 10.44% 6.91% 8.64% 4.52% 17.17% 6.93% 8.98% 7.08% 19.11% 10.35% 7.15% 8.86% 4.84% 17.89% 7.16% 9.06% 7.34% 19.84% 10.71% 7.15% 0.65 0.64 0.58 EV/S 2011E 0.74 0.38 0.97 0.55 0.68 0.49

Company Compass group ABM Rentokil Sodexo G4S Securitas Ecolab Average ISS

2010A 8.52 8.09 5.77 7.97 8.06 6.85 10.34 7.94

2010A 0.73 0.36 1.05 0.53 0.72 0.51

2012E 0.68 0.36 0.89 0.49 0.62 0.45

Source: Authors, www.4-traders.com, Companies Annual reports, 2010

The EV/EBITDA multiple shows a companys operating profitability. Looking at table 14.1, it can be seen that ISS EBITDA margin is around 3.5% lower than the average EBITDA margin for the

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peer group companies in the period 2010-2012, this means that ISS has relatively higher operating expenses compared to its peers, and this results in a lower EBITDA margin. It is decided not to include the EV/S ratios for Ecolab, because they are almost twice as high as the ratios for the other companies in the peer group, which can be verified in the electronic appendix 5, Peer group. Ecolabs EV/S ratio is therefore not found to be representative of the industry, and is thus excluded from the average. Table 14.2 shows ISS enterprise values from the multiples analysis and the corresponding share prices. Table 14.2 ISS multiple analysis (numbers in DKK million)
EV/EBITDA ISS Enterprise value Debt Minority interest Market value of Equity Share price 2010A 40,641 16,100 25 24,516 105 2011E 43,648 16,100 25 27,523 118 2012E 40,870 16,100 25 24,745 106 2010A 47,948 16,100 25 31,823 137 EV/S 2011E 48,959 16,100 25 32,834 141 2012E 47,538 16,100 25 31,413 135

Source: Authors, www.4-traders.com, Companies Annual reports, 2010

The enterprise values in table 14.2 are all between 13% and 28%40 lower than the enterprise value obtained from the DCF and real options analysis, which is DKK 56,279 million. The share price estimated based on the multiples analysis is within the range of DKK 105 141 compared to the DCF and real options analysis result of DKK 172.34 per share. One of the reasons for this may be that the share prices based on the multiples analysis represent the value that investors are willing to pay for stocks of a facilities service company at the moment (Martnez & Perron, 2004), and it does not include the long term value of ISS. The results from multiples analysis are discussed further in section 15.

15. Discussion of the results This section includes a discussion of the results that are found by using the DCF model, the real options valuation and the multiples analysis.
40

(56,279-40,641)/56,279 = 0.28 and (56,279-48,959)/56,279 = 0.13

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The DCF model ISS firm value from the DCF model is DKK 55,173 million, with an equity value of DKK 39,049 million and a share price of DKK 167.59. These values should be interpreted with caution because the DCF method is largely dependent on WACC and continuing value assumptions as concluded in the scenario and sensitivity analysis; for example in the continuing value at horizon calculation, ISS expected growth rate is assumed to be 3.5% and this results in a continuing value at horizon of DKK 84,858 million, however in the scenario analysis best case when this growth rate is assumed to be 3.8% (an increase of 0.3%), the continuing value at horizon is DKK 110,400 million (an increase of 30%). Another illustration of the DCF models dependency on the given assumptions is illustrated in the sensitivity analysis in which it is shown that a 1% change in the WACC results in large changes in firm value and share prices. These examples show that the results from the DCF model can be relatively subjective, because the DCF model is largely dependent on the analysts belief about the future direction of the company, the results should therefore be interpreted with caution. Real options Due to the fact that the DCF method does not include the value of managers flexibility, it is supplemented with a real options analysis. The enterprise value of ISS with the 5 year expansion option in South Korea is DKK 56,279 million, the equity value is DKK 40,154 million and the share price is DKK 172.34 as stated in section 13. Thus, ISS enterprise value and share price with the real option increase by 2% and 2.8% respectively compared to the enterprise value and share price without the option. This means that the expansion option creates value for ISS under the given assumptions. However, the value of the option to expand depends on accurate estimates of the value and variance of the underlying asset as discussed in section 7.4.1. The underlying value of the asset is the value of ISS obtained from the DCF model, which, as mentioned, can be relatively subjective. The variance is estimated based on the variance in market returns and the variance in returns of two local South Korean competitors. Since ISS might have different competences and experience than the local South Korean companies, it might have different firm specific variance, thus the estimated

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variance is only an approximation for ISS. For this reason the value of the expansion option is approximate, rather than exact. Multiples analysis As discussed in section 7.5, the multiples analysis only gives an approximate company value, which can be used to determine whether the company value calculated using another method e.g. DCF is reasonable. Additionally, the value from the multiples represents the markets perception of the current market value of a facility services companys stock as mentioned in section 14. ISS enterprise and equity value from the multiples analysis are within the range DKK 40,641 48,959 million and DKK 24,516-32,834 million respectively. The enterprise and equity values from the multiples analysis are between 13%-28% and 18%-39% lower than the enterprise and equity value obtained from the DCF and real options analysis. The share price estimated based on the multiples analysis is within the range of DKK 105-141 compared to the DCF and real options analysis result of DKK 172.34 per share. The values from the multiples analysis are generally lower than the values from the DCF analysis with real options. Since the multiples analysis is used to verify the results obtained from other models it can be discussed whether the value obtained from the DCF and real options analysis is overvalued. However, before drawing any conclusions it is necessary to evaluate the quality of the multiples analysis. According to section 7.5, several multiples should be used in the analysis. In this paper two multiples are determined to be relevant for ISS. It is recommended to use at least six comparable companies in section 7.5, and a peer group of seven comparable companies has been identified for the EV/EBITDA multiple, whilst six companies were used in the EV/S multiple, so this criterion is assumed to be fulfilled. However, there are not many companies that are similar to ISS in all respects, e.g. in relation to the range of services offered and the range of countries in which these services are offered. Thus, the peer group includes e.g. two security companies (Securitas and G4S) and a company which mainly operates in the US (ABM). For this reason the values of ISS obtained from the multiples analysis are not exact and a larger variation between these values and the fair value can be acceptable. It is therefore decided not to conclude that the value of ISS obtained from the DCF and the real options analysis is too high purely based on the comparison to the multiples valuation. Instead, the obtained value is compared to value estimates published by professional analysts and to the IPO share price published by ISS.

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The official equity value estimates published by professional analysts41 range from DKK 39.4-49 billion. Comparing these estimates to the equity value of DKK 40,154 million estimated in this paper, it can be concluded that the estimated equity value of ISS is within this range, but in the low end. It should be noted that the goal of this thesis is not to obtain the same value as other analysts, because all valuations are based on different assumptions, future expectations and different methods of estimating the various inputs such as beta42, the risk free rate and the market risk premium. It is therefore not possible to determine one right answer. However, comparing the obtained value to values of other analysts can give a hint about whether the estimated value is reasonable just like the multiples analysis. Based on the comparison to other value estimates of ISS, it is concluded that the equity value of ISS of DKK 40,154 million is not overvalued, since it is in the low end of the range. Lastly, the share price of ISS estimated to be DKK 172.34 per share is compared to the IPO share price published by ISS, which is given as a range of DKK 100 DKK 135 per share (ISS, 2011, 3). The share price published by ISS is 22% - 42% lower compared to the share price estimated in this paper. In general, IPO prices have a tendency of increasing on the first day of trading and this results in the common trend that IPOs are underpriced at an average of 15% (Martnez & Perron, 2004). One of the explanations for the difference between the initial and the first day trading prices is that firms going public are considered to be risky. This means that investors require a discount on the IPO share price, mainly due to the uncertainty of how the stock price of the newly listed company will develop after the IPO. Otherwise, if the share price of a company at the IPO is similar to the share prices of its competitors, investors may choose to invest in competitors shares because they know how the development of the share prices has been in the past, and can base their future expectation on that. This can partly explain and justify the lower IPO share price published by ISS compared to the estimated share price, however, the difference is somewhat higher than the common 15% discount, therefore further possible reasons for the difference in share prices are investigated. Assuming that the fair price for ISS shares is DKK 172.34 as estimated in this paper, a reason for a higher than usual discount on the IPO share price for ISS can be the fact that this is a second IPO, since the company has already been public before 2005. According to Lian and Wang (2009), a
41 42

www.ugebrev.dk; www.jyskebank.dk; www.fyens.dk; www.businessweek.com The results of the beta vary depending on the different market index, time period and return interval used.

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companys second-time IPO often sells at a major discount compared to its first-time IPO. This is because the market considers second-time IPOs to be riskier than first time IPOs, and it includes the negative information associated with the previous withdrawal when determining the price for the second-time IPOs. Furthermore, it is possible that investors require an additional discount in case of ISS, because of the companys high debt levels, which make the company riskier than average. Based on the above discussion it is concluded that the enterprise value obtained using the DCF and real options analysis of DKK 56,279 million and the equity value of DKK 40,154 million are reasonable estimates for ISS, despite the flaws of the models and the lower results obtained from the valuation using multiples. Furthermore, the estimated share price of DKK 172.34 is assumed to represent a fair value of ISS share price, since a higher than average discount for the IPO is found to be reasonable in this case.

16. Conclusion In this thesis the following corporate valuation theories have been discussed; the discounted cash flow model, the dividend discount model, the residual income model, real options valuation and valuation using multiples. Furthermore, the capital asset pricing model and the Fama and French three factor model have been evaluated as alternative methods for determination of the expected rate of return on a companys stock. The corporate valuation theories have been discussed in sections 7.1-7.5, and specifically advantages and disadvantages have been identified for each model. Based on the literature review it was decided in section 9 to use the DCF analysis with free cash flows as the primary method to value ISS and the CAPM was chosen instead of the Fame and French three factor. Furthermore, it was decided to supplement the DCF model with a real options analysis. An expansion option was found relevant for ISS, due to their growth through acquisitions strategy in the emerging markets. Based on a short review of emerging markets a five year option to expand in South Korea was defined. To verify the valuation results it was decided to apply a multiples analysis to ISS and to value the company based on a peer group of seven similar companies and two different multiples the EV/S and the EV/EBITDA.

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Before the financial valuation of ISS, a strategic analysis that includes a study of ISS corporate environment was performed by using the PESTEL analysis, Porters five forces, and the SWOT analysis as well as an identification of the companys core competences. From the PESTEL analysis, the factors that were most uncontrollable for ISS were the political and economic factors, because ISS is not able to affect a countrys politics, changes in legislation or what is happening to the macro economy. Based on Porters five forces analysis it was concluded that the facility services industry is moderately attractive for ISS to operate in due to the relatively low threat of substitutes and the relatively low bargaining power of suppliers and buyers. On the other hand, the competition in the facility services industry and the threat of new entrants is relatively high. Additionally, ISS has achieved its core competences through customization and an integration of the different facility services internationally. In the SWOT analysis, it was concluded that ISS main strength lies in its core competences but on the other hand the company is threatened by both global and local economic risk factors in all the markets. ISS major weakness is its high debt levels that have resulted in high financial expenses over the years. This indicates that there is a need for a change in the capital structure. In the financial analysis the DCF method, the real options valuation and the multiples were applied. As part of the DCF analysis ISS financial statements for the period 2005-2010 were reformulated and analyzed and the historical amounts of the free cash flow were found. Based on the analysis of the historical financial statements and the strategic analysis of ISS, the companys future FCF were forecasted in the explicit forecast period 2010-2020, and the PV of these FCF summed up to DKK 12,735 million. In order to capture the value of the free cash flows after the explicit forecast period a continuing value was estimated. The PV of the continuing value was estimated to DKK 42,438 million. This resulted in an enterprise value of DKK 55,173 million, an equity value of DKK 39,049 million and a share price of DKK 167.59. In order to account for the uncertainty of forecasts a scenario analysis with a best, base and worse case scenarios was conducted. In the best case scenario the share price was calculated to be DKK 221 due to the increased growth and in the worse case scenario the share price was calculated to be DKK 94 due to reduced growth and increased expenses. The WACC used in the DCF analysis was estimated to be 7.18%, but due to the uncertainties in relation to the inputs of the WACC formula, a sensitivity analysis of WACC was

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carried out. In the sensitivity analysis a 1% lower optimistic value of WACC and a 1% higher pessimistic value of WACC were analyzed. The result was a share price of DKK 263.03 in the optimistic case and a share price of DKK 113.37 in the pessimistic case. In the real options valuation in section 13, it was assumed that the expansion option in South Korea will increase the enterprise value of ISS with 2.33% and will come at a cost of DKK 250 million. The real options analysis was performed using the binomial model, which resulted in an option value of DKK 1,106 million. Thus, the enterprise value of ISS from the DCF analysis and the real options analysis combined was determined to be the fair value of the company found in this thesis, and it was estimated at DKK 56,279 million, with the equity value of DKK 40,154 million and a share price of DKK 172.34. In section 14 valuation using multiples was applied to ISS based on actual numbers from 2010 and forecasted numbers for 2011-2012. The share prices estimated using the EV/EBITDA multiple were in the range DKK 105 - DKK 118, and the share prices estimated using the EV/S multiple were in the range DKK 135 DKK 141. In section 15 the obtained results from all the models were compared and discussed. The enterprise and equity value obtained from the DCF and real options analysis was compared to the enterprise and equity value from the multiples analysis, and it was found that in general the values from the multiples analysis were lower. Due to the weaknesses of the multiples method the values from the DCF and the real options analysis were also compared to the published equity value estimates from professional analysts that are within the range of DKK 39.4-49 billion, and ISS published IPO share price that is within the range of DKK 100 DKK 135. It was concluded that the equity value of DKK 40,154 million is at the low end, but still within the range. The IPO share price is 22% 42% lower compared to the estimated share price of DKK 172.34. This difference is explained by the fact that investors may require additional discounts in case of ISS due to the fact that its a second-time IPO and the company has high amounts of debt. It is therefore concluded that the enterprise value for ISS of DKK 56,279 million is reasonable, and that the share price of DKK 172.34 represents the fair market value of the companys shares.

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Appendices

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List of appendices

Electronic appendices Electronic appendix 1: The DCF model Electronic appendix 2: Data for CAPM Electronic appendix 3: Data for real options Electronic appendix 4: Real options valuation Electronic appendix 5: Multiples valuation

Printed appendices Appendix A: Overview of the DCF model Appendix B: ISS competitors Appendix C: Percentage change of ISS revenues from 2006 to 2010 per service type Appendix D: Original statements of shareholders equity for the years 2005-2010 Appendix E: The reformulated statements of shareholders equity Appendix F: Original balance sheets Appendix G: The reformulated balance sheets Appendix H: Original income statements Appendix I: The reformulated income statements Appendix J: The drivers of ROCE Appendix K: Regression results for the market model

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Appendix L: South Korean competitors Appendix M: Regression results for real options Appendix N: Notes to the electronic appendix 2 Appendix O: Structure of the thesis Appendix P: List of abbreviations

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