Crash Course – Company

Valuation
The Absolute Basics
What is Being Valued?

Enterprise value – is the value of the firm to all

providers of capital.. Equity, debt and other.
Equity value – is the value of the firm to the
providers of equity capital only, i.e. Shares.
Cashflows to the enterprise are discounted
using cost of capital to the enterprise
Cashflows to equity are discounted using cost
of equity capital.
Valuation Approach – the Choices
Cashflow Valuation
 DCF
 EVA

Multiples
 Enterprise
 Equity
 Operational

Asset based – break up scenarios

Optimal Deprival Value – market power
Capitalisation Rate – real estate assets
Presentation Logic
Deals with:

Cost of capital – common to all methods

Capital structure – common to all methods

Cashflow model
Multiple model
Capital Structure
Generally the capital structure consists of:
3. Equity – representing business and asset
risk
4. Debt – representing financial risk
Debt is lower cost than equity, but
Using more debt adds financial risk, and
Thus – increases the cost of equity
Debt may have tax advantages.
Cost of Capital
Value is destroyed unless projects and
companies meet or beat their cost of capital:
1. Cost of capital is an opportunity cost – the
sacrifice to investing in the company
2. Cost of capital represents the risks in investing
in the company
3. All providers face their own cost of capital –
debt, equity, or a mixture
4. The company faces a mix or blend called
weighted average cost of capital.
All Roads Lead to Cost of Capital
Despite their apparent differences, all valuation
methods:
3. Can and are related to a cost of capital –
DCF, EVA, Cap rate, ODV, asset value
4. Multiples can be directly linked to cost of
capital through the reciprocal relationship
5. Express cost of capital components in one
way or another
The Cost of Debt Capital
The market cost of raising the marginal tranche
of debt capital (the next increment)...
3. The riskfree rate (as proxied by [say] well
traded government debt in country of
cashflow origin)
Plus
5. A debt premium reflecting industry and
company business risk
As determined by rating or market data.
The Cost of Equity Capital
The market cost of raising the marginal tranche
of equity capital (the next increment)...
3. The riskfree rate (as proxied by [say] well traded
government debt in country of cashflow origin)
Plus
6. The premium for investing in equities (ERP equity
risk premium) of 4.0% – 7.0%
Times Equity Beta (the index of company risk)
Two Betas – Equity and Asset
Equity beta = asset beta / (1 – debt % )
 Only equity beta can be measured in the market
Asset beta = equity beta * (1 – debt % )
 Asset beta must be derived from equity beta
Building an equity beta
 Establish the equity beta for an industry
 Find asset beta given industry capital structure
 Use company capital structure to find company
equity beta
Draw data from Bloomberg or similar
Summarising....
Cost of debt = risk free + debt risk premium
Cost of equity = risk free + (equity beta * ERP)
In the capital structure of debt and equity:
 Equity is valued at the cost of equity
 Debt is valued at the cost of debt
Last twist:
Debt is adjusted for tax deductibility... Multiply
it by (1 – Tc).... The corporate tax rate.
Weighted Average Cost of Capital

Riskfree Debt Tax rate ERP Equity

rate Premium Beta
Cost of Debt 5.0% 2.0% 30.0% N/A N/A 4.9%
Cost of Equity 5.0% N/A N/A 5% 1.25 11.3%

Percent debt 40% Weighted cost debt 1.96%

Percent equity 60% Weighted cost equity 6.75%
TOTAL 100% WACC 8.71%
The Cashflow Valuation Equation
Value of near term cashflows
Plus
Terminal value

Discounted to Present value at:

7. The WACC for the value of the enterprise
8. The flows to equity for the value of equity
Cashflow to the enterprise is....
Earnings before interest and taxes (EBIT)
Minus Cash taxes on EBIT
Minus Investments
Plus Depreciation
Plus (minus)
Change in Working capital
equals
Free Cash Flow…. Available to ALL
INVESTORS
Estimating Terminal Value

2. Estimate a constant growth rate ( g ) from

last year of the near term flows
4. Multiply the estimated cashflow of the last
year of the near forecast period by 1 + g
6. Divide this value by WACC minus g to get
terminal value
8. Discount TV back to the present using
WACC.
Enterprise and Equity Value
Enterprise value = near term plus terminal
Equity value = enterprise value less debt

Test:
 Cashflow sensitivities
 Cost of capital sensitivities
 Terminal value sensitivities (growth rate)
The Valuation Multiple Equation
Based on comparative analysis
Comparisons drawn from:
 Market observations
 Transaction observations
 Fundamental data
All adjusted to “normalise” data and allow as
analysis of “like with like” to greatest extent
possible or feasible.
Multiple Valuation - Process
Process to calculate:
 Identify an appropriate variable
 Find the necessary inputs for the calculation
 Normalise - adjust the numbers to remove
extraordinary or one off effects
 Compute ratio – numerous formulae available
 Apply multiple to company being valued
 Check against another method
Enterprise Multiples
Estimate value of the enterprise to all capital
providers:
EBITDA – most “cash like”, skirts accounting
issues, captures operating costs, only deals
with tax indirectly.
Revenue – useful with negative or zero
earnings, skirts accounting treatment,
difficult to “launder”.
Equity Multiples
Estimate value of the enterprise to equity
capital providers:
P|EBIT – avoids tax and capital structure
differences, pre tax relationship to other
methods.
P|E – very popular, oft quoted, simple to
understand, difficult to compare because of
tax and capital structure differences.
NOTE: 1 / P|EBIT = (pre tax) ROIC
Operating Multiples
Many industries have unique operating
multiples which can be used comparatively:

Media P | number of subscribers

Energy P | KWh production capacity
Accommodation P | number of room
Tourism P | visitor nights / spend
Agriculture P | output per stock unit
Telecommunication P | fixed / mobile subscribers

Identical process to other cases. Identical weaknesses.

Multiples - Characteristics
Advantages
 Simple and resource light
 Easy to communicate
 Commonly used
Disadvantages
 Single variable focus simplistic
 Assume “straight line” trend
 Subjective in normalising and comparing
Conclusions
Valuation is...
A blend of art and science but a disciplined and
systematic blend.
Thoroughly dependent on all of the explicit and
implicit assumptions made.
An estimation process whose outer limits ought
to be tested for revision purposes.
Likely to perform best when it reflects “fit for
purpose” decisions in design.