Valuation Measurement and

Value Creation
Valuation Situations

 We encounter valuation in many situations:

 Mergers & Acquisitions
 Initial Public Offerings / Follow on Offering
 Qualified Institutional Placements
 Private Equity and Buyout
 Investors buying a minority interest in Companies
 Sell-offs, Spin-offs and Divestment

 How do we measure value?

 How can I-Bankers create value?
Business Valuation Techniques

 Discounted Cash Flow (DCF) approaches

 Dividend Discount Model (DDM)
 Free Cash Flows to Equity Model (FCFE) - Direct Approach
 Free Cash Flows to the Firm Model (FCFF) - Indirect
Approach

 Relative Valuation approaches

 P/E Multiples (capitalization of earnings)
 Enterprise Value / EBITDA
 Others: P/CF, P/B, P/S

 Mergers and Acquisitions

 Control transaction based models
(eg., value based on acquisition premia or control premium)
Discounted Cash Flow Valuation

 What cash flow to discount?

 Investors in stock receive dividends, or periodic cash
distributions from the company, and capital gains on
re-sale of stock in future
 If investor buys and holds stock forever, all they
receive are dividends
 In Dividend Discount Model (DDM), analysts forecast
future dividends for a company and discount at the
required equity return
Dividend Discount Model (DDM)

 The value of equity (Ve) is the present value of the

(expected) future stream of dividends
Ve = Div1/(1+r) + Div1(1+g2)/(1+r)2 + Div1(1+g2)
(1+g3)/(1+r)3 +...

 If growth is constant (g2 = g3 = . . . = g) , the

valuation formula reduces to (Geometric Progression):
Ve = Div1/(r - g)

 Some estimation problems:

 firms may not (currently) pay dividends
 dividend payments may be not be stable
Dividends: The Stability Factor

Factors that influence Dividend changes: Publicly traded U.S. Firms

dividends:
90%
80%
Desire for stability
70%
Future investment 60%
needs 50% No Change
Tax factors 40% Increase
Signaling prerogatives 30%
Decrease

20%
10%
0%
1981 1984 1987 1990 1993

Source: A. Damodaran, Investment Valuation, Wiley, 1997

Discounted Free Cash Flow to Equity (FCFE)
Approach (“Direct” Method)

 Buying equity of firm is buying future stream of free

cash flows (available, not just paid to common as
dividends) to equity holders (FCFE)
 FCFE is residual cash flows left to equity holders after:
 meeting interest and principal payments
 providing for capital expenditures and working capital to
maintain and create new assets for growth

FCFE = Net Income + Non-Cash Expenses - Cap. Exp.

- Increase in WC - Principal Repayments

 Problem: Calculating cash flows related to debt (interest

and principal) and other obligations is often difficult!
Valuation: Back to First Principles

 Value of the firm =

value of fixed claims (debt) + value of equity

 How do finance managers add to equity value?

 By taking on projects with positive net present
value (NPV)

 Equity Value =
Equity capital provided + NPV of future
projects
Note: Market to book ratio > 1 if market expects firm to
take on positive NPV projects (i.e. firm has significant
“growth opportunities”)
Discounted Free Cash Flow to the Firm
(FCFF) Approach (“Indirect” Approach)

 Identify cash flows available to all stakeholders

 Compute present value of cash flows
 Discount the cash flows at the firm’s weighted
average cost of capital (WACC)
 The present value of future cash flows is referred
to as:
 Value of the firm’s invested capital, or
 Value of “Operating Assets” or “Total Enterprise
Value” (TEV)
DCFF Valuation Process

 Value of all the firm’s assets (or value of “the

firm”)
= Vfirm = TEV + the value of uninvested capital

 Uninvested capital includes:

 assets not required (“redundant assets”)
 “excess” cash (not needed for day-to-day
operations)

 Value of the firm’s equity

= Vequity = Vfirm - Vdebt

where Vdebt is value of fixed obligations (primarily debt)

Total Enterprise Value (TEV)

 For most firms, the most significant item of

uninvested capital is cash

Vfirm = Vequity + Vdebt = TEV + cash

TEV = Vequity + Vdebt - cash

TEV = Vequity + Net debt

where Net debt is debt - cash

(note: this assumes all cash is “excess”)
Measuring Free Cash Flows to the Firm

 Free Cash Flow to the Firm (FCFF) represents cash

flows to which all stakeholders make claim

FCFF = EBIT – Actual tax

+ Depreciation and amortization (non cash
items)
- Capital Expenditures
- Increase in Working Capital

 What is working capital?

Non-cash current assets - non-interest bearing
current liabilities (e.g. A/c Payable & accrued liab.)
CAPM (Cost of Equity)

 Capital Asset Pricing Model (CAPM) is a way of finding an

acceptable rate of return for an asset (think Modern
Portfolio Theory). It is often used in valuation as the cost
of equity for a company.
CAPM or RE = Rf + β x [E(RM) – Rf]
Rf = Risk-Free Rate (10-year G-Sec)
E(RM) = Expected Return of the Market

 [E(RM) – Rf] is usually referred to as the market-risk

premium. This is essentially the return someone investing
in the market (Nifty or Sensex) can expect to make
above and beyond the risk-free rate. Currently, you
would be safe to assume the market-risk premium as 8-
9%.
FCFF v/s Accounting Cash Flows

Income Statement, Hazira Bay Cash Flow Statement, Hazira Bay,

(Rs. millions, FYE March 2010) (Rs. millions, FYE March 2010)
Sales 7,075 Cash flow from operations
Cost of Goods Sold 6,719 Net Income 40
EBITDA 356 Non-cash expenses 169
Depreciation 169 Changes in WC (116)
EBIT 187 Cash provided (used) by Inv. / Capex (79)
Interest Expense 97 Cash provided (used) by financing
Income Taxes 50 Additions (reductions) to debt 25
Net Income 40 Additions (reductions) to equity 35
Dividends 53 Dividends (53)
Overall Net Cash Flows 21

Hazira’s Bay FCFF = 187 - 50 + 169 - 79 - 116 = 111

FCFF: Definition Issues

Why is FCFF different from accounting cash flows?

 Accounting cash flows include interest paid

 We want to identify cash flows before they are
allocated to claimholders

 FCFF also does not consider any equity or debt issue

as the same has been captured in the capex
An Illustration

 Rs. 1 million capital required to start firm

 Capital Structure:
 20% debt (10% pre-tax required return): Rs.200,000
 80% equity (15% required return): Rs.800,000

 Tax rate is 40%

 Firm expects to generate Rs. 220,000 EBIT in perpetuity
(all earnings are paid as dividends)
 future capital expenditures just offset depreciation
 no future additional working capital investments are
required

 What should be the value of this firm?

An Illustration (continued….)

 Let us look first at how the EBIT is distributed to the

various claimants:
EBIT Rs.220,000
Interest (20,000)
(Rs.200,000*10%)
EBT Rs.200,000
Tax (80,000) 40% rate
EAT Rs.120,000

Div. to common Rs.120,000

Note: The dividend to equity equals 15% of equity capital

An Illustration (continued….)

 The firm here generates a cash flow that is just enough to

deliver the returns required by the different claimants,
i.e.,
 the NPV of the firms projects = 0
 Another way to see this:
 WACC = 0.2 * 10% * (1 – 0.4) + 0.8 * 15% =
13.2%
 Pre-tax WACC = 13.2% / (1 – 0.4) = 22%
 EBIT / Capital is also 22%,
 NPV of future projects for this firm = 0

 Hence, the value of the firm should equal the invested

capital, or Rs.1,000,000
An Illustration (continued….)

 Now consider FCFF valuation of this firm

 FCFF = EBIT * (1-t) = Rs.220,000 * (1 – 0.4) =
Rs.132,000
 Value = 132,000 / 0.132 = Rs.1,000,000

 We could have accounted for taxes in cash flow and not

WACC
 WACC without tax adjustment = 14%
 Adjusted FCFF = EBIT – actual taxes
= Rs.220,000 – 80,000 = Rs.140,000
 Value = Rs.140,000 / 0.14 = Rs.1,000,000

 Key: Account for tax benefit, but only once (no double
counting)!
Two Stage FCFF Valuation

 Impossible to forecast cash flow indefinitely into the

future with accuracy
 Typical solution: break future into “stages”
 Stage 1 : firm experiences high growth
 Sources of extraordinary growth:
 product segmentation
 low cost producer
 Period of extraordinary growth:
 based on competitive analysis / industry
analysis
 Stage 2: firm experiences stable growth
Stage 1 – Valuation

 Forecast annual FCFF as far as firm expects to experience

extraordinary growth
 generally sales driven forecasts based on historical
growth rates or analyst forecasts
 EBIT, capital expenditures, working capital given as a
percentage of sales

 Discount FCFF at the firm’s WACC (kc)

FCFF1 + FCFF2 + . . . + FCFFt

VALUE1 =
1+kc (1+kc)2 (1+kc)t
Stage 2 – Valuation

 Start with last FCFF in Stage 1

 Assume that cash flow will grow at constant rate in
perpetuity
 Initial FCFF of Stage 2 may need adjustment if
last cash flow of Stage 1 is “unusual”
 spike in sales or other items
 capital expenditures should be close to depreciation

 Value 1 year before Stage 2 begins = FCFFt * (1+g)

Kc - g
Stage 2 – Valuation

Present value of Stage 2 cash flows (Terminal Value or

TV):

FCFFt * (1+g) 1
TV = x
Kc - (1+kc)t
g
 Key issue in implementation: Terminal growth (g)
 rate of “stable” growth in the economy (real rate of
return ~1-2% plus inflation)

 Stage 1 and Stage 2 –

 TEV = VALUEt + TV
Discounted FCCF: Illustration

Assumptions

Year EBIT Dep Capex W/C Change

1 40 4 6 2
2 50 5 7 3
3 60 6 8 4

Tax rate = 40%

kc = 10%
Vdebt = value of debt = Rs.100
Growth (g) of FCFFs beyond year 3 = 3%
Discounted FCCF: Illustration (continued)

FCFF = EBIT*(1-t) + Dep - Capex - Increase in WC

Year 1 FCFF = 40*(1 - 0.4) + 4 - 6 - 2 = 20

Year 2 FCFF = 50*(1 - 0.4) + 5 - 7 - 3 = 25

Year 3 FCFF = 60*(1 - 0.4) + 6 - 8 - 4 = 30

Discounted FCCF: Illustration (continued)

20 25 30 30*(1+g) 30*(1+g) 2
| | | | | |
t=0 1 2 3 4 5
P = Vfirm

30*(1+g)/(kc-g)

TEV = 20 / (1+kc) + 25 / (1+kc)2 + 30 / (1+kc)3 +

[30 * (1+g) / (kc-g)] / (1+kc)3
Discounted FCCF: Illustration (continued)

TEV = 20 / (1.10) + 25 / (1.10)2 + 30 / (1.10)3 +

[30 * (1.03) / (0.10 - 0.03)] / (1.10)3

= 18.2 + 20.7 + 22.5 + 331.7 = 393.0

TEV + Cash (unused assets) = Vfirm

==> Vfirm = TEV =393.0

Vfirm = Vdebt + Vequity ==> Vequity = Vfirm - Vdebt

Vequity = 393.0 - 100.0 = 293.0

Relative Valuation: Capitalisation of
Earnings

 Compute the ratio of stock price to forecasted

earnings for “comparable” firms
 determine an appropriate “P/E multiple”

 If EPS1 is the expected earnings for firm we are

valuing, then the price of the firm (P) should be such
that:
P / EPS1 = “P/E multiple”

 Rearranging,
P = “P/E multiple” x EPS1
P/E Multiple Valuation: Illustration

 ABC Company:
 Next year’s forecasted EPS = Rs.1.50
 Comparable Company: XYZ corporation
 Next year’s forecasted EPS = Rs.0.80
 Current share price = Rs.20
 PE ratio = 20 / 0.80 = 25
 If ABC and XYZ are comparable, they should trade at
same PE
 Implied price of ABC = 25 * 1.50 = Rs.37.5

 Note: Analyst prefer “forward looking” ratios but

“backward looking” ratios are more readily available
 Key: Make comparisons “apples with apples”
P/E Ratio Based Valuation

 Fundamentally, the “P/E multiple” relates to

growth and risk of underlying cash flows for
firm

 Key: identification of “comparable” firms

 similar industry, growth prospects, risk, leverage
 industry average
EV / EBIDTA Approach (EBIDTA Multiple)

 TEV = MVequity + MVdebt - Cash

 EBITDA: Earnings before Interest, Taxes,
Depreciation and Amortization

 Compute the ratio of TEV to forecasted EBITDA for

“comparable” firms
 determine an appropriate “TEV / EBITDA multiple”

 If EBITDA1 is the expected earnings for the firm we

are valuing, then the TEV for the firm should be such
that:

TEV / EBITDA1 = “EV / EBITDA multiple”

EV / EBIDTA Approach (EBIDTA Multiple)

 Rearranging:
TEV = “EV / EBITDA multiple” x EBITDA1

 Next solve for equity value using:

MVequity = TEV - MVdebt + cash

 Multiples again determined from “comparable”

firms
 similar issues as in the application of P/E
multiples
 leverage less important concern
EV / EBIDTA Multiple Valuation: Illustration

 ABC Company:
 Next year’s forecasted EBITDA = Rs.50 million
 Shares outstanding = Rs. 20 million; Value of Debt = Rs.50
million; Cash = Rs.0
 Comparable Company: XYZ Corporation
 Next year’s forecasted EBITDA = Rs.40 million
 Current share price = Rs.20; Shares outstanding = 10
million; Value of Debt = Rs.100 million; Cash = Rs.0
 EV = 20 * 10 + 100 – 0 = Rs.300 million
 EV / EBITDA ratio = 300 / 40 = 7.5
 If ABC and XYZ are comparable, they should trade at
same EV/EBITDA
 Implied EV for ABC = 7.5 * 50 = 375 million
 Value of equity = 375 + 0 – 50 = Rs.325 million
 Price per share = 325 / 20 = Rs.16.25
Other Multiple based Approaches

 Other multiples:
 Price to Cash Flow:
 P = “P/CF multiple” X CF1
 Price to Revenue:
 P = “P / Rev multiple” X REV1

 Multiple again determined from “comparable”

firms

 Why would you consider price to revenue over, for

example, price to earnings?
Merger Methods

Comparable transactions:
 Identify recent transactions that are “similar”

 Ratio-based valuation
 Look at ratios to price paid in transaction to
various target financials (earnings, EBITDA,
sales, etc.)
 Ratio should be similar in this transaction

 Premium paid analysis

 Look at premiums in recent merger transactions
(price paid to recent stock price)
 Premium should be similar in this transaction
Some Valuation Myths

 Since valuation models are quantitative, valuation is objective

 models are quantitative, inputs are subjective

 A well-researched, well-done model is timeless

 values will change as new information is revealed

 A good valuation provides a precise estimate of value

 a valuation by necessity involves many assumptions

 The more quantitative a model, the better the valuation

 the quality of a valuation will be directly proportional to the time spent
in collecting the data and in understanding the firm being valued

 The market is generally wrong

 the presumption should be that the market is correct and that it is up
to the analyst to prove their valuation offers a better estimate

Source: A. Damodaran, “Investment Valuation: Tools and Techniques for

Determining The Value of Any Asset”
Valuation Creation Summary

 Firms create value by earning a return on invested

capital above the cost of capital
 The more firms invest at returns above the cost of
capital the more value is created
 Firms should select strategies that maximize the
present value of expected cash flows
 The market value of shares is the intrinsic value based
on market expectations of future performance (but
expectations may not be “unbiased”)
 Shareholder returns depend primarily on changes in
expectations more than actual firm performance

Source: “Valuation: Measuring and Managing the Value of Companies”,

McKinsey & Co.
Valuation Cases

 Size-up the firm being valued

 Do projections seem realistic (look at past growth
rates, past ratios to sales, etc.)?
 What are the key risks?
 Valuation Analysis
 several approaches + sensitivities (tied to risks)
 Address case specific issues
 e.g. for M&A: identification of fit (size-up bidder), any
synergies, bidding strategy, structuring the
transaction, etc.
 e.g. for capital raising: timing, deal structure, etc.
Valuation References

Copeland, Koller and Murrin,1994, Valuation: Measuring and Managing the Value of
Companies (Wiley)

A Damodaran,1996, Investment Valuation (Wiley);

Pratt, Reilly and Schweihs, 1996, Valuing a Business: The Analysis and Appraisal of
Closely Held Companies (Irwin)

Benninga and Sarig, 1997, Corporate Finance: A Valuation Approach (McGraw Hill)

Stewart, 1991, The Quest for Value (Harper Collins)

Harvard Business School Notes:

An Introduction to Cash Flow
Valuation Methods (9-295-155)
A Note on Valuation in Private
Settings (9-297-050)
Note on Adjusted Present Value
(9-293-092)
Questions