Business Valuation (When)

• IPO

• Privatization

• Going Private (LBO, MBO)

• Mergers and Acquisitions

• Downsizing and Restructuring

• Security Analysis

• Value Management

Business Valuation (Who)

• Acquirer, Target, and Intermediary• Managers• Investors• Investment Bank• Commercial Bank• Law Firm• Accounting Firm• Consulting Firm

Business Valuation (Why)

• Successful Transaction or Negotiation: Overvaluation or Undervaluation?

• Value Increasing or Decreasing?

• Buy or Sell?

Approaches of Business Valuation (How)

• Industry Multiple• Discounted Free Cash Flow• Discounted Cash Dividend• Book Value: not meaningful in finance• Liquidity Value: as the minimum value• Premium Analysis: used for M&A pre-offer market price / offer price

Industry Multiple

• V = AI* Ind (V / AI)• V = market value of the firm or equity (B+S or S)• AI: choice of accounting item, e.g., asset, sales,

EBIT, EBITDA, net income, free cash flow, cash dividend, replacement cost……

• How to choose AI? Manipulation vs Relevancy• Ind ( ) = Industry average or median• Assumptions: * V is related to AI and stable relationship * Industry influence

Industry Multiple

• Notice 1: V can be dividend by number of shares or not

• Notice 2: diversified firm• Notice 3: non-manufacturing firm, e.g.,

bank• Strength: easy, intuitive, and extensively

used in industry practice and court cases• Weakness: bias of choosing comparable

firm, bias of market influence

Discounted Free Cash Flow Model

• Weakness: Must forecast future. Only if firm generates cash flow mainly from fixed asset investment.

• Strength: must forecast future, focus on fundamental, extensively used

• Four models: WACC, APV, Compressed APV, FTE

Discounted Free Cash Flow Model

• FCFs= (EBIT-Int)*(1-T) + Dep - CE - ∆NWC – PR + New Debt

• FCFB= Int* (1-T) + PR - New Debt• FCFA= EBIT*(1-T) + Dep – CE - ∆NWC = EBIT* (1-T) - ∆NFA – ∆NWCNote ： CE= 資本支出 (capital expenditure) = ∆PPE ( property, plant, equipment) = ∆GFA ( 期末減去期初的固定資產毛額 ) PR= 當期償還的本金 (principal repayment) ∆NFA= 期末減期初的固定資產淨額 NWC = (CA - cash - marketable security) -

(CL - long-term debt matured in one year)

Discounted Free Cash Flow Model

FTE:share value = {[ ∑ FCFs,t / (1+Ks )t] + cash and mkt security}

÷ number of sharesHow to compute Ks (cost of equity)?1. CAPM: Ks = rf + βs * [E(rm) - rf]2. investor’s historical realized yield in this firm or in this ind

ustrya. on the market basis: dividend yield plus capital gain retur

nb. on the accounting basis: ROE3. long-term debt yield plus historical equity risk premium4. dividend growth model, e.g., Ks= D1 / S + g = expected di

vidend yield plus expected dividend growth

Discounted Free Cash Flow Model

• WACC:

1. firm value =[∑ FCFA,t / (1+KA)t ] + cash and mkt security2. share value = (firm value – B) / number of shares

3. KA= WACC = KS * S / (B+S) + KB * (1-T) * B / (B+S)

• APV:

1. VU = Unlevered firm value = [∑ FCFA,t / (1+Ko)t ] + cash and mkt security

2. How to compute Ko (cost of capital for all-equity firm)?• Ko = rf + βo * [E(rm) - rf]• βo = [βs * S + βB * B * (1-T)] / [B * (1-T) + S]}• Hamada formula: ssume βB = 0, solve for βo

Discounted Free Cash Flow Model

• VL = Levered firm value = VU + PV of Leverage

• Where PV of Leverage includes1. Tax shield (+)2. 2.Government subsidization (+)3. Financial distress (-)4. Flotation cost (-)• share value = VL / number of shares

Discounted Free Cash Flow Model

Where tax shield is most important

PV of Leverage = ∑ (T * KB * Bt-1)t / (1 + KB)t = B * T, if assumes T, KB, Bt-1 are all constant over time

Compressed APV assumes that the denominator (1+ KB) is replaced by (1+K0) and then the formula for VL will be simplified

Discounted Free Cash Flow Model

• How to choose among these models?

1. If maintain a stable debt ratio in the future, then use WACC or FTE

2. If the year end outstanding debt in the future is certain and the debt ratio in the future will change, e.g., LBO, then use APV

MM Proposition II with No Corporate Taxes

Debt-to-equity Ratio

Cos

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capi

tal:

r (%

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r0

rB

SBWACC rSB

Sr

SB

Br

)( 00 BL

S rrS

Brr

rB

S

B

MM Proposition II with Corporate Taxes

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr

SL

LCB

LWACC r

SB

STr

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Business Valuation in practice

• Step 1: Industry Analysis, e.g., SWOT or Boston Consulting Group Matrix

1. External Economic & Political Dataa. Business Cycle Stagesb. Inflation Trendsc. Interest Rate Trendsd. Exchange Rate Trendse. Freedom of Cross-Border Currency Flowsf. Political Stabilityg. Regulationsh. Taxation

Business Valuation in practice

2. Non-Financial Dataa. Distribution Channelsb. Labor Force Informationc. Labor-Management Relationsd. Organizational Forme. Corporate Goals and Strategiesf. Information Flow and: Feedback Systemg. Status of Technological Change in the Industryh. Competitive Analysis of the Industry: vertical vs hor

izontali. Potential Competitive Reactions

Business Valuation in practice

• Step 2: Financial Statement Analysis: Time-series and Cross-sectional

1. Liquidity ratio

2. Activity ratio

3. Leverage ratio

4. Profitability ratio

5. DuPont system

Business Valuation in Practice

• Step 3: Perform the Business Valuation: Let’s take the Discounted Free Cash Flow Analysis as an example

1. Collect historical input data2. Compute the weighted or un-weighted average

for each input variable3. Adjusted by subjective judgment4. Use spreadsheet method or formula method:

formula method must estimate the growth rate and investment rate

5. Sensitivity analysis

Business Valuation in Practice

• How to estimate growth rate?1. Use historical data: given 11 years of EBIT dataa. Arithmetic average (a): unweighted / weighted ave annual growth rateb. Geometric average [Discrete compound annual growth rate (d)]: EBIT11=EBIT1×FVIFi%,10 or (EBIT11÷EBIT1)0.1-1c. Continuously compounded growth rate (c) slope in regression of ln(EBIT) on year (1,2,3….)d. If EBIT is a straight line (no fluctuation), then d=ec-1. Also a ＞ d ＞

c2. Judgment about firm’s prospect and business cycle is important!3. Nominal growth rate is the sum of expected inflation rate and the real

growth rate and is upper bounded by economic growth rate.4. Foe zero growth firm, CE=Dep and ΔNWC=03. Use analyst or management forecast

Discounted Cash Dividend

• Constant Growth Model: share value = D1 / (Ks – g)

• Two-Stage growth model: high constant growth in the first n years, then followed by low constant growth forever

Discounted Cash Dividend

• H Model: growth rate is negatively related to time in the first n years, then followed by a constant low growth rate forever

• Three-Stage Model: constant high growth rate in the first period, growth rate is negatively related to time in the second period, constant low growth rate forever in the third period

• Notice that growth rate is positively related to Ks, and negatively related to payout ratio

Conclusion

• Valuation is science vs art• Due diligence and inside information is crucial• Must perform sensitivity analysis• Most suitable for stable, low tech, undiversified firm• Special cases for 1. Distressed firm2. Diversified firm3. Cyclical firms4. Firms with unutilized or under-utilized fixed assets5. Firms with cash flows not generated by fixed asset6. Value of flexibility7. Private firms