Corporate Valuation Keith M. Howe Scholl Professor of Finance DePaul University Summer 2009

Corporate Valuation

Keith M. Howe

Scholl Professor of Finance

DePaul University

Summer 2009

I. Discounted cash flow (DCF) analysis

II. Relative valuation analysis comparable companies analysis equity valuation using P/E multiples enterprise valuation using EBITDA multiples

Valuation Approaches

Basic idea: find the present value of the expected future cash

flows over the asset’s life and discount at cost of capital

(required rate).

Where:

CFt =Cash flow in period t

r = discount rate

Notes:

1. Discount rate is an opportunity cost.

2. CF = Rev - Costs - Taxes - Investment

= (Rev - Costs) (1 - Tc) + (Tc * Dep) - Investment

Discounted cash flow (DCF) analysis

ValueCFt

(1 r)tt 1

N

4

A DCF model has three parts:

Explicit forecast period Cash flows are after-tax incremental cash flows

Continuing value or terminal period Perpetuity FCF, NOPLAT, NOPAT Constant growth Multiples

Discount rate Discount rates can be determined a number of different

ways (e.g., CAPM, Gordon growth model, APT, etc), but the expected free cash flows are discounted at the rate that reflects the risk of the cash flows.


Continuing Value

)()1(1

NtbeyondCFsPVr

CFV

N

tt

tO

PV of forecasted CFs

Continuing Value (CV)


For the continuing value (or terminal value) component, simplifying assumptions are made about future CFs (e.g., g=3% in perpetuity) or future valuation alignment based on market multiples.

Two general approaches:

1) Constant growth rate of CFs.

2) Market-based multiples

Two general approaches are taken:


Forecasting Continuing Value CFs

10 2 3 4 5

g = ?

Explicit forecast Assumed growth path

Forecasted Cash Flows

Time


1) Constant growth approach:

• Over what period will the firm earn abnormal returns?

• What is the relation between the period of competitive advantage and the continuing value formula?


FCFt+1

WACC - g CVt =

2) Multiples Approach:

Where: EV = enterprise valueEBITDA = earning before interest, tax, depreciation and amortization

• Aligns DCF value with market pricing for the industry


EVt

EBITDA Peers

CVt = EBITDA*

Example: Discounted Free Cash flow

Free Discount PresentYear Cash flow Factor (10%) Value

2008 250 0.9091 227.282009 260 0.8264 214.862010 280 0.7513 210.362011 300 0.6830 204.90Terminal Value 3,000 0.6830 2,049.00

Value of Operations 2,906.40Less: Value of Debt (600.00)Equity Value $2,306.40

Price per share $4.16


r =D1/P0 + g Gordon’s Model

r = rf + β (rm - rf) CAPM

r = rf + β1 (r1 - rf) + β2 (r2 - rf) +…

Arbitrage Pricing Theory Fama-French model (size, BV/MV)

Required Rates for DCF Method


Weighted average cost of capital (WACC)


WACC = RD(1-T) * D/V + RE * E/V

Where:

RD(1-T) = after-tax cost of debt (current)

RE = cost of equity (CAPM)

D/V, E/V = debt and equity proportions (market-value based)

Value DriversValue Drivers

MarketMarketForcesForces

CompetitiveCompetitivePositionPosition

Profitability

Investment

Growth

Risk

Competitive

Nature

RequiredInvestment

MarketDemand

Cost Advantage

Product Differentiation

CorporateValue


1. Develop the forecast period

• How long will it take to reach an mature, equilibrium stage? (often 10 years is used)

2. Define strategic perspective

• Tell the story - give the context (For example, demand will peak in 4-5 years and then decline as competitors enter the market. Margins will decline following the period.)

Forecasting CF Performance


3. Period of competitive advantage (ROIC > WACC)

• Providing superior value to consumers thru better service, a differentiated product.• Low cost provider• Barriers to entry - patents, government policy

4. Develop financial forecast based on the strategic perspective

• Begin with revenue forecast.• Develop the income and balance sheet forecasts.• Then calculate CFs and key value drivers.



5. Develop performance scenarios (best and worst cases)

• Sets of plausible assumptions.

6. Check consistency and alignment with industry structure

• Entry barriers, technology, strategic issues



How to Display a DCF- Based Model AssumptionsExample:

Here we develop a base case model from Wall Street Research and CSFB projections

Actuals Research Estimates CSFB Estimates

2000A 2001A 2002A 2003E 2004E 2005E 2006E 2007E

`Revenue $8,872.8 $7,090.6 $5,438.4 $6,345.9 $7,511.5 $8,413.0 $9,254.3 $10,179.7 % Growth 32.1% (20.1%) (23.3%) 16.7% 18.4% 12.0% 10.0% 10.0%

EBITDA 2,689.1 568.9 122.7 1,179.4 1,656.9 2,271.6 2,591.2 2,952.1 % of Sales 30.3% 8.0% 2.3% 18.6% 22.1% 27.0% 28.0% 29.0%

EBIT 2,256.9 20.7 (402.7) 417.9 755.5 1,262.0 1,480.7 1,730.6 % of Sales 25.4% 0.3% (7.4%) 6.6% 10.1% 15.0% 16.0% 17.0%

Net Income 1,782.1 (507.7) (118.7) 419.8 615.3 1,010.6 1,159.7 1,318.4 % of Sales 20.1% (7.2%) (2.2%) 6.6% 8.2% 12.0% 12.5% 13.0%

FCF 2,768.50 620.30 120.60 1,212.50 1,755.40 2,268.50 2,444.30 2,860.30

Real Asset Growth % 33.8% 7.1% (1.5%) 8.7% 12.8% 12.2% 11.2% 10.8%

CFROI % 19.6% 3.9% 1.1% 5.2% 6.2% 7.1% 6.9% 6.9%

18

EBITDA TERMINAL VALUEDISCOUNT RATE 5.5x 6.0x 6.5x

11.25% $107 $107 $107 Present Value of Free Cash Flow178 194 210 Present Value of Terminal Value

$285 $302 $318 Enterprise Value8.2x 8.6x 9.1x Implied EV / 2004E EBITDA5.7x 6.0x 6.4x Implied EV / 2005E EBITDA0.1% 0.9% 1.7% Implied Perpetuity Growth Rate





2004E(1) 2005E 2006E 2007E 2008E 2009EEBITDA $35.0 $50.0 $52.1 $53.1 $54.1 $55.2Less: D&A (7.9) (7.8) (7.8) (7.8) (8.0) (8.1)EBIT $27.1 $42.2 $44.3 $45.3 $46.1 $47.0

Less: Cash Taxes (8.6) (9.9) (10.5) (11.4) (12.3) (13.1)Unlevered Net Income $18.5 $32.3 $33.7 $33.9 $33.8 $33.9Plus: D&A 7.9 7.8 7.8 7.8 8.0 8.1Less: Capital Expenditures (11.6) (23.4) (8.0) (8.0) (8.0) (8.0)Less: Change in Working Capital (1.8) 0.0 (0.8) (0.3) (0.3) (0.3)

Unlevered Free Cash Flow $13.0 $16.7 $32.7 $33.3 $33.5 $33.8

Discounted Cash Flow Valuation($ in millions)

($ in millions)

(1) 2004E not included in calculating NPV of cash flows.

critically review your assumptions on the following variables

Broad economic conditions: How sensitive is the forecast to the economic conditions?

Competitive structure of the industry: How competitive and concentrated is the industry? What impact will this have?

Internal capabilities of the company : Can the company develop its products on time and manufacture them within the expected range of costs?

Financing capabilities of the company: Can the company finance the changes in its plan? How?

Scenario analysis

20

Pros Widely accepted Provides a generally reliable and sophisticated approach to

valuation by accounting for: Profitability Growth Capital investment/intensity Capital structure Risk and opportunity cost

Cons Generally not easy to calculate Grounded by assumptions Gives only an absolute valuation, which in isolation is not

telling Loaded with assumptions


21

We can use free cash flows to find:

a) Enterprise Value

b) Value of Equity

Note on Cash Flow Analysis

22

Matching CFs and discount rates in DCF analysis

Note on Cash Flow Analysis

Note that we have the same value of equity and the value of project

(firm) from using project and equity valuation methods

Project or Firm Valuation

Steps (Debt Plus Equity Claim) Equity Valuation

Step 1: Estimate the amount and timing of future cash flows

Project (firm) free cash flow (i.e., PFCF = FFCF)

Equity free cash flow (EFCF)

Step 2: Estimate a risk appropriate discount rate

Combine debt and equity discount rate (weighted average cost of capital - WACC)

Equity required rate of returm (cost of equity)

Step 3: Discount the cash flowsCalculate the PV(FCF) using the WACC to estimate V(Firm)

Calculate the PV(EFCF) using the equity discount rate to estimate V(Equity)

Definitions:Definitions:Project (firm) free cash flow

Sales #####

Less: Cost #####

EBITDA #####

Less: Depreciation #####

EBIT #####

Less: Tax @ 40% #####

Unlevered Net Income #####

Add: Depreciation #####

Less: CAPEX #####

Less: NWC Increase #####

Free Cash Flows to the firm

Sales #####

Less: Cost #####

EBITDA #####

Less: Depreciation #####

EBIT #####

Less: Interest expense #####

Levered net income before taxes #####

Less: Tax @ 40% #####

Levered net income or Net Income* #####

Add: Depreciation #####

Less: CAPEX #####

Less: NWC Increase #####

Cash Flows to equity

*Note that Net Income + Interest (1-t) = EBIT (1-t)

Definitions:Definitions:Equity free cash flow

EBIT

Subtract taxes(tax rate X EBIT)

Unlevered Net Income

Plus Depreciation, Less Capital Expenditure, Less Working Capital Change

Firm Free Cash Flow

Subtract Interest Expense

Net Income before Taxes

Subtract taxes(Tax rate X Net income

before taxes)

Plus Depreciation, Less Capital Expenditure,

Less Working Capital Change

Equity Free Cash Flow

Discount at WACC Discount at

Cost of Equity

Cash Flow Outline

Firm Valuation Method Equity Valuation Method

Example:

Sample data Cost of Equity (Rs) = 12% Cost of Debt (Rd) = 8% Tax rate = 40% Earnings before Interest and taxes (EBIT) = $40 million Depreciation = $15 million Capital Expenditures = $15 million The EBIT is perpetual (mature firm) Target debt-to-value ratio (D/V) = 40% Current value of debt is $105.26 million

Using free cash flows to find: Enterprise Value Value of Equity

Firm Free Cash FlowFirm Free Cash Flow

million $157.9105.26263.16

DebtValue Enterprise

million $263.16.0912

million $24WACC

Flow Cash Free

9.12% or .0912

.6*.12.4)(1*.4*.08

E/V*RT)D/V(1R

million $24

0$15$150.4)$40(1

NWC in Chang

esExpenditur CapitalonDepreciatiT)EBIT(1

Sd

WACCWACC

Enterprise Value (EV) Enterprise Value (EV)

Value of EquityValue of Equity

Firm Valuation Method

- Change in NWC

Interest PaymentsInterest Payments

million $263.16

$105.26$157.35

DebtValue Equity

million $157.9.12

million $18.947

Equity of Cost

Equity to Flows Cash

million $18.947

01515.4)8.42](1[40

NWC in ChangeCAPEX

onDepreciatiT)1Interest]([EBIT

million $8.42105.26*8%

Cash Flows to EquityCash Flows to Equity

Equity ValueEquity Value

Enterprise ValueEnterprise Value

Equity Valuation Method

29

General thoughts on relative valuations

Most valuations on Wall Street use multiples

Multiples reflect current market perceptions

Relative valuations require fewer explicit assumptions and are easier to use

Relative valuations often find a more receptive audience (easier to understand as there are fewer assumptions)

Relative valuation analysis

Relative valuation analysis Equity valuation using P/E multiples

Pros Most commonly used and accepted multiple with sell side research Easy to calculate (simply need to ensure you match time periods, trailing, current,

future) Takes into account profitability

Cons Cannot use if companies do not have accounting earnings

• Are GAAP earnings a good measure of cash flow?• Adjustments for normalized earnings?

Ignores Economic Profitability• A company could be buying earnings

Completely ignores capital structure Debt not included in the value of the firm Interest costs and tax shield are ignored Ignores future growth opportunities Ignores capital intensity and investment

Although widely accepted, P/E has serious drawbacks.

Example: P/E multiples

peersmsubjectfir E

PEPS )(

Multiple of comparable firms

Price of subject firm

)(EP

peers

Comparable firm example (Automotive):

P/E RatioToyota Motor Corp 13.2DaimlerChrysler AG 10.5 General Motors Corp 6.6Ford Motor Company 16.0Average 11.575

Equity valuation using P/E multiples

Example

Relative valuation analysis

Private Company: EPS = $2.50 P = 2.50 x 11.575 = $28.94 Estimate

Traded Company: GM P/E=6.6 What can we say about GM? Price too low?

Need to look at accounting methods, risk, growth rates, and payout to see if comparable.

Relative valuation analysisEquity valuation using P/E multiples

Example (con’t)

34

Display Example: A Valuation Perspective

From our analysis what can you tell me about our company?

P/E 2004E

15.8x16.0x16.0x18.3x

6.9x

13.3x14.0x

0.0x

5.0x

10.0x

15.0x

20.0x

JEC TANGO TTEK FLR CBI GVA URS

Median 15.8x

35

PX’s trading multiples are consistent with the market’s expectations for future performance.

16.4x18.1x

15.6x

18.0x

15.3x

17.8x

15.1x

17.5x

14.0x

17.1x

13.2x14.9x

0.0X

5.0X

10.0X

15.0X

20.0X

APD AIRL ARG PX LNDE BOC AIRL ARG PX APD LNDE BOC

2003E P/E 2004E P/E

P/E - 2004E

EV / 2004E EBITDA

Display Example: Relative Valuation - Correct Time Periods

4.8x6.0x

7.3x7.7x8.2x8.7x

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

PX ARG APD AIRL BOC LNDE

Source: I/B/E/S Estimate.

2003 P/E 2004E P/E

Relative valuation analysisEnterprise valuation using EBITDA multiples

Pros Second most commonly used and accepted multiple on Wall Street Easy to calculate (but need to ensure you match time periods,

trailing, current, future) Takes into account profitability EBITDA generally a good proxy for cash Takes into account capital structure

• Includes debt in the value of the firm (should use net debt)

• Includes Interest as part of cash flow

Cons Ignores Economic Profitability Ignores capital intensity and investment

The EBITDA multiple is a “cleaner” multiple, however it still misses the hurdle rate and investment required into the business.

Implementing a Multiples Approach

Define the multiple There are different definitions for the same multiple (current, trailing,

forward).

It is integral to look at the entire distribution of the multiple Understand the differences between the mean, median and standard

deviation Understand why the outlier are outliers (question relevance of the

multiple and the companies inclusion in the peer group)

Understand the fundamentals of the multiple What are the strengths and weaknesses of the multiple?

Choosing a peer group for Relative Valuation Methods Why are you trying to determine value?

Documents

Corporate Valuation Keith M. Howe Scholl Professor of Finance DePaul University Summer 2009