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valuation, merger and acquisition

*Valuation AnalysisJudson W. Russell, Ph.D., CFAUniversity of North Carolina-Charlotte

*AgendaEquity Valuation Fundamentals: Intrinsic Value

Enterprise Valuation Fundamentals: Free Cash Flow

Equity Valuation Fundamentals: Relative Value

*IntroductionValuation is both art and scienceArt through reasonable, defensible:Assumptions Judgment and interpretation of dataScience through application of analytical formulaeValuation is based on future performance

*IntroductionTwo main valuation questions:

What is a company worth by valuation metrics?

2) What can or will a potential buyer pay?

*IntroductionThree main valuation methodologiesIntrinsic Value Approach: A stocks price equals the net present value of its dividends.Relative Value Approach: A stocks value is determined by comparing similar stock values.Acquisition Value Approach: Calculate a companys stock price by determining its worth to a third party acquirer.

Golden Rule: Footnote your assumptions

*IntroductionEQUITY VALUE: Value of shareholders interestAfter interest expense, preferred dividends and minority interest expenseMultiples of net income, book value, EPSOther common terms:Market Value, Market Capitalization, Offer Value (in an acquisition context)

*IntroductionENTERPRISE VALUE:Includes all forms of capitalMarket value of equity, debt, preferred stock, minority interestBefore interest expense, preferred dividends and minority interest expenseMultiples of sales, EBITDA, EBIT or any other applicable metric (per subscriber, per bed, etc.)Other common terms:Aggregate Value, Firm Value, Total Capitalization, Adjusted Market Value, Transaction Value

*IntroductionEnterprise Value=Equity Market Cap.Net DebtPreferred StockMinority InterestEquity Market Cap.

*IntroductionCOMPARABLE (or similar) in terms of:

Operations

Financial Aspects

Industry

Size

Products

Leverage

Markets

Margins & Profitability

Distribution channels

Growth prospects

Customers

Shareholder base

Seasonality

Market conditions (acquisitions)

Cyclicality

Consideration paid (acquisitions)

Circumstances surrounding the transaction

*Equity Valuation ProcessThe Graham and Dodd Approach to Security Selection

Study the available factsPrepare an organized reportProject earnings and related dataDraw valuation conclusions based on established principles and sound logicMake a decision

*Valuation ProcessThe top-down approach starts with an analysis of alternative economies and security markets.The initial objective is to decide how to allocate investment funds among countries and within countries to bonds, stocks, and cash.The second phase is the analysis of alternative industries. The objective at this stage is to determine which industries will prosper based on your analysis of the economy.The final, third, phase focuses on security selection. The objective is to determine which companies within the selected industries will prosper and which stocks are undervalued.

Analysis of Alternative Economies and Security MarketsAnalysis of Alternative IndustriesAnalysis of Individual Companies and Stocks

*Valuation Process ExampleThe top-down analysis for a U.S. homebuilder:EconomyGDP will increase 3%Capital MarketsInterest rates will remain lowIndustryHousing starts to stay strongHomebuilding CompanyHomebuilder to gain market share.

Sales will increase by 15% versus the industry average of 10%. Steady profit margins signify a 15% earnings increase.

*Economic Cycles

*Industry AnalysisForecast SalesAn insightful analysis when predicting industry sales is to view the industry over time and divide its development into stages.Pioneering development - ARapid accelerating growth - BMature growth - CStabilization and market maturity - DDeceleration of growth and decline - E

TimeRate of Sales GrowthBADCE

*Porters Five Forces

Valuation Approach Intrinsic Value

*Valuation Approaches Intrinsic ValueThe value of an asset is the present value of its expected returns.

The process of valuation requires estimates of (1) the stream of expected returns and (2) the required rate of return on the investment.

The value of a preferred stock (perpetuity) is simply the stated annual dividend divided by the required rate of return on preferred stock (kp). A preferred stock with an $8 per year dividend and required return of 9% is valued as:

V = $8 / 0.09 = $88.89

*The valuation of common stock is more difficult than bonds or preferred stock because an investor is uncertain about the size of the returns, the time pattern of returns, and the required rate of return (ke).

However, the value of common stock is still the present value of its future cash flows. The only cash flows an equity investor ever gets are dividends (cash or liquidating).

A model to value common stock is the dividend discount model (DDM).Valuation Approaches Intrinsic Value

*The DDM assumes that the value of a share of common stock is the present value of all future dividends as;

V = [D1/(1+ke)1 + D2/(1+ke)2 + + D/(1+ke)]

Since estimating D is impossible, other methods have evolved based upon a terminal stock value, or a constant rate of growth.

Valuation Approaches Intrinsic Value

*Assume an investor wants to buy a stock, hold it for one year, and then sell it. We must evaluate the dividend cash flows as well as the terminal value in one year. These cash flows are then discounted at the investors required rate of return.A company earned $2.50 a share last year and paid a $1 dividend (40% dividend payout). The firm has a consistent record regarding payout and we expect it to earn $2.75 per share during the coming year. We expect the stock to trade at $22 at the end of the coming year. Further, the risk-free rate is 5%, the market return is 10%, and the stocks beta is 1.2.

ke = rf + b(E(rm) rf ) = 5 + 1.2 (10-5) = 11%, D1 = E1(dividend payout) = $2.75(.4) = $1.10

V = [D1/(1+ke)1 + Stock Value1/(1+ke)1]V = [$1.10/(1+.11)1 + $22/(1+.11)1]V = 0.99 + 19.82 = $20.81

Valuation Approaches Intrinsic Value

*When valuing a firm with an infinite holding period we assume that dividends, at some point, exhibit a constant rate of growth. Assume that a firm is in a state of constant growth, we can value the infinite stream of cash flows using the following abbreviated formula:

V = D1/(ke - g)

For instance, in our previous example lets assume that the holding period is infinite and the firms dividends are growing at 6% per year perpetually. The dividend in one year was $1.10 and the required rate of return was 11%.

V = $1.10/(.11- .06) = $22.00

Valuation Approaches Intrinsic Value

*We can employ the same technique for firms that have varying rates of growth by assuming that the growth rate becomes constant, at some point.For instance, suppose we have a firm experiencing rapid growth due to its position in the product cycle. At some point the growth rate has to slow or the firm will become the market!We can accommodate this scenario with a multistage model by discounting the rapid growth phase dividends individually and then determining the terminal value using the constant growth methodology.

V = [D1/(1+ke)1 + D2/(1+ke)2 + + (Dn+1/(ke-g)) /(1+ke)n]

Valuation Approaches Intrinsic Value

*Suppose that ABC Company has a current dividend of $1.00 per share with growth expectations of 20% for each of the next two years. After that point, the firm expects dividends to grow at 4% each year indefinitely. Given a cost of equity of 11%, calculate the value of the firms shares.

V = [D1/(1+ke)1 + D2/(1+ke)2 + V2/(1+ke)2]where V2= D3/(ke g)

V = [$1.20/(1+.11)1 + $1.44/(1+.11)2 + ($1.50/(.11-.04)) /(1+.11)2]

V = $1.08 + $1.17 + $17.39 = $19.64

Valuation Approaches Intrinsic Value

*Valuation Approach Intrinsic ValueDISCOUNTED CASH FLOW ANALYSISIntrinsic value of the companyUnlevered free cash flowsIndependent of capital structureFree cash flows generated by the assets that are available to all capital holdersPresent value of: (1) free cash flows and (2) projected terminal valueTerminal value is used to estimate value beyond the forecast periodExit Multiple Method (assumes the sale of the business)Perpetuity Growth Rate Method(3) Discount rate = Weighted average cost of capital (WACC)WACC = ka = wdkd(1-t) + weke

*

*FCF1FCF2FCF3FCF4FCF5How do we account for the remaining cash flows of the firm?

Terminal Value ApproachConstant Growth MethodFree Cash Flow AnalysisFCFn

*Terminal Value CalculationA. The Exit Multiple Method

*The Present Value of the Terminal ValueDiscounted Cash Flow Analysis

12010 EBITDA (Terminal Value) $113.10 2x Exit multiple6.5x3= Pretax Sales Proceeds (future value)$735.15 4/ discount factor (back 5 years at 12%)0.56745Present value of terminal value$417.14

*Terminal Value as % of Enterprise ValueProvides a reality check of the DCF valueHigher the %, more of the Enterprise Value is being realized with the assumed sale of the business at the end of the forecast periodConfidence level in the 70-85% range, depending on the company and situationDiscounted Cash Flow Analysis

*Terminal Value as % of Enterprise ValueHow much of the Enterprise Value for the Company is being generated by the Terminal Value?What is your comfort level with this percentage?

Discounted Cash Flow AnalysisPresent Value of Exit Multiple = $417En