VALUATION OF A FIRM

Fair Market Value

IRS Revenue Ruling 59-60, as amended:The price at which the property would change hands between a willing buyer and a willing seller when the latter is not under any compulsion to sell and both parties have reasonable knowledge of the relevant facts.

Relevant Factors

The nature of the business and the history of the enterprise since inception.The economic outlook in general and the condition and outlook of the specific industry in particular.The earning capacity of the company.The dividend-paying capacity of the company.Sales of the stock and the size of the block of stock to be valued.The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Valuation Methodologies

Liquidation value Only in specific circumstances, i.e.

distress.

Net book value = assets - liabilities Accounting values – enough said.

Comparable ratios**

P/E, P/Sales, P/Book, Dividends/Price. Very popular in investment banking

circles.

Valuation Methodologies

Capitalization of Income Not a cash flow and “Times 6 Rule??”

Capitalization of Dividends Flow to equity approach discussed in text.

Recent stock sales/trades As Higgins tells us this gives the value of

a minority position, may not be appropriate.

Capitalization of “free cash flow”**

Comparables

Again, very popular with investment bankers when valuing private companies. The smart ones use it as validation, others use it alone.The idea is very simple, if we can find an exact match for the firm in question, i.e. a match for the business risk and the financial risk, that trades on a liquid market, the market would price them in the same way.This ignores the criticisms of using recent trades by taking trading prices of the comps.

Comparables

What is a “comparable” firm? We’ve been saying “an otherwise

identical firm” in discussions of capital structure and dividend policy. That’s what we want.

Never going to find it. Most common to select publicly

traded firms that match: (1) industry, (2) size, (3) location, and (4) financial leverage as closely as possible.

ComparablesGather a sample (2 – 4) of firms that are most comparable to the target firm.If you could find an exact match, same industry, same markets, same risk, same leverage, and the same level of expected cash flows you would be done since the two firms would have the same value.Given that you won’t what do you do?Hope the ratios (see below) capture all else and control for the level of cash flow using one of several proxies.

Comparables

What, if anything, do I mean by that? Think about the price earnings ratio as an

example. By getting a representative price earnings ratio of

comparable, publicly traded firms we see that, for such a firm, the market values each dollar of earnings at the level of this ratio.

Given that the target firm’s earnings are not the same as the comparable firm’s earnings we can’t just use the comparable firm’s price.

Thus we multiply the comparable P/E ratio times the target’s E to find an estimate of the target’s P.

Comparables

Calculate the “representative” ratio for your sample of comparable firms.Calculate the “representative” level of the base parameter (for the target firm), i.e. for the price earnings ratio this is earnings. Here it may be wise to look at a weighted

average of the base parameter for the last several periods using heavier weights on the most recent observations.

Then simply multiply the comparable ratio by the target’s level of the base parameter.

Comparables

P/E – measure the “average” P/E ratio of the set of comparable firms Then multiply this by the earnings per share of

the target firm to find price per share of equity.

Very important that growth potential is similar.

P/Sales – came into vogue in the internet age when you were trying to value firms that had only negative earnings. Even worse than earnings (which are not cash

flows) this ignores differences in efficiencies.

Comparables

P/Book – here we are looking at book value of assets as an indicator of earning power, heroic.Dividends/Price – a bit better in that dividends are a cash flow but they are discretionary and two similar firms with different dividend policies will be valued very differently with this technique.

Example – P/E Ratio

Suppose that I think Oracle is a perfect match for the private company (Ralph Inc.) I want to value.The P/E ratio of Oracle is 25.6.To value Ralph Inc. I multiply Ralph’s EPS of $0.47 per share by the 25.6 to estimate a $12.03 share priceQuestion: A much smaller firm (Phoenix Technologies) in the same industry sector has a P/E ratio of 103.9. What’s that about?

FCF Valuation Techniques

WACC Discount FCF (cash flow available to be

distributed to contributors of capital in an unlevered firm) at the WACC to find firm value.

APV Discount FCF at the unlevered cost of capital

(cost of capital of the assets) to find the value of the unlevered firm then add the value of the effects of the use of debt financing (largely debt tax shields).

Clearly our starting point is FCF TVC Case

Free Cash Flow

For each year you want to calculate:FCF = EBIT(1 – Tc) (no debt tax shields)

+ Depr & Amort. (adjust for non cash expenses)

- Capital Expenditures (a cash flow not considered in

EBIT)- Changes in NWC (almost, to

adjust for incr. or decr. in ST assets and liab.)

Free Cash Flow

We start with earnings before interest and taxes. Why? Before interest because financing

costs should not be taken out. Before taxes to make it easier to

ignore the debt tax shields that are likely to be there.

Ignore Financing Costs?

Consider a very simple example: You are considering a risk free

investment. It costs $1,000 to undertake now and will

provide a payout in one year of $1,100 (FCF). You will borrow the $1,000.

The risk free rate is 8%. What is it’s NPV?

Ans: -$1,000 + $1,100/1.08 = $18.52

Ignore Financing Costs?

Now suppose that we take the interest payments on the loan out of the FCF.8% interest on $1,000 for a year is $80.After interest FCF is $1,100 - $80 = $1,020

The NPV of this is: -$1,000 + $1,020/1.08 = -$55.56 Clearly wrong.

Ignore Financing Costs?Can we do it “like this” and be correct? Flow to equity approach. This separates the cash flows that go to the debt

holders and the equity holders, then values the equity piece at the cost of equity capital.

This assumes that the money raised up front by selling the debt just equals the PV of the cash flows that go to the debt holders (NPV = 0).

$1,000 from debt (now), $1,080 to debt (later). $0 from equity (now), $20 to equity (later) All cash flows are risk free so NPV = -$0 +

$20/1.08 = $18.52

Why is it almost -NWC?

Two reasons: 1st – one of the NWC accounts is current portion of

long term debt. We leave out changes in long term debt from cash flow since this is a financing cash flow. Why put it in 19 years later?

2nd – a level of the cash account is necessary only up to a balance required for liquidity. Increases in the cash account above this minimum could be paid out as dividends or used to pay down principal without reducing the effectiveness of the firm going forward. Thus increases in cash above the minimum are not to be subtracted to find FCF.

Teton Valley CorporationSales growth at 10% for 5 years then 4% in perpetuity.CGS at 65% of sales.SGA at $500,000 + 4.5% of sales.Net Fixed assets grow at 5% per year for next 5 years.Depreciation is 20% of beginning of year net fixed assets.NWC is $80,000, grow with sales growth.FCFs grow at 4% in perpetuity after 2005.

WACC Method

First find the value of the 5 years of FCFs that we forecasted by discounting at the WACC.Find the present value of the terminal value of the FCFs, again using the WACC.The sum of the two is the total firm value before any discount.Subtract the value of the debt from total firm value to find the value of the equity.Apply the 20% liquidity discount to the equity value.

APV Method

Use the cost of capital of the assets (or the cost of equity capital for an unlevered firm) to value the forecasted and the terminal value of the FCFs, this is the unlevered firm value.Add the total value of the tax shields (using the cost of debt capital as the appropriate discount rate) to find firm value.Subtract debt value from firm value to find equity value before the discount.Apply the 20% discount to the equity value to find your estimated value of the equity.

Terminal Value Calculations

5 most popular estimation methods: Level Perpetuity in FCF. Growing Perpetuity in FCF. P/E ratio today applied to EPS at end of

forecast period. Market/Book ratio today applied to book

value of assets/equity at end of forecast period.

Liquidation value of assets.