Overview of Corporate Valuation Techniques
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Overview of the session
Introduction
Discounted Cash Flow (DCF)
Trading Multiples (or market multiples)
Comparable deals
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Valuation skills are critical in most of Morgan’s businesses
M&A
Investment Banking
Equity Capital Markets
Principal investing
Equity derivatives
Global Credit
Asset Management
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Probing for evidence of analytical skills is a primary interview objective
Investment banking involves a great deal of modeling, forecasting, and valuation work
Investment bank interviewers typically ask questions about valuation techniques or finance transactions
– e.g. “You are advising a large technology company on an acquisition of a smaller niche technology company. What are the issues you would consider in valuing it? How would you estimate its value?”
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General themes of this session
There is not one right way to value a firm
– Consultants almost always evaluates DCF, trading values, and comparable transactions
– Other techniques are appropriate in selected situations (dividend discount model, leveraged value, liquidation value)
– Understanding differences between various valuation techniques is often critical to the appropriate decision
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Overview of the session
Introduction
Discounted Cash Flow (DCF) Value based on estimated future cash flows of a company discounted by a rate that reflects the risk of its business and capital structure
Trading Multiples (or market multiples)
Comparable deals
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Discounted cash flow analysis has three key components
Forecasted free cash flows– Cash flows before debt service or distributions to shareholders
Terminal value– Estimate of future value at “stable state”
Cost of capital – Represents current return requirements of debt and equity holders– Reflects target capital structure on a market weighted basis
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Projecting cash flows requires in-depth understanding of the business
Industry outlook
– Anticipated industry growth
– Major opportunities/risks
Competitive position
– Pricing flexibility
– Possible market share changes
– Cost structure
Reinvestment needs
– Working capital
– Required capital expenditures
– Discretionary investments
Expansion opportunities
– New product/stores/format
– Development costs
– Economies of scale
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Defining free cash flow
Free cash flow is the cash that remains after all necessary reinvestments have been made
Free cash flow is measured prior to any debt service (interest and debt repayment), but after taxes
Free cash flow therefore is the amount of cash that can be distributed to shareholders and creditors
Free cash flow is typically defined as:
Operating Profit
- Taxes (Cash)
= Net Operating Profit After Tax (NOPAT)
- Capital expenditures
+ Depreciation
+ Amortization of goodwill
- Change in net working investment 1
+/- All other items (that affect cash flow)
= Free cash flow
1 Inventory plus receivables less payables and accruals (net change; usually a use of funds)
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The terminal value must also be estimated in a DCF valuation
Terminal Value is the portion of a company’s total value that can be attributed to cash flows expected in the period beyond the specific forecast period
The terminal value period is the time from the end of the specific forecast period to infinity
Terminal value should be estimated when the forecast reaches “steady state”– Long-term assumptions have stabilized– Little added value to forecasting more years– Usually around ten years
The terminal value is equivalent to making infinite year-by-year forecasts
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Perpetuity model
Price multiples (i.e., P/E ratios, EBIT multiples, market value/book value, etc.)
Liquidation value – for projects with a limited life which will not generate cash flows forever
Different methods of determining a terminal value
___FCF___(1 + WACC)
FCF (1+g) (1 + WACC)²
FCF (1+g)² (1 + WACC)³
Terminalvalue += + + . . .+
FCF WACC - g=
FCF (1+g) (1 + WACC) n
n-1
g = growth rate in perpetuityWACC = weighted average cost of capitalFCF = free cash flow in terminal value
year (year after last projected period)
Where . . .
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The discount rate applied to free cash flows reflects several key factors
Cost of equity
Cost of debt
Target capital structure
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The cost of equity is the major component of the discount rate
The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation)
J.P. Morgan, McKinsey and PwC always estimate the cost of equity using the capital asset pricing model (“CAPM”)– Risk-free rate based on government securities– A market-wide equity risk premium adjusted for the specific risk of the
investment under consideration
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The CAPM has several components
Cost of equity = Risk free rate + (Beta xEquity riskpremium)
Long-term return onequity investment intoday’s market
=
Long-term risk-freerate of return (beta=0)
+
Adjustment forcorrelation tostock marketreturns
x
Appropriate “extra”return above risk freerate
= 10-year U.S.Treasury bond
+ Predicted betasfrom BARRA
x Estimated usingvarious techniques
For market average = 5.75% + ( 1.00 x 4.00% )
= 9.75%
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The cost of equity and debt are blended together based on a target capital structure
The target reflects the company’s rating objective– Firms generally try to minimize the cost of capital through the
appropriate use of leverage
The percentage weighting of debt and equity is usually based on the market value of a firm’s equity and net debt position– Most firms are at their target capital structure– Adjustments should be made for seasonal or cyclical swings, as well
as for firms moving toward a target
Using a weighted average cost of capital assumes that all investments are funded with an equal mix of equity and debt
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The cost of equity and debt are blended together based on a target capital structure
[ (D/(D+E)) x (kd (1-t)) ] + [ (E/(D+E)) x ke ]
EXAMPLE
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The three elements are pulled together to derive a value
The forecasted free cash flows and the terminal value are discounted by the weighted average cost of capital
The present value of these cash flows is an estimate of Firm Value, i.e. the value of the entire enterprise
The value of claims held by debt holders and preferred stock holders must be deducted to arrive at an estimate of Equity Value
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Overview of the session
Introduction
Discounted Cash Flow (DCF)
Trading Multiples (or market multiples) Estimate of the value at which a firm should publicly trade in today’s market based on the multiples of similar firms
Comparable deals
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Multiples analysis looks to the market for guidance on value
Multiples are ratios of total value to certain operating metrics such as earnings or cash flow
An example is the widely-used P/E ratio– Quoted market price = $24– Earnings per share = $2.00– P/E = 12 x
Multiples are useful because they allow us to normalize for differences in size
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Multiples analysis can be broken down into a 7-step process
1. Identify the peer group
2. Select appropriate multiples
3. Perform financial analysis on peers and establish values for ratios
4. Calculate summary multiples for peer group
5. Apply summary multiples to TargetCo’s forecasted results, derive values
6. Adjust implied values for debt & cash, establish equity value range
7. Assess position of TargetCo within value range
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The basics of trading multiples
Understand the company you are valuing
Understand its industry factors
Develop as similar a peer group as possible– Quantitative factors– Qualitative
Check for data errors– Whether done by hand, or using an automatic model which pulls in
data and generates multiples, always check for mistakes
Review several multiples– Different multiples are important for different industries
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Trading multiples that are typically used
Multiple Comment
Firm value/op. Profit1 3 Generally most accurate multiple to use
Firm value/op. profit DA 2 3 Used if amortization of goodwill or acquisition-related depreciation is significant
Firm value/ EBIT or EBITDA Similar to op. profit multiples (watch out for interestincome)
Market value/ trailing net income P/E ratio – affected by one time charges
Market value/FY14 net income Forward looking – actively used by Wall Streetanalysts
Market value/FY2 net income Forward looking – Firms with near-term losses
Market value/ next 12mos. Net inc.5 Forward looking – avoids problems with differentfiscal years
Market value / cash earnings GAAP EPS + amortization of acquisition-relatedgoodwill & intangibles – growing in use; shouldbecome more popular
Firm value/sales Generally not very accurate or appropriate (exceptfor start-up/small add-on acquisitions)
Market value/book value Most appropriate for financial institutions
Industry specific Price per subscriber/ barrel/pop., etc.
1 Operating profit before interest and taxes2 Operating profit before interest, taxes, depreciation and amortization of goodwill3 EBIT is often substituted for operating profit. This substitution does not create a problem unless interest income is significant4 Net income projected by brokerage firms for the current fiscal year5 Calculated using estimates for fiscal year one (current year) and fiscal year two
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Why trading values can differ from DCF
Market may view the firms’ outlook differently (different implied forecast)
Discounts– Lack of liquidity– IPO/Spin-off– Conglomerate
Supply/demand imbalance
Difference in capital structure
Company doesn’t distribute all of its free cash flow to shareholders
Option value
Acquisition speculation
Event risk
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Overview of the session
Introduction
Discounted Cash Flow (DCF)
Trading Multiples (or Market Multiples)
Comparable deals - Estimate value based on what buyers have paid for 100% of similar firms in the past
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Comparable deals analysis is usually problematic
Often a limited number of transactions
Dated information – Stock market has changed– Business has changed– Financing has changed– Bidders have changed
Missing data– Earnings usually unavailable on subsidiary transactions
Hard-to-find data
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Why bother with comparable transactions?
Important part of “deal-speak”
Our clients typically want to know deal history
Our competition will certainly provide this– Premium needed in the past to win bidding– Valuation techniques used by buyers– List of likely buyers– Bidding strategies
Industry-specific multiples can be important
Often necessary information for Board of Directors, fairness opinions, etc.
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Example of a comparable deals list
Transaction multiples
Dateannc Target Target business
Totalfirm
value Debt
Totalequityvalue Sales EBIT EBITDA
Equityvalue/LTM
net income
6/99 JustLike You Inc. Widgets 400 (100) 300 1.18 11.8 9.0 18.6
12/98 HighGrowth Corp. Widgets for internet 150 NA 1.67 16.7 12.8 NA
7/98 MuchBigger Co. Widgets and other stuff 3,500 (500) 3,000 1.09 10.9 8.4 17.2
1/98 FarEast Inc. Widgets for emerging market 50 NA 5.00 NA NA NA
9/97 SomeData Co. Widgets 250 NA 1.22 NA NA NA
5/97 LotsaGoodwill Inc. Widgets 900 (300) 600 1.15 14.4 8.8 25.0
6/96 BadComp Co. Cement and Widgets 400 NA 0.71 10.2 7.1 NA
8/95 HiddenAsset Inc. Widgets and gold mine 600 (100) 500 2.00 15.4 13.5 26.0
2/94 BadData Plc Widgets for Europe 750 (350) 400 1.15 23.0 11.5 139.5
7/89 OverPaid Corp. Widgets for Hollywood 1,200 (200) 1,000 1.54 15.4 11.8 26.0
7/84 OldDeal Co. Widgets 700 (50) 650 0.91 .91 7.0 14.4
Average 1.60 14.01 10.0 38.1
Median 1.18 14.4 9.0 25.0
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Valuing target based on transaction multiples
$ millionsSales EBIT EBITDA Net Income
Data for target $290 $28.2 $36.2 $17.2
Multiples based on:
Average 1.60 14.1 10.0 38.1Median 1.18 14.1 9.0 25.0JustlLike You inc. 1.18 11.8 9.0 18.6
Value based on:
Average multiples $465 $398 $362 $655Median multiples 342 406 326 430Just like you 342 333 326 320
Average multiples
Median multiples
JustLikeYou Inc.
Valuation Summary
362 655
430
320 342
326
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When can transaction values differ from DCF
Cost of capital differences– Buyer may have a lower cost of capital
High level of synergies– Revenue enhancements– Cost savings
Cross-border– Differences in capital costs, tax rules, repatriation levels, etc.
Differences in view of the future – Buyer may have a dramatically different view of the future than the
market• Other strategic reasons
- Buy vs. build- Platform for other investments - Defensive acquisitions
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Conclusion
There is not one right way to value a firm– Morgan almost always evaluates DCF, trading values, and
comparable transactions
Understanding differences between various valuation techniques if often critical to the appropriate decision
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Preliminary analysis is summarized for the client by indicating a value range
$80 $97
$55 $69
$97 $101
$88 $92
$61 $73
50 60 70 80 90 100 110
Share price as of [date]
Total equity valueUS$ millions
Comparable trading
analysis
– Base case
– Aggressive case
– Conservative case
Discounted cash flow
analysis
Comparable transaction
analysis
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Summary of valuation methodologies
Analysis of purchase prices of selected transactions
Can be difficult to draw conclusions due to dissimilarities in transactions
May provide insights into acquisition strategy of potential competing buyers/industry peers
Includes control premium
Selected transaction multiples analysis
Discounted cash flow (“DCF”) analysis
Preferred measure of intrinsic value
Present value of free cash flows to debt and equity holders
Incorporates both short-term and long-term expected performance
Risk in cash flows and capital structure captured by discount rate
Free cash flow incorporates future requirements to reinvest in working capital and fixed assets
Provides ability to separate sources of value– Business by business– Standalone value vs. synergies
Selected trading multiples analysis
Analysis of how selected companies trade relative to business being valued
Applied using historical and prospective multiples
Key multiples include [price/earnings] and [firm value/EBITDA]
Does not include a control premium