Posted in Finance Articles, Total Reads: 2913
, Published on 05 July 2012
A good valuation analysis is not a purely statistical process. It requires judgement and attention to detail. Sometimes, only one particular method may be relevant (e.g., cable TV industry: cash flow and subscriber multiples). In other instances, many methods are appropriate and comfort in values is gained through several analyses, all pointing towards the same value range.
Also, timing will impact achievable values in the real world. Availability and attractiveness of financing will impact participation in auctions. When stock performance is strong, strategic buyers are at an advantage vs. financial buyers, while in more difficult markets, the opposite may be true.Investment banking professionals must be focused in the analysis performed on the key objectives and issues of an assignment. They must perform sufficient analysis to draw appropriate conclusions.
Applications of valuation analysis include:
Acquisitions:How much should we pay to buy the assets/company?
Divestitures:How much could we sell our company/division for?
Defense: Is our company undervalued/vulnerable to a raider?
Fairness Opinions:Is the price offered for a company/division fair (from a financial point of view)?
Public Equity Offerings: For how much could we sell our company/division in the public market?
Initiation of New Business: Identifying undervalued targets
There are typically two stakeholders in any firm, the Debt Holders and the Equity Holders. The concept of Enterprise Value contemplates that the earnings of the Company are allocated to both the Debt Holders (through interest payments) and the Equity Holders (through dividends and appreciation in stock price)
Enterprise Value = Value of Assets
Equity Value = Value of the Shareholders’ Equity
Equity Value = Enterprise Value – Net Debt
When to use Enterprise Value
Enterprise Value is used in circumstances when the financial statistic beingutilized is flowing to the debt and equity holders. In general, this means that any financialstatistic that is pre-interest expense will use Enterprise Value to determine valuation
When to use Equity Value
Equity Value is used in circumstances when the financial statistic being utilized isflowing only to the equity holders. In general, this means that any financial statistic that is postinterestexpense will use an Equity Value concept to determine valuation
Emphasis is given on Enterprise Value/EBITDA (also referred to as a cash flow multiple)because this metric excludes most variables which do not affect value (or can be easily changed) making companies more comparable for valuation purposes.
Interest is a function of capital structure
Taxes are a function of incorporation and tax structure
Depreciation is a function of depreciation policy/asset lives
Amortization is a function of how acquisitive a company has been
Comparable Company Analysis
Comparable companies analysis values a company by referencing to other publicly-traded companies with similar operating and financial characteristics i.e., looking for companies with characteristics similar to those of the business being valued
Once we have chosen the comparable companies, we need to calculate the implied value of our asset/company by multiplying our asset/company’s sales, operating income, operating cash flow, net income, book value and other key operating statistics by the respective comparable company multiples.
Things to be taken into consideration
1) Multiply the operating results (revenues, operating income, etc.) of the company being valued by the relevant comparable company multiples to derive implied values. Ideally, most recent historical and forward-looking operating results should be used in comparable company valuations: latest twelve-month (.LTM.) results and projected full-year results
2) Remember to convert the equity values derived from applying comparable multiples of net income and book value (equity value multiples) to enterprise values by adding the company’s net debt
3) Adjust the resulting implied values for unusual assets or liabilities not reflected in the results on which the comparable company analysis is based. Examples include unfunded pension liabilities, unconsolidated minority investments, unallocated corporate overhead expense (if valuing a division), etc.
Discounted cash flow (DCF) analysis is a theoretical valuation approach, as opposed to arelative valuation technique like CompCo or CompAcq.
An asset’s (or company’s) value is simply the sum of the present value of its expected cashflows over some forecast period
An asset’s intrinsic value is derived based on its characteristics in terms of cash flows, growth and risk profile
Works best for assets / firms where cash flows are currently positive and relatively stable overtime
Step 1: Forecast Cash Flows over Explicit Period
Unlevered Free Cash Flow = EBIT (1-tax rate) + Increase in net deferred Tax liability + Depreciation and Amortization - Increase in net working capital - Capital Expenditures
Step 2: Calculate Terminal Value
Since DCF analysis is based on a limited forecast period, a terminal value must be used to capture the value of the business at the end of the explicit forecast period. The terminal value is usually added to the free cash flow in the final year of the projections and then discounted back to the valuation date, or it can be discounted separately to the valuation date
Step 3: Calculate Weighted Average Cost of Capital
The discount rate is a function of the risk inherent in any business and industry, the degree of uncertainty regarding the projected cash flows, and the assumed capital structure.
WACC = [Rd*(1 - tax rate)]*D/V + Re*E/V
Rd = cost of debt
Re = cost of equity (usually from CAPM)
D = market value of debt
E = market value of equity
V = D + E
Tax Rate = corporate tax rate
Step 4: Calculate Present Value of Cash Flows
Discounting is the process of finding the present value of a future sum. A rupee today is worth more than a rupee tomorrow. For e.g., assuming the discount rate is 10%, 100 rs. 1 year henceforth is worth 100*1/1.1 = 90.91 now.
Step 5: Apply Sensitivities to Get Valuation Range& Do a Sensibility Check
Apply Sensitivities to Key Drivers like Sales growth rate, CapEx assumptions, EBITDA Margin, Terminal value, WACC, Target capital structure etc. to get Valuation Range
Using DCF: Advantages and Disadvantages
Accretion / Dilution analysis is most frequently used in the context of a Merger Consequences Analysis. The company is primarily concerned with pro forma. earnings per share (adjusted for the transaction being considered).
Accretion: Pro forma EPS > Acquirer’s EPS;
Dilution: Pro forma EPS < Acquirer’s EPS;
Neutral: Pro forma EPS = Acquirer’s EPS
Leverage Buyout Analysis
The LBO analysis provides a "floor" valuation for the company, and is useful in determining what a financial sponsor can pay for the target and still earn an adequate return on its investment.
Steps in the LBO Analysis
Develop operating assumptions for the standalone company to arrive at EBITDA and cash flow available for debt repayment over the investment horizon.
Determine key leverage levels and capital structure (subordinated debt, mezzanine financing, etc.) that result in realistic financial coverage and credit statistics.
Estimate the multiple at which the sponsor is expected to exit the investment
Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range of leverage and exit multiples, as well as investment horizons.
Solve for the price that can be paid to meet the above parameters
Valuation Analysis: Summing It Up
Having derived comparable companies, comparable acquisitions and DCF values, one should select a single range of reference values for the company in question. Then calculate the multiples of the company’s results implied by the highest and lowest values in the reference range. Complement with a final reality check of the resulting multiples and check whether reference value imply the company is worth 10 times operating cash flow when no similar company has ever traded or been sold for more than seven times? If so, one should revisit his assumptions. Also one should try to develop and use judgment in valuation analysis about the company, the public and private markets for comparable businesses, etc. Judgment is the key to an accurate valuation analysis; the arithmetic is not that difficult.