Valuation Basics
Revised May 12, 2014 By Scott Beber, ExcelModels
Table of Contents
1. INTRODUCTION .......................................................................................................... 3 2. METHODOLOGY 1: DISCOUNTED CASH FLOW ......................................................... 3 2.1. WEIGHTED AVERAGE COST OF CAPITAL ................................................................................... 3 2.2. PRESENT VALUE OF FREE CASH FLOWS ..................................................................................... 3
3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES ................................................. 4 3.1. PRICE‐TO‐EARNINGS .................................................................................................................. 4 3.2. EV‐TO‐EBITDA ......................................................................................................................... 5
4. METHODOLOGY 4: INCREMENTAL VALUE-ADD ...................................................... 5 4.1. UNDERSTANDING SYNERGY ....................................................................................................... 5 4.2. METHODOLOGY .......................................................................................................................... 5
5. FORECASTING CASH FLOWS ..................................................................................... 6 5.1. 5.2. 5.3. 5.4.
STRAIGHT‐LINE .......................................................................................................................... 6 PERCENT OF SALES ..................................................................................................................... 6 COMPOUND ANNUAL GROWTH RATE (CAGR) ....................................................................... 6 REGRESSION ................................................................................................................................ 6
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1. INTRODUCTION This document is intended to explain rudimentary company valuation techniques. A rigorous valuation will often rely on these, and other, measures, to arrive at a range.
2. METHODOLOGY 1: DISCOUNTED CASH FLOW The Discounted Cash Flow method calculates a Net Present Value of the company as a whole. It is dependent on an accurate depiction of historical cash flow, the basis of which is used to make cash flow projections for future years, plus a residual value of cash flows in perpetuity thereafter. Each forecasted year is then discounted by the company’s Weighted Average Cost of Capital (WACC) to bring all future cash flows into present-day terms. The value of any enterprise is the set of all expected future cash flows stated in today’s dollars.
2.1. Weighted Average Cost of Capital The definition of WACC can be formally stated according to the equation:
WACC = Value of Company Debt x Cost of Debt + Value of Company Equity Value of Debt + Equity Value of Debt + Equity
x Cost of Equity
In basic terms, a company’s WACC is the opportunity cost of a dollar investment in the company versus a dollar investment elsewhere. Cost of Equity is estimated to be historical return on equity (or Average Net Income / Average Equity Value for as many historical years are relevant to the forecast) as a percentage of the value of equity in the company’s current capitalization. Cost of Debt is estimated to be the overall average interest rate paid to lenders and debt financiers as a percentage of the value of debt in the company’s current capitalization. Stated differently, the WACC is the return equity that investors demand and the return that lenders demand according to the amount each has invested in the company.
2.2. Present Value of Free Cash Flows The WACC figure is used as the denominator in each forecasted year’s cash flow value, taking into account compounded interest for the number of years being used in the forecast (plus the residual value). Residual values (also called valuation horizons) are often chosen arbitrarily, but tend to be a number of years for which a realistic cash flow forecast and a realistic long-run growth rate can be made. The sum of all future years’ cash flow projections, translated into present-day dollars according to the company’s cost of capital, yields the company’s Present Value of Free Cash Flows (PVFCF). The definition of PV can be formally stated according to the equation: PV =
Cash Flow in year 1 CF year 2 ... CF year n PV (horizon value) 2 n n (1+WACC) (1+WACC) (1+WACC) + + + 1+ WACC +
where PV (horizon value) =
Cash Flow in year n+1 WACC - (long-run growth rate)
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3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES Using the PVFCF method to value the company has advantages and disadvantages over the other major valuation method: applying a standard industry price multiple to the company’s earnings (i.e. net income). A benefit of the PVFCF model is the ‘theoretical’ accuracy. In addition to providing a company valuation, this model is used constantly by companies to value individual projects they might undertake. The “Net Present Value” of a project, or the present value less the required capital investment, must be greater than $0 for the venture to be a good use of the company’s money. Otherwise, the company is better off plowing the money back into the company and earning its expected WACC. This is another reason why WACC represents a company’s opportunity cost of capital. The problem with the PVFCF is that ‘theoretical’ accuracy requires a large number of assumptions, including:
Accurate historical and projected cash flows
Return on equity
Return on debt
WACC
Number of years to forecast
Horizon value
Long-run growth rate
If each of these figures can be estimated to a reasonable degree of accuracy, the formula for PVFCF will give a very solid answer. NPV calculations for internal projects are generally safe to use because there is little alternative in how worthwhile a project may be, and because by definition they give management information on a smaller scale. The value of a company, in contrast, is arguably the most important value (the “holy grail”) in corporate finance and needs to be extremely accurate in order to be useful. In contrast, the price multiple valuation method has the advantage of being extremely ‘safe’, in the sense that a public market has placed a value on a company or industry based on widely-available knowledge of historical and expected performance. Given the presumption that markets are highly efficient, such a multiple is considered to be the best available estimate of a company’s value. The problem with using a price multiple is that no two companies are alike, and using another company’s basis for valuation may or may not be appropriate to use for another’s. This holds true for using the general price multiple for an industry as a whole. In either case, price multiples are as accurate as the similarity between a competitor’s or industry’s profitability, risks, and growth opportunities and the company being valued. In fact, using an industry price multiple is often a worse method than using another company’s because it is theoretically possible to select a competitor whose business prospects more closely mimic those of ABC Corporation than using, for example, the price multiple of the industry as a whole. Nevertheless, it is worthwhile to use one or more price multiple valuation methods, particularly as a ‘check’ against the PVFCF results.
3.1. Price‐to‐Earnings A price-to-earnings ratio is simply the market price of a company divided by its earnings, or net income. The newspaper gives the ratio of current price to the most recent earnings; however, investors are more concerned with price relative to future earnings. Since future earnings are difficult to know for certain, projections are used, which makes the P/E method closer to PVFCF in terms of accuracy, and helps support the argument for using PVFCF instead. Typically, however, a P/E multiple is calculated without discounting future earnings, but rather, using past and present earnings as indicative of the company’s expected performance.
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3.2. EV‐to‐EBITDA EV/EBITDA ratios are similar to P/Es but rather than Price in the numerator, the Enterprise Value is used; and EBITDA, rather than Net Income, comprises the denominator. One advantage of using EV/EBITDA over P/E is that EBITDA is higher up on the income statement and less subject to creative accounting. By the time an earnings estimate is derived, a lot of mitigating factors can significantly diminish the comparability between two firms. As for the numerator, EV takes the entire company into account, rather than just the value, or Price, of its Equity. For this reason, using a P/E ratio for an industry is a safer bet. Nevertheless, EV/EBITDA has its drawbacks. For one, Enterprise Value requires more work to calculate than Price. Also, there are so many ways of booking Depreciation & Amortization that EBITDA by no means immune to creative accounting. Particularly with growth stocks and risky ventures, Enterprise Value is still a far cry from the ultimate measure of a company’s value: cash flow. Outside of steady streams of cash, any metric can be considered a poor proxy to use in evaluating a company’s performance. Large costs, poor management, dim prospects, tough competition, creeping regulation, obsolescence, and countless other factors can turn an otherwise attractive EBITDA-generating company into a poor investment.
4. METHODOLOGY 4: INCREMENTAL VALUE-ADD The most subjective of the methodologies described herein, an Incremental Value-Add analysis builds on the muchmisunderstood concept of synergy. It is a valuation of two or more individual entities being proposed as candidates for a merger.
4.1. Understanding Synergy “Synergy” is often correctly described as “the whole is greater than the sum of the parts”, but then incorrectly illustrated. It is very difficult to find examples of true synergies in the real world. Proposed mergers often tout how joining two companies will create synergistic effects that will lower costs or increased sales. In practice, those results almost never hold. What may result is a larger enterprise due to horizontal or vertical integration, or a combined entity that is better positioned for growth. These are not synergistic, and do not produce positive Incremental Value. For example, if two manufacturers merge their HR, Legal, or Customer Service departments “under one roof” and reduce headcount, that ISN’T synergy. As over 100 years of failed mergers will attest, no such merger of operations makes things run more smoothly & efficiently in the long run. Workers might be laid off, reducing salary expense, but the net result is ultimately a less efficient or more costly system, more work for non-downsized labor, cut corners, missed opportunities, a worse customer experience, or some other unanticipated burden. Someone invariably pays the supposed “synergy”-driven cost reduction. After the dust has cleared, the merged unit invariably hires people back at a later date (often with decreased benefits) or increases the use of independent contractors, to do the increased and untenable per-person workload perpetrated by the layoffs. Costs are shifted, not eliminated. No synergy has occurred. True synergy, on the other hand, manifests, for example, thorough implementing innovative new technology & automation, greater leveraging of established distribution channels, or utilizing fixed-cost resources at full capacity … all resulting in greater revenue with the same costs, or lower per-unit cost of delivery for the same revenue.
4.2. Methodology Incremental Value-Add places a new valuation on a combined company that results in greater sustainable cash flow than that of both companies individually added together. It is a line-by-line breakdown of the Income Statements and Balance Sheets of Company A, Company B, and Company A+B, when placed side-by-side. Typically, the comparison involves more than just combining financial statements, and requires in-depth analysis on the quantitative effects of the resulting merger. In the end, if the Cash Flows don’t increase by more than the sum of the parts, whether due to increased Revenues, lower Costs, or both, the Incremental Value-Add is negative. See the accompanying spreadsheet example. Page 5
5. FORECASTING CASH FLOWS Forecasting is most important when using the PVFCF model, because by definition an accurate estimate of future cash flows is necessary to evaluate against the company’s WACC. As mentioned in the above section, P/E and EV/EBITDA multiples generally use past and current results in their formulas. There are numerous methods for generating forecasts based on past and current performance, including:
5.1. Straight‐Line The simplest method, Straight-Lining takes the most recent period’s Cash Flow and forecasts it out at a constant (assumed) percentage rate of growth each year; the rate is often taken to be that of the most recent year’s growth.
5.2. Percent of Sales The Percent of Sales method assumes an accurate medium-term Sales forecast. All Sales-driven line-items on the income statement (e.g. COGS) and Balance Sheet (e.g. Receivables, Inventory) are grown at the same rate as Sales. All other line-items (e.g.Salaries, Debt, Interest Expense) are fixed or treated individually). Free Cash Flow is then calculated normally.
5.3. Compound Annual Growth Rate (CAGR) CAGR takes the historical cash flows from the first and last periods and computes the singe annual percentage growth number that, when compounded over the number of historical periods, connects the two figures. This same growth rate is then used to project future cash flows.
5.4. Regression A regression is a statistical analysis that attempts to explain the trend in cash flows (upward or downward) with a “trendline” drawn through the data points. This line can be extrapolated out to the future to predict future cash flows that would follow if all other factors remain constant.
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