Corporate Strategy

1
Corporate Strategy

• Business Valuation

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What is Being Valued?

• Equity
• Equity Value Firm Value - Debt
• Assets (Firm)
• Whose management is being valued?

3
Approaches to Valuation

• Cost
• Market Multiples
• (Comparables)
• Cash Flow
• (NPV WACC Adjusted Present Value)

4
Cost (Asset Based)

• Book Value
• Book Value of Equity (Assets) Shares O/S
• Not really value
• Reflects historical value of transactions only
• Modified Book Value
• Obtain appraisals
• Still doesnt reflect going concern value

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Market Multiples - Comparables(Relative
Valuation Approach)

• Looking to Market for Valuation
• How does Market Value Similar Assets
• Ex Real Estate - how does market value similar
  houses
• Two Issues
• Which Multiples should be used?
• What does similar or comparable mean?

6
Market Multiple Approach

• Gives a relative value as opposed to an
  intrinsic value
• Reflects current mood of market
• If market over or undervalues comparable firms,
  this approach will over or undervalue your firm

7
Market Multiples

• (Price per Share) / (Economic Measure per share)
  ? Value of Equity
• Value of firm / Economic Measure ? Value of
  Firm

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Accounting Based Multiples

• Earnings (P/E) ? Equity
• Revenues ? normally Equity
• Cash Flows ? Equity or Firm
• Enterprise Value/EBITDA is most common
• NI Deprec.
• Book Value ? Equity or Firm (also called
  market/book)

9
Industry Multiples

• Examples
• Beds/Rooms (Hospitals, hotels)
• Customers (e-tailers)
• Million Barrels of Oil ounces of gold
• Cases sold (Beverage distribution)
• Subscribers (Cable, newspapers, internet
  cellular)
• Any performance measure
• Industry specific multiples more predictive of
  value

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Market Multiple Issues

• Defined consistently and measured consistently
  across firms
• Understand cross-sectional distribution of
  multiples across sector and market
• Understand fundamental determinants of multiple
• Find right firms for comparison

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Defined Consistently

• Consider P/E ratio Earnings definition
• Price Price per share
• Earnings
• Current earnings (from most recent F/S)
• Trailing (last four quarters)
• Forward (expected in next financial year)
• Diluted - W/WO extraordinary items

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Distributional Characteristics

• Price/earnings ratios cannot be negative
• Constrained below by 0 unconstrained above
• Skewed to the right median more representative
  than the average average too high
• Outliers ? can have very high P/E when E is close
  to 0
• Throw out negative earnings, or use aggregate
  earnings and equity

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Multiple Determinants

• What are the fundamentals that determine a
  multiple? (Also known as quality)
• Normally, one or more of the following
• Growth
• Risk (stability)
• Profitability (margins)
• Reinvestment
• Entrepreneurial firms liquidity lack of
  marketability

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Determinants of Quality Accounting Multiples

• Earnings
• Growth
• Stability (Risk)
• Reinvestment needs
• Revenues
• Net or operating margin
• Growth
• Stability (Risk)
• Reinvestment needs

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Quality Accounting Multiples

• Cash Flows
• Growth
• Stability
• Reinvestment needs
• Risk

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Quality Industry Multiples

• Profit margin (subscribers customers)
• Cost to obtain (oil reserves customers)
• Cost to retain (subscribers customers)
• Cost to service

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Multiple Fundamentals Ex.

• P EPS(1 - r) / (R g)
• P/EPS (1 - r)/(R g)
• P/EPS f(reinvestment (r), risk (R), growth
  (g)), as stated

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Multiple Fundamentals Ex.

• Suppose we want to consider P/Sales
• Divide by Sales
• P/Sales EPS/Sales x (1-r)/(R-g)
• P/Sales f(net margin, reinvestment, risk,
  growth), as stated.

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Multiple of Sales

• CPA Firms
• Medical firms
• Internet firms
• No Earnings
• No Cash Flow
• Most appropriate for acquisition of Customers or
  a Revenue stream

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Multiple of Sales Abuses

• Internet Firms
• No Earnings or cash flow Revenue only positive
  number
• Higher revenues ? higher valuation
• Barter trade ad space (sale purchase)
  multiple of revenue recognizes sale only
• Accounting treatment of e-tailers
• Net sales v. gross
• Solution Multiple of gross margins

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Market Multiple Application

• Select a sample of comparable companies
• Same Industry (SIC, NAIC code)
• Go through descriptions to narrow list
• Earnings or cash flow companies with positive
• Size Stage
• Growth history and potential

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Comparable Example

• Consider a private health maintenance
  organization (Pri-HMO) that is being offered for
  sale. Financial data for Pri-HMO and two
  comparable, publicly traded firms are contained
  on the following slide. You have no other
  information concerning growth, risk or
  reinvestment needs. Estimate the value of
  Pri-HMO using the information provided.

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Market Multiple, example
24
Market Multiple, example
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Market Multiple, example
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Mkt Multiples Determinants of Quality

• P/E f(Growth, Risk, Reinvestment)
• (Equity value)
• P/Revenues f(Growth, Net or Operating Margin,
  Risk, Reinvestment)
• (Firm or equity)
• P/CF f(Growth, Risk, Reinvestment?)
• (Equity value or firm value depends on cash flow
  measure)
• P/BK (equity) f(ROE, Risk, Reinvestment)
• (Equity value)
• P/BK (assets) f(ROA or ROIC, Risk,
  Reinvestment)
• (Firm value)

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Discounted Cash Flow

• Other Names
• Firm
• Net Present Value approach
• WACC approach
• Free Cash Flow to Firm approach
• Adjusted Present Value approach
• Equity
• Free Cash Flow to Equity approach

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Discounted Cash Flow

• Cash Flows to Firm
• EBIT
• Non-Cash items (depreciation)
• - Taxes (tax rate x EBIT)
• - ? NWC
• - Capital Spending
• FREE CASH FLOW (FCF)

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Change in Net Working Capital

• What is in current level of NWC?
• Examine component pieces
• What is history of NWC to sales?
• Is current level of NWC optimal?
• Excess Cash Should be subtracted from debt
• Usually maintain constant of sales

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Capital Spending

• Usually most difficult input consistent with
  growth assumptions?
• Short-run capital budgets spending plans to
  support high short-run growth
• Long-run
• No real growth equal to depreciation
• Capital spendingt1 Net Fixed assetst x (g i)
  (nominal minus inflation)

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Discounted Cash Flow Mechanics

• Project out cash flows until stable
• Calculate Terminal Value (Residual Value)
• Terminal Value Value of perpetual cash flow
  stream TVt CFt1/(R - g)
• Discount Projected CFs TVt to present

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Discounted Cash Flow
Firm Value
33
Discounted Cash Flow

• Two-Stage Model

CFt
Time
TVt
34
Discounted Cash Flow

• TERMINAL VALUE

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Terminal Value

• Assume Company is stable/mature
• Use P/E approach, V/EBITDA or other multiple
  multiples taken from comparable publicly traded
  firms
• Use DCF approach w/ constant or no growth

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WACC

• WACC weighted average cost of capital
• WACC Rd (1-t) (D/V) Re (E/V)
• V D E
• Rd required return on debt (YTM)
• Re required return on equity

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Re

• Capital Asset Pricing Model
• Re Rf B(Rm Rf)
• Beta obtained from sample of comparable
  companies
• Rf risk-free rate use T-bonds
• Rm Rf historical risk premium (5-6?)

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Obtaining Beta

• Find similar, publicly traded firms equity betas
• Compute asset beta as follows for each firm
• Bu Be / (1 D/E), or, Bu Be x E/V
• Compute average Bu
• Relever Bu using subject firms capital structure
  as follows
• Be Bu x (1 D/E), or, Be Bu x V/E
• (assuming constant D/E ratio)

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Growth

• Short-run growth ? business plans
• Long-run growth
• Economy growth rate
• Industry growth rate
• Sustainable growth rate (r x ROIC), where r
  (Cap. Spend. dep Change in NWC) / EBIT(1-t)

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DCF comments

• Free Cash Flow to firm (WACC) approach assumes
  capital structure and tax rates are constant
• If acquisition, should be WACC of acquired firm
• If capital structure is not constant, then use
  Adjusted Present Value Approach

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Adjusted Present Value

• Appropriate when capital structure is changing
• Ex Highly leveraged transaction or future
  leverage
• Calculate PV of FCF using Ru
• Add present value of tax shields from interest

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Assumptions Needed
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Example

• Assume firm has debt of 300 million
• Firm has 50 million shares O/S
• WACC 14
• Cash flows per pro-formas given
• L-R growth 4

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Example
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Example, cont.

• Firm Value 579.7
• Value of Debt 300
• gt Equity Value 279.7 50
• 5.59/share

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Example, cont.

• Assume Firm will be mature in 2007
• Mature Firms sell for 8 x earnings (i.e., P/E
  8)
• Firm will have 300 million in debt O/S in 2007
  bearing an interest rate of 14

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Example
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Example, cont.

• Firm Value 671
• Value of Debt 300
• gt Equity Value 371 50
• 7.42/share

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Privately Held Cos

• Excess Compensation
• Owners getting money out of company
• Deficient Compensation
• Owner not taking out enough
• Compensation should reflect economic value of
  services

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Private Businesses, cont.

• Personal expenses in company
• Whether you adjust depends on whether you are
  valuing a controlling interest
• Discount rate higher for smaller cos gt value
  lower