Valuation methodology from an academic perspective.

1. Valuation methodology An overview “If I am not worth the wooing, I am surely not worth the winning.” - Henry Wadsworth Longfellow

2. Methodologies 2 So what multiple do we use? P/E multiple Market to Book multiple Price to Revenue multiple Enterprise value to EBIT multiple How about Discounted Cash Flows (DCF) NPV, IRR, or EVA based Methods WACC method APV method CF to Equity method

3. Valuation: P/E multiple 3 IPO or a takeover target? This is how we get value; Value of firm = Average Transaction P/E multiple  EPS of firm Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may be) If valuation is being done to estimate the firm’s value Value of firm = Average P/E multiple in industry  EPS of firm This method can be used when firms in the industry are making a profit (have positive earnings) firms in the industry have similar growth rates (more likely for “mature” industries) firms in the industry have analogous capital structure

4. Valuation: Price to book multiple 4 The application of this method is similar to that of the P/E multiple method. Since the book value of equity is essentially the amount of equity capital injected in the firm, this method measures the market value of each dollar of equity injected. This method can be used for companies in the manufacturing sector which have huge capital requirements. companies which are not in technical default (negative book value of equity)

5. Valuation: Value to EBITDA multiple 5 This gives us the enterprise value, the value of the business operations (versus the value of the equity). In figuring out the enterprise value, just the operational value of the business is included. Value from investment activities, such as investment in T-bills or bonds, or investment in stocks of other companies, is not factored in. The following economic value balance sheet brings to light the concept of enterprise value.

6. Enterprise Value 6 Enterprise Value

7. Value to EBITDA multiple: Example 7 Let’s value a Target using the following data points: Enterprise Value to EBITDA (business operations only) multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3. Recent EBITDA of target company = $20 million Cash in hand of target company = $5 million Marketable securities held by target company = $45 million Interest rate received on marketable securities = 6%. Sum of long-term and short-term debt held by target = $75 million

8. Value to EBITDA multiple: Example 8 Take the mean (Value/ EBITDA) of recent transactions (10.1+9.8+9.2+10.5+10.3)/5 = 9.98 Interest income from marketable securities 0.06  45 = $2.7 million EBITDA – Interest income from marketable securities 20 – 2.7 = $17.3 million Estimated enterprise value of the target 9.98  17.3 = $172.65 million Add cash plus marketable securities 172.65 + 5 + 45 = $222.65 million Subtract debt to find equity value: 222.65 – 75 = $147.65 million.

9. Valuation: Value to EBITDA multiple 9 Since this method measures enterprise value it accounts for different capital structures cash and security holdings By evaluating cash flows prior to discretionary capital investments, this method provides a better estimate of value. Appropriate for valuing companies with heavy debt burdens: while earnings might be negative, EBIT is likely to be positive. It provides a measure of cash flows that can be used to support debt payments in levered companies.

10. Heuristic methods: drawbacks 10 While heuristic methods are simple, all of them share several common disadvantages: they do not accurately reflect the synergies that may be produced in a takeover. they assume that the market valuations are accurate. For example, in an overvalued market, we might overvalue the firm. They assume that the firm being valued is similar to the median or average firm in the industry. They require that firms use uniform accounting practices.

11. Valuation: DCF method 11 Here we follow the discounted cash flow (DCF) technique we used in capital budgeting: Estimate expected cash flows considering the synergy in a takeover “PV it,” Discount it at the appropriate cost of capital

12. DCF methods: Starting data 12 Free Cash Flow (FCF) of the firm Cost of debt of firm Cost of equity of firm Target debt ratio (debt to total value) of the firm.

13. Template for Free Cash Flow 13 “Income Statement”

14. Template for Free Cash Flow 14 The goal of the template is to estimate cash flows, not profits. Template is made up of three parts. An “Income Statement” Adjustments for non-cash items included in the “Income statement” to calculate taxes Adjustments for Capital items, such as capital expenditures, working capital, salvage, etc. The “Income Statement” portion differs from the usual income statement because it ignores interest. This is because, interest, the cost of debt, is included in the cost of capital and including it in the cash flow would be double counting. Sign convention: Inflows are positive, outflows are negative. Items are entered with the appropriate sign to avoid confusion.

15. Template for Free Cash Flow 15 There are four categories of items in our “Income Statement”. While the first three items occur most of the time, the last one is likely to be less frequent. Revenue items Cost items Depreciation items Profit from asset sales Adjustments for non-cash items is to simply add all non-cash items subtracted earlier (e.g. depreciation) and subtract all non-cash items added earlier (e.g. gain from salvage). There are two type of capital items Fixed capital (also called Capital Expenditure (Cap-Ex), or Property, Plant, and Equipment (PP&E)) Working capital

16. Template for Free Cash Flow 16 It is important to recover both at the end of a finite-lived project. Salvage the market value property plant and equipment Recover the working capital left in the project (assume full recovery)

17. Template for Free Cash Flow 17

18. Estimating Horizon 18 For a finite stream, it is usually either the life of the product or the life of the equipment used to manufacture it. Since a company is assumed to have infinite life: Estimate FCF on a yearly basis for about 5  10 years. After that, calculate a “Terminal Value”, which is the ongoing value of the firm. Terminal value is calculated one of two ways: Estimate a long-term growth and use the constant growth perpetuity model. Use a Enterprise value to EBIT multiple, or some such multiple

19. Costs of debt and equity 19 Cost of debt can be approximated by the yield to maturity (YTM) of the debt. If it is not directly available, check the bond rating of the company and find the YTM of similar rated bonds. Cost of equity Capital Asset Pricing Model (CAPM) Findbeand calculate required re. Use Gordon-growth model and find expected re. Under the assumption that market is efficient, this is the required re.

20. Model of a Firm 20 Value from Operations Value from investments Value generated Equal if debt is fairly priced Enterprise value FIRM Value to Equity DEBT and other liabilities EQUITY

21. Value of equity 21 Value of equity = Enterprise value + Value of cash and investments - Value of debt and other liabilities