Corporate Valuation
Keith M. Howe
Scholl Professor of Finance
DePaul University
Summer 2009
Valuation Approaches
I.
Discounted cash flow (DCF) analysis
II.
Relative valuation analysis



comparable companies analysis
equity valuation using P/E multiples
enterprise valuation using EBITDA multiples
Discounted cash flow (DCF) analysis
Basic idea: find the present value of the expected future cash
flows over the asset’s life and discount at cost of capital
(required rate).
CF
t
Value  
t 1(1r)t
N
Where:
CFt =Cash flow in period t
r = discount rate
Notes:
1.
2.
Discount rate is an opportunity cost.
CF = Rev - Costs - Taxes - Investment
= (Rev - Costs) (1 - Tc) + (Tc * Dep) - Investment
Discounted cash flow (DCF) analysis
A DCF model has three parts:

Explicit forecast period
 Cash flows are after-tax incremental cash flows

Continuing value or terminal period
 Perpetuity
 FCF, NOPLAT, NOPAT
 Constant growth
 Multiples

Discount rate
 Discount rates can be determined a number of different
ways (e.g., CAPM, Gordon growth model, APT, etc), but the
expected free cash flows are discounted at the rate that
reflects the risk of the cash flows.
4
Discounted cash flow (DCF) analysis
Continuing Value
CFt
VO  
 PV (CFs beyond t  N )
t
t 1 (1  r )
N
PV of
forecasted CFs
Continuing Value (CV)
Discounted cash flow (DCF) analysis
Two general approaches are taken:
For the continuing value (or terminal value) component,
simplifying assumptions are made about future CFs
(e.g., g=3% in perpetuity) or future valuation alignment
based on market multiples.
Two general approaches:
1) Constant growth rate of CFs.
2) Market-based multiples
Discounted cash flow (DCF) analysis
Forecasting Continuing Value CFs
Forecasted Cash
Flows
g=?
Time
0
1
2
Explicit forecast
3
4
5
Assumed growth path
Discounted cash flow (DCF) analysis
1) Constant growth approach:
CVt =
FCFt+1
WACC - g
• Over what period will the firm earn abnormal returns?
• What is the relation between the period of competitive
advantage and the continuing value formula?
Discounted cash flow (DCF) analysis
2) Multiples Approach:
CVt =
EVt
EBITDA
* EBITDA
Peers
Where:
EV
= enterprise value
EBITDA = earning before interest, tax, depreciation and amortization
• Aligns DCF value with market pricing for the industry
Discounted cash flow (DCF) analysis
Example: Discounted Free Cash flow
Year
Free
Cash flow
2008
250
2009
260
2010
280
2011
300
Terminal Value
3,000
Value of Operations
Less: Value of Debt
Equity Value
Price per share
Discount
Factor (10%)
Present
Value
0.9091
0.8264
0.7513
0.6830
0.6830
227.28
214.86
210.36
204.90
2,049.00
2,906.40
(600.00)
$2,306.40
$4.16
Discounted cash flow (DCF) analysis
Required Rates for DCF Method




r =D1/P0 + g
Gordon’s Model
r = rf + β (rm - rf) CAPM
r = rf + β1 (r1 - rf) + β2 (r2 - rf) +…
Arbitrage Pricing Theory
Fama-French model (size, BV/MV)
Discounted cash flow (DCF) analysis
Weighted average cost of capital (WACC)
WACC = RD(1-T) * D/V + RE * E/V
Where:
RD(1-T) = after-tax cost of debt (current)
RE
= cost of equity (CAPM)
D/V, E/V = debt and equity proportions (market-value based)
Discounted cash flow (DCF) analysis
Market
Forces
Competitive
Nature
Value Drivers
Profitability
Required
Investment
Market
Demand
Investment
Competitive
Position
Growth
Cost
Advantage
Product
Differentiation
Risk
Corporate
Value
Discounted cash flow (DCF) analysis
Forecasting CF Performance
1. Develop the forecast period
• How long will it take to reach an mature, equilibrium stage?
(often 10 years is used)
2. Define strategic perspective
• Tell the story - give the context
(For example, demand will peak in 4-5 years and then decline as
competitors enter the market. Margins will decline following
the period.)
Discounted cash flow (DCF) analysis
Forecasting CF Performance
3. Period of competitive advantage
(ROIC > WACC)
• Providing superior value to consumers thru better service, a
differentiated product.
• Low cost provider
• Barriers to entry - patents, government policy
4. Develop financial forecast based on the strategic perspective
• Begin with revenue forecast.
• Develop the income and balance sheet forecasts.
• Then calculate CFs and key value drivers.
Discounted cash flow (DCF) analysis
Forecasting CF Performance
5. Develop performance scenarios
(best and worst cases)
• Sets of plausible assumptions.
6. Check consistency and alignment with industry structure
• Entry barriers, technology, strategic issues
How to Display a DCF- Based Model Assumptions
Example:
Actuals
2000A
2001A
Research Estimates
2002A
CSFB Estimates
2003E
2004E
2005E
2006E
2007E
$8,413.0
12.0%
$9,254.3
10.0%
$10,179.7
10.0%
$8,872.8
32.1%
$7,090.6
(20.1%)
$5,438.4
(23.3%)
$6,345.9
16.7%
`
$7,511.5
18.4%
2,689.1
30.3%
568.9
8.0%
122.7
2.3%
1,179.4
18.6%
1,656.9
22.1%
2,271.6
27.0%
2,591.2
28.0%
2,952.1
29.0%
2,256.9
25.4%
20.7
0.3%
(402.7)
(7.4%)
417.9
6.6%
755.5
10.1%
1,262.0
15.0%
1,480.7
16.0%
1,730.6
17.0%
% of Sales
1,782.1
20.1%
(507.7)
(7.2%)
(118.7)
(2.2%)
419.8
6.6%
615.3
8.2%
1,010.6
12.0%
1,159.7
12.5%
1,318.4
13.0%
FCF
2,768.50
620.30
120.60
1,212.50
1,755.40
2,268.50
2,444.30
2,860.30
Real Asset Growth %
33.8%
7.1%
(1.5%)
8.7%
12.8%
12.2%
11.2%
10.8%
CFROI %
19.6%
3.9%
1.1%
5.2%
6.2%
7.1%
6.9%
6.9%
Revenue
% Growth
EBITDA
% of Sales
EBIT
% of Sales
Net Income
Here we develop a base case model from Wall Street Research and CSFB projections
Discounted Cash Flow Valuation
($ in millions)
2004E(1)
$35.0
(7.9)
$27.1
2005E
$50.0
(7.8)
$42.2
2006E
$52.1
(7.8)
$44.3
2007E
$53.1
(7.8)
$45.3
2008E
$54.1
(8.0)
$46.1
2009E
$55.2
(8.1)
$47.0
Less: Cash Taxes
Unlevered Net Income
Plus: D&A
Less: Capital Expenditures
Less: Change in Working Capital
(8.6)
$18.5
7.9
(11.6)
(1.8)
(9.9)
$32.3
7.8
(23.4)
0.0
(10.5)
$33.7
7.8
(8.0)
(0.8)
(11.4)
$33.9
7.8
(8.0)
(0.3)
(12.3)
$33.8
8.0
(8.0)
(0.3)
(13.1)
$33.9
8.1
(8.0)
(0.3)
Unlevered Free Cash Flow
$13.0
$16.7
$32.7
$33.3
$33.5
$33.8
EBITDA
Less: D&A
EBIT
(1) 2004E not included in calculating NPV of cash flows.
($ in millions)
EBITDA TERMINAL VALUE
6.0x
6.5x
DISCOUNT RATE
5.5x
11.25%
$107
178
$285
8.2x
5.7x
0.1%
$107
194
$302
8.6x
6.0x
0.9%
$107
210
$318
9.1x
6.4x
1.7%
Present Value of Free Cash Flow
Present Value of Terminal Value
Enterprise Value
Implied EV / 2004E EBITDA
Implied EV / 2005E EBITDA
Implied Perpetuity Growth Rate
11.75%
$106
174
$280
8.0x
5.6x
0.6%
$106
190
$296
8.4x
5.9x
1.4%
$106
206
$312
8.9x
6.2x
2.1%
Present Value of Free Cash Flow
Present Value of Terminal Value
Enterprise Value
Implied EV / 2004E EBITDA
Implied EV / 2005E EBITDA
Implied Perpetuity Growth Rate
12.25%
$104
170
$275
7.8x
5.5x
1.0%
$104
186
$290
8.3x
5.8x
1.9%
$104
201
$306
8.7x
6.1x
2.6%
Present Value of Free Cash Flow
Present Value of Terminal Value
Enterprise Value
Implied EV / 2004E EBITDA
Implied EV / 2005E EBITDA
Implied Perpetuity Growth Rate
18
Scenario analysis
critically review your assumptions on the following variables

Broad economic conditions: How sensitive is the forecast to the
economic conditions?

Competitive structure of the industry: How competitive and
concentrated is the industry? What impact will this have?

Internal capabilities of the company : Can the company develop its
products on time and manufacture them within the expected range of
costs?

Financing capabilities of the company: Can the company finance the
changes in its plan? How?
Discounted cash flow (DCF) analysis
Pros


Widely accepted
Provides a generally reliable and sophisticated approach to
valuation by accounting for:
 Profitability
 Growth
 Capital investment/intensity
 Capital structure
 Risk and opportunity cost
Cons




Generally not easy to calculate
Grounded by assumptions
Gives only an absolute valuation, which in isolation is not
telling
Loaded with assumptions
20
Note on Cash Flow Analysis
We can use free cash flows to find:
a) Enterprise Value
b) Value of Equity
21
Note on Cash Flow Analysis
Matching CFs and discount rates in DCF analysis
Project or Firm Valuation
Steps
(Debt Plus Equity Claim)
Equity Valuation
Step 1: Estimate the amount and
timing of future cash flows
Project (firm) free cash flow (i.e., PFCF
= FFCF)
Equity free cash flow (EFCF)
Step 2: Estimate a risk appropriate
discount rate
Combine debt and equity discount rate
(weighted average cost of capital WACC)
Equity required rate of returm (cost of
equity)
Step 3: Discount the cash flows
Calculate the PV(FCF) using the WACC
to estimate V(Firm)
Calculate the PV(EFCF) using the
equity discount rate to estimate
V(Equity)
Note that we have the same value of equity and the value of project
(firm) from using project and equity valuation methods
22
Definitions:
Project (firm) free cash flow
Sales
#####
Cost
#####
EBITDA
#####
Depreciation
#####
EBIT
#####
Tax @ 40%
#####
Unlevered Net Income
#####
Add:
Depreciation
#####
Less:
CAPEX
#####
Less:
NWC Increase
#####
Less:
Less:
Less:
Free Cash Flows to the firm
Definitions:
Equity free cash flow
Sales
#####
Cost
#####
EBITDA
#####
Depreciation
#####
EBIT
#####
Interest expense
#####
Levered net income before taxes
#####
Tax @ 40%
#####
Levered net income or Net Income*
#####
Add:
Depreciation
#####
Less:
CAPEX
#####
Less:
NWC Increase
#####
Less:
Less:
Less:
Less:
Cash Flows to equity
*Note that Net Income + Interest (1-t) = EBIT (1-t)
Cash Flow Outline
Firm Valuation Method
EBIT
Equity Valuation Method
Subtract taxes
(tax rate X EBIT)
Subtract Interest
Expense
Unlevered Net Income
Net Income before Taxes
Plus Depreciation, Less
Capital Expenditure, Less
Working Capital Change
Subtract taxes
(Tax rate X Net income
before taxes)
Plus Depreciation, Less
Capital Expenditure,
Less Working Capital Change
Firm Free Cash Flow
Equity Free Cash Flow
Discount at WACC
Discount at
Cost of Equity
Example:
Sample data









Cost of Equity (Rs) = 12%
Cost of Debt (Rd) = 8%
Tax rate = 40%
Earnings before Interest and taxes (EBIT) = $40 million
Depreciation = $15 million
Capital Expenditures = $15 million
The EBIT is perpetual (mature firm)
Target debt-to-value ratio (D/V) = 40%
Current value of debt is $105.26 million
Using free cash flows to find:


Enterprise Value
Value of Equity
Firm Valuation Method
Firm Free Cash Flow
 EBIT(1  T)  Depreciation  Capital Expenditur es
Chang ininNWC
- Change
NWC
 $40(1  0.4)  $15  $15  0
 $24 million
WACC
 Rd(1  T)D/V  RS * E/V
 .08 * .4 * (1  .4)  .12 * .6
 .0912 or 9.12%
Enterprise Value (EV)
Value of Equity
Free Cash Flow
WACC
$24 million

.0912
 $263.16 million

 Enterprise Value  Debt
 263.16  105.26  $157.9 million
Equity Valuation Method
Interest Payments
Cash Flows to Equity
 8% * 105.26  $8.42 million
 [EBIT  Interest]( 1  T)  Depreciation
 CAPEX  Change in NWC
 [40  8.42](1  .4)  15  15  0
 $18.947 million
Equity Value
Enterprise Value
Cash Flows to Equity
Cost of Equity
$18.947 million

.12
 $157.9 million

 Equity Value  Debt
 $157.35  $105.26
 $263.16 million
Relative valuation analysis
General thoughts on relative valuations

Most valuations on Wall Street use multiples

Multiples reflect current market perceptions

Relative valuations require fewer explicit assumptions
and are easier to use

Relative valuations often find a more receptive
audience (easier to understand as there are fewer
assumptions)
29
Relative valuation analysis
Equity valuation using P/E multiples
Pros



Most commonly used and accepted multiple with sell side research
Easy to calculate (simply need to ensure you match time periods, trailing, current,
future)
Takes into account profitability
Cons







Cannot use if companies do not have accounting earnings
•
Are GAAP earnings a good measure of cash flow?
•
Adjustments for normalized earnings?
Ignores Economic Profitability
•
A company could be buying earnings
Completely ignores capital structure
Debt not included in the value of the firm
Interest costs and tax shield are ignored
Ignores future growth opportunities
Ignores capital intensity and investment
Although widely accepted, P/E has serious drawbacks.
Example: P/E multiples
P

( )
E peers
Multiple of comparable firms
P
EPSsubjectfirm  ( ) peers 
E
Price of subject firm
Relative valuation analysis
Equity valuation using P/E multiples
Example
Comparable firm example (Automotive):
Toyota Motor Corp
DaimlerChrysler AG
General Motors Corp
Ford Motor Company
Average
P/E Ratio
13.2
10.5
6.6
16.0
11.575
Relative valuation analysis
Equity valuation using P/E multiples
Example (con’t)
Private Company:
 EPS = $2.50
 P = 2.50 x 11.575 = $28.94 Estimate
Traded Company: GM P/E=6.6
 What can we say about GM? Price too low?
 Need to look at accounting methods, risk, growth
rates, and payout to see if comparable.
Display Example: A Valuation Perspective
P/E 2004E
20.0x
18.3x
16.0x
16.0x
15.8x
14.0x
13.3x
Median 15.8x
15.0x
10.0x
6.9x
5.0x
0.0x
JEC
TANGO
TTEK
FLR
CBI
GVA
URS
From our analysis what can you tell me about our company?
34
Display Example:
Relative Valuation - Correct Time Periods
P/E - 2004E
20.0X
18.1x 18.0x 17.8x 17.5x
17.1x
14.9x
16.4x 15.6x
PX LNDE BOC
AIRL ARG
15.0X
15.3x 15.1x
14.0x 13.2x
10.0X
5.0X
0.0X
APD AIRL ARG
2003E P/E
PX
APD LNDE BOC
2004E P/E
2003 P/E
2004E P/E
Source: I/B/E/S Estimate.
EV / 2004E EBITDA
10.0x
8.7x
8.2x
8.0x
7.7x
7.3x
6.0x
6.0x
4.8x
4.0x
2.0x
0.0x
PX
ARG
APD
AIRL
BOC
LNDE
PX’s trading multiples are consistent with the market’s expectations for future performance.
35
Relative valuation analysis
Enterprise valuation using EBITDA multiples
Pros





Second most commonly used and accepted multiple on Wall Street
Easy to calculate (but need to ensure you match time periods,
trailing, current, future)
Takes into account profitability
EBITDA generally a good proxy for cash
Takes into account capital structure
• Includes debt in the value of the firm (should use net debt)
• Includes Interest as part of cash flow
Cons


Ignores Economic Profitability
Ignores capital intensity and investment
The EBITDA multiple is a “cleaner” multiple, however it still misses the hurdle rate and
investment required into the business.
Implementing a Multiples Approach

Define the multiple
 There are different definitions for the same multiple (current, trailing,
forward).

It is integral to look at the entire distribution of the multiple
 Understand the differences between the mean, median and standard
deviation
 Understand why the outlier are outliers (question relevance of the
multiple and the companies inclusion in the peer group)

Understand the fundamentals of the multiple
 What are the strengths and weaknesses of the multiple?

Choosing a peer group for Relative Valuation Methods
 Why are you trying to determine value?