FIN
Valuation methods
An overview
For details, see “Finance for Strategic Decision Making,”
by M. P. Narayanan & Vikram Nanda,
Published by Jossey-Bass
©2006 M. P. Narayanan
Methodologies
FIN
 Comparable multiples
 P/E multiple
 Market to Book multiple
 Price to Revenue multiple
 Enterprise value to EBITDA multiple
 Discounted Cash Flow (DCF)
 NPV, IRR, or EVA based methods


WACC method
CF to Equity method
©2006 M. P. Narayanan
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Understanding Value
FIN
 In the context of valuing companies, it is important to
understand what we mean by value.
 From an economic perspective, value is the present
value of future free cash flows (FCF) expected to be
produced by the company, discounted at the weighted
average cost of capital (WACC) that reflects the risk of
the cash flows.


For a definition of free cash flow, see cash flow template later
For an understanding of the WACC, see conceptual diagram
later
©2006 M. P. Narayanan
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Understanding Value
FIN
 This value, is often called the “Economic Value” or
“Market Value” of the company.
 Let us first clearly understand the differences between


Economic value of the company
Accounting or book value of the company
©2006 M. P. Narayanan
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Understanding Value: Book Value
FIN
 Consider a company whose balance sheet is shown
on the next page.
 The important points to note are:






Fixed assets represent the investment in property, plant and
equipment, minus the depreciation
Cash is cash on hand
Accounts receivable is the amount due from customers. It is
an interest free loan to customers.
Accounts payable is the amount owed to suppliers. It is an
interest free loan from suppliers.
Accrued expenses are amounts owed to employees,
government, etc. It is also an interest free loan.
Financial investments include holdings in other companies.
©2006 M. P. Narayanan
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FIN
Understanding Value: Book Value
Accounting Balance Sheet
Fixed assets
$1500
Current assets
Cash
Marketable securities
& financial investments
Current liabilities
Short-term debt
$150
$200
Payable
$320
$150
Accrued expenses
Inventory
$350
Noncurrent liabilities
Receivable
$400
Long-term debt
Equity
$2600
©2006 M. P. Narayanan
$80
$1000
$1050
$2600
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Understanding Value: Book Value
FIN
 Finally the Shareholder funds in an accounting
balance sheet (called the book value of equity) is the
amount of equity capital invested in the company. This
includes



The original equity capital invested when the company was
started.
Additional equity invested in the company through subsequent
external equity financings minus any equity repurchases.
Profits reinvested in the company.
 It is important to understand that the value of equity in
the accounting balance sheet is NOT what the
shareholders can obtain if they sold the company and
paid off all the debt.
©2006 M. P. Narayanan
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Understanding Value: Book Value
FIN
 Before we relate the accounting balance sheet to
economic values, we slightly reconfigure the
accounting balance sheet.
 The cash on hand is decomposed into “operating
cash” and “excess cash”.



Operating cash is the cash required for working capital
purposes.
It is determined by the company’s cash budgeting process.
“Excess cash” is cash that is not required for working capital
purposes.



It is presumably kept for strategic reasons
In this example, we assume that $25 cash is required for
operating purposes.
Remaining cash ($175) is “Excess cash.”
©2006 M. P. Narayanan
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FIN
Understanding Value: Book Value
 Marketable securities and financial investments are
taken out of current assets which is now re-labeled as
“current operating assets.”
 If there are any interest-bearing current liabilities, they
are left on the sources side of the balance sheet.
 Remaining items are re-labeled as “current operating
liabilities.”
©2006 M. P. Narayanan
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Understanding Value: Book Value
FIN
Accounting Balance Sheet: Reconfigured
Sources
Uses
Fixed assets
$1500
Excess Cash
$175
Marketable securities &
financial investments
$150
Working capital
Current operating assets
Operating cash
25
Inventory
$350
Receivable
$400
Current operating liabilities
Payable
Accrued expenses
($320)
($80)
$2200
©2006 M. P. Narayanan
Short-term debt
$150
Long-term debt
$1000
Equity
$1050
$2200
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Understanding Value: Book Value
FIN
 The total capital (on which a return must be provided)
raised by the company is $2200:



Short-term debt = $150
Long-term debt = $1000
Equity = $1050
 Note that accounts payable and accrued expenses are
not included as they are not interest-bearing liabilities.
©2006 M. P. Narayanan
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FIN
Understanding Value: Book Value
 This capital is used to
 Acquire fixed assets = $1500
 Invest in working capital = $375
 Acquire financial holdings in other companies and invest in
excess cash and marketable securities (possibly for future
investment needs) = $325
 Note that working capital is the difference between
current operating assets and current operating
liabilities.
©2006 M. P. Narayanan
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FIN
Understanding Value: Economic Value
 Using the reconfigured accounting balance sheet as a
model, we can now create an economic balance
sheet.
 The main difference is that


Values in the accounting balance sheet represent what has
been invested.
Values in the economic balance sheet represent the current
value of what has been invested.
 The goal of companies is to ensure that the economic
value exceeds the accounting value!!
©2006 M. P. Narayanan
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FIN
Understanding Value: Economic Value
Economic Balance Sheet
Free CF @ WACC
$2500
Short-term debt
150
Excess Cash
$175
Long-term debt
$1000
Marketable securities &
financial investments
$150
Equity
$1675
$2825
$2825
Enterprise value
©2006 M. P. Narayanan
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FIN
Understanding Value: Economic Value
 Fixed assets and working capital in the accounting
balance sheet have been replaced by the present
value of the free cash flow they are expected to
generate in the future ($2500).

This figure is just an assumed number.
 This is the economic value of the operations of the
company and is often called Enterprise Value.
 Excess cash and marketable securities are usually
valued the same as in the accounting balance sheet
as their values are unlikely to be different.
 Financial investments should be valued at market

It is assumed in this example that the market and book values
are the same.
©2006 M. P. Narayanan
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FIN
Understanding Value: Economic Value
 The total value of the company is:
 Enterprise Value + Excess cash + Marketable securities +
Financial investments
 In this example it is assumed the economic value of
the debt is the same as in the accounting balance
sheet.



This is more likely to be true for short-term debt.
The value of the long-term debt is more sensitive to changes
in interest rates.
If the interest rates had increases since their issue, their value
would decrease from the face value.
©2006 M. P. Narayanan
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FIN
Understanding Value: Economic Value
 In general, liabilities also include, in addition to debt,
obligations to other parties such as


Legal and environmental liabilities
Liabilities to employees such as pension
 The value of equity is the difference between the total
value of the company and all its liabilities.

It is also called the market capitalization and is equal to the
share price times the number of shares outstanding.
 This is the current value of the equity, i.e., what the
shareholder will receive if they were to sell the
company off at its current value and payoff all the
liabilities.
©2006 M. P. Narayanan
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Constructing Economic Value
Balance Sheet
FIN
 If a company is publicly traded, it is easy to construct
the right side of the balance sheet:


Debt values can be obtained from the accounting balance
sheet
Equity value can be calculated by multiplying the share price
by the number of outstanding shares.
 Value of items such as excess cash, marketable
securities, and financial investments can be obtained
from the accounting balance sheet and market prices
of these items.
 The enterprise value can then be calculated as the
residual.
©2006 M. P. Narayanan
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Multiples: P/E
FIN
 If valuation is being done for an IPO or a takeover,
 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 firm value
 Value of firm = Average P/E multiple in industry  EPS of firm
 This method can be used when
 firms in the industry are profitable (have positive earnings)
 firms in the industry have similar growth (more likely for
“mature” industries)
 firms in the industry have similar capital structure

See next page
©2006 M. P. Narayanan
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P/E and leverage
FIN
 Gordon growth model: P0 = D1/(re − g)
 P0 = Stock price today
 D1 = Expected next-year dividend per share
 re = Cost of equity
 g = Expected dividend growth rate
 Assume constant payout ratio
 K = Payout ratio = D1/ EPS1
 P0 = K × EPS1/(re − g)
 Simple algebra yields P0/EPS1 = K /(re − g)
 As leverage increases, re increases, decreasing P/E
multiple
©2006 M. P. Narayanan
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Multiples: Price to book
FIN
 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 invested in the firm, this
method measures the market value of each dollar of
equity invested.
 This method can be used for


companies in the manufacturing sector which have significant
capital requirements.
companies which are not in technical default (negative book
value of equity)
©2006 M. P. Narayanan
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FIN
Multiples: Enterprise Value to
EBITDA
 This multiple measures the enterprise value, that is
the value of the business operations (as opposed to
the value of the equity).
 In calculating enterprise value, only the operational
value of the business is included.
 Value from investment activities, such as investment in
treasury bills or bonds, or investment in stocks of other
companies, is excluded.
©2006 M. P. Narayanan
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Value to EBITDA multiple: Example
FIN
 Suppose you wish to value a target company using the
following data:



Revenue = $800 million
COGS = $500 million
SG&A = $150 million







All from continuing operations only
Excludes any non-operating income such as interest and dividend
income
Excludes interest expenses
Depreciation (from CF statement) = $50 million
Cash in hand = $25 million
Marketable securities = $45 million
Sum of long-term and short-term debt held by target = $750
million
©2006 M. P. Narayanan
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Value to EBITDA multiple: Example
FIN
 You collect the following data about a recent takeover
in the same industry







Selling price = $40 a share (40 shares)
Cash on hand = $50 million (all assumed “Excess Cash”)
Marketable securities = $200 million
Market value of financial investments = $120 million
Short-term debt = $200 million
Long-term debt = $1100 million
From continuing operations




Revenue = $1000 million
COGS = $650 million
SG&A = $120 million
Depreciation = $70 million
©2006 M. P. Narayanan
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Value to EBITDA multiple: Example
FIN
 First compute enterprise value at which this comparable company
sold.


Equity value = 40 × 40 = $1600 million
Enterprise value = 1600 + 1100 + 200 − 250 − 120 = $2530 million
Economic Balance Sheet
Enterprise value
Excess Cash &
marketable securities
Market value of financial
investments
$2530
Short-term debt
200
$250
Long-term debt
$1100
$120
Equity
$1600
$2900
©2006 M. P. Narayanan
$2900
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Value to EBITDA multiple: Example
FIN
 Next compute the EBITDA of the comparable
company from continuing operations


EBITDA = Revenue − COGS − SG&A + Depreciation
EBITDA = 1000 − 650 − 120 + 70 = $300 million
 Compute the Enterprise value/EBITDA multiple at
which the comparable firm sold

Enterprise value/EBITDA = 2530/300 = 8.43
 Compute EBITDA of your target company
 EBITDA of target = 800 − 500 − 150 + 50 = $200 million
 Compute enterprise value of the target
 Enterprise value of target = 200 × 8.43 = $1686 million
©2006 M. P. Narayanan
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FIN
Value to EBITDA multiple: Example
 Compute equity value of target company
 Equity value = 1686 + 70 − 750 = $1006 million
 Finally, if there are acquisition costs (Investment banking, legal) and
financing costs (bank fees, transaction costs) subtract from equity
value (not done in this example).
Economic Balance Sheet
Enterprise value
Excess Cash &
marketable securities
$1686
$70
$1756
©2006 M. P. Narayanan
Total debt
Equity
$750
$1006
$1756
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Valuation: Value to EBITDA
multiple
FIN
 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 large debt
burden: while earnings might be negative, EBIT is
likely to be positive.
 Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.
©2006 M. P. Narayanan
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Mutiples methods: drawbacks
FIN
 While Multiples methods are simple, all of them share
several common disadvantages:




They do not accurately reflect the synergies that may be
generated in a takeover.
They assume that the market valuations are accurate. For
example, in an overvalued market, we might overvalue the
firm under consideration.
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.
©2006 M. P. Narayanan
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Valuation: DCF method
FIN
 This is similar to the technique we used in capital
budgeting:



Estimate expected free cash flows of the target including any
synergies resulting from the takeover
Discount it at the appropriate cost of capital
This yields enterprise value
 After calculating enterprise value, equity value of
target is calculated using the same process as before.
©2006 M. P. Narayanan
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Valuation: DCF method
FIN
 DCF methods impose stricter discipline on the
acquiring company



They need to specify the value drivers of the takeover
They need to provide estimates of the value created and their
sources
Allows for post-audit of the takeover based on these
benchmarks
©2006 M. P. Narayanan
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FIN
DCF methods: Starting data
 Free Cash Flow (FCF) of the firm
 WACC
©2006 M. P. Narayanan
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Template for Free Cash Flow
FIN
Revenue
Operating Income
Statement
Less Costs
Less Depreciation
Profits from asset sale
Taxable income
Less Tax
NOPAT
Add back Depreciation
Less Profits from asset sale
Operating cash flow
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
©2006 M. P. Narayanan
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Template for Free Cash Flow
FIN
 The goal of the template is to estimate cash flows, not profits.
 Template is made up of three parts.
An Operating Income Statement
 Adjustments for non-cash items included in the Operating
Income Statement to calculate taxes
 Capital items, such as capital expenditures, working capital,
cash from asset sales, etc.
 The Operating 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.

©2006 M. P. Narayanan
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Template for Free Cash Flow
FIN
 There are four categories of items in our Operating 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


Cash from asset sale − Book value of asset
Book value of asset = Initial investment − Accumulated depreciation
 Adjustments for non-cash items is to simply add all non-cash
items subtracted earlier (e.g. depreciation) and subtract all noncash items added earlier (e.g. Profit from asset sale).
©2006 M. P. Narayanan
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Template for Free Cash Flow
FIN
 There are two type of capital items
 Fixed capital (also called Capital Expenditure (Cap-Ex), or
Property, Plant, and Equipment (PP&E))
 Working capital
 We need to include only additions to capital (both fixed
and working) since the capital originally invested is still
employed in the project.
 It is important to recover both types of capital at the
end of a finite-lived project.

Recover the market value property plant and equipment


Cash from asset sale
Recover the working capital left in the project (assume full
recovery)
©2006 M. P. Narayanan
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Template for Free Cash Flow
FIN
 What is the FCF template
actually doing?




See table on the right
The template is longer
because of tax calculations
Items on the right are the
value drivers
You may view this as a
conceptual template
©2006 M. P. Narayanan
Revenue
Less Costs
Less Tax
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
37
Estimating Horizon
FIN
 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 years.
After that, calculate a “Terminal Value”, which is the ongoing
value of the firm.
©2006 M. P. Narayanan
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Terminal Value
FIN
 Terminal value can be calculated several ways:
 Use the constant growth perpetuity model with a long-term
growth closer to economy growth rates.


Estimate a two- or three-stage model,



Works for mature industries
Higher growth rate(s) in the initial stage(s) (for about 10 years)
A lower long-term growth for the final stage
Use a Enterprise value to EBITDA multiple based on industry
averages to estimate terminal value
©2006 M. P. Narayanan
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WACC
FIN
 One of the issues in the valuation of companies for
acquisition is what WACC to use.

Should we use the target company’s WACC or the acquirer’s
WACC? Or something else?
 As always, the answer is “it depends.”
 If a conglomerate is buying a target company, it is
appropriate to use the target company’s WACC.

There is likely to be very little interaction between the target
company’s operations and that of the acquirer.
 If it is a horizontal merger, the WACC of acquirer and
target are likely to be close.

A weighted average WACC may be appropriate (weights
based on the enterprise values of the two parties)
©2006 M. P. Narayanan
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WACC
FIN
 The idea is that if the integration of the target with the
acquirer is minimal, the target’s WACC is appropriate.
 If there is substantial integration, but companies are
not in the same industry, it becomes more difficult to
figure out a precise WACC to value the target.

The issue has to be dealt on a case by case basis.
©2006 M. P. Narayanan
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Valuation of private companies
FIN
 Private company stocks are very illiquid
 Similar to small firms with less liquid stocks, private company
stocks also will sell at a discount. The liquidity issue much
more severe with private companies.
 Private company owners are likely to be less
diversified. Therefore, they bear both the market risk
and the company-specific risk, increasing their cost of
capital and decreasing the value of the firm to them.


If you own only GM stock you are bearing the risk of the auto
industry as well risk that is GM-specific (a strike at GM).
If you own all the auto company stocks (GM, Ford, Toyota,
Nissan, Volkswagen, Diamler-Chrysler), you bear only the
auto industry risk.
©2006 M. P. Narayanan
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Valuation of private companies
FIN
 The typical method of valuing a private company is to
value it as if it is a public company and then apply a
discount for the reasons stated earlier.

Find a pure-play and use its WACC to discount the cash flows
of the private company


Pure-play is a public company that has the same business risk as
the private company
Or, use the multiples of a public company
 The trick is to compute this discount. There are ways
to get some handle on this discount.

The discounts are in the 20-40% range
©2006 M. P. Narayanan
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Weighted average cost of capital:
Overview
Required rate = 8%
Required rate = 12%
Equity capital
$60
Total capital
$100
Annual return
$9.28
Total return = $10.40
Rate of return on capital
required to payoff the debt and
minimally satisfy stockholders,
i.e., WACC
©2006 M. P. Narayanan
Annual return
$7.20
Stockholders
Annual return
$3.20
Lenders
Debt capital
$40
Annual tax saving
from interest
deduction = $1.12
(35% of 3.20)
FIN
Operations
Required rate = 9.28%
44
Costs of debt and equity
FIN
 Cost of debt can be approximated by the yield to
maturity of the debt.
 If the yield is not directly available, check the bond
rating of the company and find the YTM of similar
rated bonds.
 Cost of equity

CAPM


Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the
assumption that market is efficient, this is the required re.


You need an estimate of future dividend growth rate to do this.
Therefore, works better for firms with a history of dividend
payments
©2006 M. P. Narayanan
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Valuation: CF to Equity method
FIN
 In the WACC method, we compute
 Enterprise value by discounting the free cash flows at WACC
 Add value of any financial investments
 Subtract value of debt to obtain equity value
 In CF to Equity method, we
 Compute CF that are available to equity-holders


This is Free Cash Flow less principal and after-tax interest
payments
Discount this at cost of equity and directly compute equity
value
©2006 M. P. Narayanan
46
Equity value: WACC method
FIN
Value from
Operations
Enterprise value
Value from
investments
Value generated
Value of Debt
Equity value
All are values: CF discounted at appropriate cost of capital
©2006 M. P. Narayanan
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FIN
Equity value: CF to Equity method
FCF from
Operations
CF from
investments
Total CF generated
CF to Debt
(Principal, after-tax
interest)
All are CF
CF to Equity
Equity value = CF to Equity @ re
©2006 M. P. Narayanan
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