Corporate Financial Strategy
4th edition
Dr Ruth Bender
Chapter 14
Valuations and forecasting
Corporate Financial Strategy
Valuations and forecasting: contents
 Learning objectives
 Valuing companies – header slide
 Three approaches to company
valuation
 Balance sheet methods of valuation
 Discounted cash flow valuation
using WACC
 Terminal value (narrative)
 Terminal value (graph)
 Valuation on multiples
 Valuation on multiples – generic
equations
 Problems with valuation on multiples
 Valuing a loss-making business
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 Forecasting – header slide
 Process of forecast preparation
 Triangulate the forecasts
 The declining base case
 Sensitivity analysis
 Changing forecast drivers
 Some common psychological biases
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Learning objectives
1. Apply the three main methods of valuing a company – assets,
multiples, and discounted cash flow.
2. Appreciate the advantages and disadvantages of each method of
valuation, and the need for sensitivity analysis.
3. Explain why a suite of forecasts needs to comprise an integrated
income statement, cash flow, and balance sheet.
4. Question the assumptions underlying any forecast by understanding
some common behavioural biases.
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Valuing companies
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Three approaches to company valuation
(Net) Assets
bases
 Based on equity in the balance sheet.
Multiples of
profits
 After-tax profits multiplied by appropriate
price/earnings ratio
 May reflect revaluation of assets, or assets
at replacement price, or liquidation values.
 EBIT or EBITDA multiplied by appropriate
ratios
Discounted cash
flows
 Forecast the free cash flow for many years
ahead, and discount it back to today at an
appropriate cost of capital
In practice, several different valuation methods will be used, to check reasonableness
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Balance sheet methods of valuation
 Balance sheets are backward-looking
 Historic cost convention distorts values
 Intangible assets are only included if they were acquired
 Debt can be stated at market value rather than the sums owing
 Accounting policies can vary considerably
For most businesses, the
balance sheet does not provide
a useful valuation mechanism
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Discounted cash flow valuation using WACC
The value of the company represents the present value of the
future cash flows it is expected to generate
1. Determine a suitable time frame
2. Calculate Free Cash Flow over that period
•
•
•
•
Operating profit, adding back depreciation and amortization (EBITDA)
Less tax
Less expenditure on fixed assets
Add/less changes in working capital
3. Determine a Terminal Value
4. Discount these cash flows at an appropriate rate
•
Normal to use Target WACC
5. Add in the value of non-operating assets
This gives the Enterprise
Value
6. Deduct net debt
This gives the Equity
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value
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Terminal value
 Take an initial period for which you can reasonably forecast
− 10 years?
 At the end of that period assign a Terminal Value
− Based on assets?
− Based on a multiple of profits?
− Based on cash flow as a perpetuity?
[cash flow  discount rate]
− Based on cash flow as a growing perpetuity?
[cash flow  (discount rate – growth rate)]
− Other??
It is helpful in valuation to use several
different methods for terminal value, as
they will all give different answers
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Terminal value
Free cash
flow
Perpetuity growing at g% per year
FCFn
Perpetuity
0
Time
n
Initial
period
Perpetuity value is FCFn ÷ Discount rate
Growing perpetuity value is (FCFn x (1+g) ÷ (Discount rate – g)
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Valuation on multiples
 Valuation on multiples compares a company with peers whose market
value is known, and values on a comparative basis
 Valuation on a P/E basis compares the eps of companies with their
share prices
− For the whole company, this is net income and market capitalization
 Valuation on other multiples can eliminate differences due to capital
structures
− Enterprise value is calculated and compared with EBIT, or EBITA, or EBITDA
 Valuation on multiples can be done on a historic or prospective basis
 The income figures used should be ‘sustainable’, adjusted for one-off
items affecting a year’s results
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Valuation on multiples – generic equations
Valuecomparators = (Average profit)comparators x (Average multiple)comparators
Therefore, for our target company in the same business we can
assume that
Valuetarget = (Profit)target x (Average multiple)comparators
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Problems with valuation on multiples
 It is difficult to find true comparator companies
 Sustainable profit levels might be difficult to determine, for the target
company or the comparators
 Market values might not be ‘correct’
− E.g. during the dot.com bubble, or if there is low trading liquidity
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Valuing a loss-making business
Why do you want to buy this company?
− That might give you an idea where the future value is coming from
Assets basis
− If it’s never going to make profits, just break it up and sell the assets
separately
Multiples basis
− Valuation on multiples is about future sustainable profits. Can you see
such profits arising? If so, maybe do a valuation on multiples for, say,
3 years’ time when you expect profits to arise, and then discount that
sum back to today
DCF methods
− Probably the most useful – forces you to examine the underlying cash
flow forecasts and see if/when/how the company will start generating
profits
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Forecasting
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Process of forecast preparation
Determine the reason for the forecast
and the required timescale
Obtain the supporting data
Prepare the forecast
Revise
assumptions and
forecasts as the
picture becomes
clearer
Analyse the forecast
Do a sensitivity analysis
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Triangulate the forecasts
Income
statement
Cash flow
forecast
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Triangulation is
necessary but
not sufficient to
ensure sensible
forecasts
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Balance
sheet
The declining base case
Trajectory if we
undertake investment
Current trajectory
for the business
Trajectory if we fail to
invest
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Sensitivity analysis
Change
each input
individually
by a certain
amount
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Reverseengineer
the forecast
to
determine
tolerance
on each
input
Prepare
several
different
scenarios
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Monte
Carlo
analysis
Changing forecast drivers
Some examples of changes to explore
Sales volumes
Decrease or increase by x%; slow (or accelerate) the sales growth plan
by one year, or two years; change the rate of growth of the market as a
whole, or the market penetration rate.
Profit margin
Change input costs individually; assume selling prices fall over time;
assume that production costs or expenses change in a different
pattern to that anticipated; look at the effect of a movement in the ratio
of fixed and variable costs.
Tax rate
Flex the tax rate.
Working capital
Change the assumptions for inventory days, and debtor or creditor
terms.
Examine the impact of price changes in the future, and of delaying or
bringing forward capacity changes. Consider the impact of leasing
rather than buying.
Capital expenditure
Run the forecast for one year more, or one year fewer, to see the
Timescale of
competitive advantage impact. Change the terminal value assumptions in a DCF analysis.
Cost of capital
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Flex the cost of capital. Change the timing of interest payments and
loan repayments where appropriate in a forecast to evaluate funding
requirements.
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Some common psychological biases
Anchoring
Framing
Over-optimism
Over-confidence
Representativeness
Cognitive
dissonance
Confirmation bias
Ambiguity
avoidance
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