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From Enterprise Value to Equity Value
1
Session Overview
•
When you have completed the valuation of core operations, you are ready to
estimate three values: enterprise value, equity value, and value per share.
1. To determine enterprise value, add to the value of core operations the value of
nonoperating assets, such as excess cash and nonconsolidated subsidiaries.
2. To convert enterprise value to equity value, subtract short-term and long-term
debt, debt equivalents (such as unfunded pension liabilities), and hybrid
securities (such as employee stock options).
3. To estimate value per share, divide the resulting equity value by the most recent
number of undiluted shares outstanding.
•
Estimating the value per share completes the technical aspect of the
valuation, yet the entire job is not complete. It is time to revisit the valuation
with a comprehensive look at its implications. We examine this process in
the next session.
2
Enterprise Value and Equity Value
• Enterprise value (i.e., a company’s value to all financial stakeholders) equals the
combined value of a company’s operations and the value of its nonoperating assets.
• A company’s value is shared between nonequity claims and equity holders. The equity
value of a company equals enterprise value less the value of nonequity claims.
PRESENT VALUE
OF OPERATIONS
Present value of
free cash flows
+
Present value of
continuing value
+
NONOPERATING
ASSETS
=
ENTERPRISE
VALUE
−
NONEQUITY
CLAIMS
=
Excess cash and
marketable
securities
Debt
+
Pensions/leases
Illiquid investments
and unconsolidated
subsidiaries
EQUITY
VALUE
+
+
Employee options
+
Minority interests
3
The Valuation Buildup: An Example
• When measured properly, free cash
flow from operations should not
include any cash flows from
nonoperating assets.
Sample Comprehensive Valuation Buildup
• Instead, nonoperating assets should
be valued separately.
$ million
DCF value of operations
5,000
• Nonoperating assets can be
segmented into two groups,
marketable securities (marked to
market) and illiquid investments
(held at cost). Given their different
accounting treatments, each
nonoperating asset type must be
valued separately.
Excess cash and marketable securities
Excess real estate
Nonconsolidated subsidiaries
Financial subsidiary
Tax loss carry-forwards
Discontinued operations
Enterprise value
50
5
270
300
10
30
5,665
4
The Valuation Buildup: An Example
• To calculate the value of common
equity, you need to deduct the
value of all nonequity claims from
the enterprise value.
• Although nonequity claims include a
long array of items, they can be
grouped into four categories:
1. Traditional debt
2. Debt equivalents such as
operating leases, pensions,
specific types of provisions
3. Hybrid claims such as
employee stock options and
convertible bonds
Sample Comprehensive Valuation Buildup
Enterprise value
Interest-bearing debt
Bank loans
Bonds
Debt equivalents
Operating leases
Securitized receivables
Unfunded pension liabilities
Long-term operating provisions
Nonoperating provisions
Contingent liabilities
Debt and debt equivalents
Hybrid claims
Convertible debt
Preferred stock
Employee stock options
Minority interests
Equity value
5,665
(250)
(550)
(250)
(50)
(150)
(50)
(75)
(40)
(1,415)
(200)
(100)
(50)
(150)
3,750
Debt and debt
equivalents
Hybrid claims
and minority
interests
4. Minority interests
5
Session Overview
•
When you have completed the valuation of core operations, you are ready to
estimate three values: enterprise value, equity value, and value per share.
1. To determine enterprise value, add to the value of core operations the value of
nonoperating assets, such as excess cash and nonconsolidated subsidiaries.
2. To convert enterprise value to equity value, subtract short-term and long-term
debt, debt equivalents (such as unfunded pension liabilities), and hybrid
securities (such as employee stock options).
3. To estimate value per share, divide the resulting equity value by the most recent
number of undiluted shares outstanding.
•
Estimating the value per share completes the technical aspect of the
valuation, yet the entire job is not complete. It is time to revisit the valuation
with a comprehensive look at its implications. We examine this process in the
next session.
6
Common Nonoperating Assets
• Nonoperating assets are assets that do not generate free cash flow (or
economic profit) and, therefore, do not impact the value of operations.
• Excess cash and marketable securities. Under U.S. generally accepted
accounting principles (GAAP) and International Financial Reporting Standards (IFRS),
companies must report such assets at their fair market value on the balance sheet.
Therefore, use the most recent book value as a proxy for the current market value.
• Nonconsolidated subsidiaries. Nonconsolidated subsidiaries and equity
investments are companies in which the parent company holds a noncontrolling
equity stake. Because the parent company does not have formal control over these
subsidiaries, their financials are not consolidated, so these investments must be
valued separately from operations.
• Customer financing arms. Because financial subsidiaries differ greatly from
manufacturing and services businesses, it is critical to separate revenues, expenses,
and balance sheet accounts associated with the subsidiary from core operations.
7
Nonconsolidated Subsidiaries: Valuation
The best approach to valuing subsidiaries depends on information available:
•
Publicly Listed Subsidiary
Use the market value for the company’s equity stake. Verify that the market price reflects
intrinsic value (i.e., that there is adequate liquidity and free float so that the trading price
reflects current information).
•
Privately Held Subsidiary
Financial statements are available.
If financial statements are available, perform separate DCF valuation. Use appropriate
WACC, which may vary from parent company’s WACC.
No separate financial statements are available.
There are three alternatives to value a subsidiary with limited financial information:
1. Simplified cash flow to equity
2. Multiples valuation
3. Tracking portfolio
Triangulate results as much as
possible given the lack of precision of
these three valuation approaches.
8
Valuing Publicly Traded Subsidiaries
•
As of October 2008, Philips owned stakes in a few unconsolidated subsidiaries. One
significant investment was LG Display, a South Korean manufacturer of TFT-LCD
panels for use in televisions, notebook computers, and other applications.
Step 1
Philips Enterprise Value, October 2008
millions of euros
Core operating value
21,630
Valuation of LG Display stake
Market capitalization (millions of wons)
Associates
LG Display
Holding
19.9%
1,236
TPV Technologies
13.4%
95
NXP Semiconductors
Pace Micro Technologies
19.9%
23.0%
598
76
Excess cash
Enterprise value
10,433,000
÷ Currency conversion (wons/euros)
Market capitalization
1,680
6,211
×Percent ownership
Ownership stake
19.9%
1,236
8,233
31,868
Source: UBS Analyst Report, October 2008, Thomson First Call.
To estimate Philips’s stake in
LG Display, start with LG
Display’s market capitalization,
and divide by the exchange rate
of South Korean wons to euros.
This converts LG Display’s local
market capitalization into euros.
Step 2
To determine the value of
Philips’s partial ownership,
multiply the resulting market
capitalization in euros by
Philips’s ownership stake.
9
Valuing Privately Held Subsidiaries
If the parent company’s accounts are the only sources of financial information for the
subsidiary, use the following alternatives:
• If the parent has a 20 to 50 percent equity stake, net income and approximate book equity
are disclosed in the parent’s accounts.
1. Simplified cash-flow-to-equity valuation: Build forecasts for how the key value
drivers will develop and discount at cost of equity for subsidiary and not at the parent
company’s WACC.
2. Multiples valuation: Build a valuation based on the price-to-earnings and/or marketto-book multiple. An appropriate multiple can be estimated from a group of listed
peers.
• For parent equity stakes below 20 percent, the only information available may be the
investment’s original cost and the date when the stake was acquired.
3. Tracking portfolio: Approximate its current market value by adding the relative price
increase (or subtracting a decrease) for a portfolio of comparable stocks over the
same holding period.
10
Customer Financing Arms
• To make their products more accessible, some companies
operate customer financing businesses.
• Because financial subsidiaries differ greatly from manufacturing
and services businesses, it is critical to separate revenues,
expenses, and balance sheet accounts associated with the
subsidiary from core operations.
• Failing to do so will distort return on invested capital, free cash
flow, and ultimately your perspective on the company’s valuation.
11
Customer Financing Arms
•
Let’s examine FinanceCo. Last year, the company sold $1,100 million of machinery
at a cost of $800 million. The company finances a significant percentage of its
products for its customers, generating $300 million per year in lease revenue.
•
The company currently holds $3,500 million in financial receivables. To finance its
leasing business, FinanceCo raises securitized debt, collateralized by the financial
receivables. The company also has general obligation debt to fund everyday
operations.
FinanceCo: Reorganized Financial Statements
Income statement
Sales of machinery
Revenues of financial products
Total revenues
Cost of goods sold
Interest expense of financial products
Total operating costs
1,100
300
1,400
(800)
(250)
(1,050)
Operating profit
Interest expense, general obligation
350
(50)
Net income
300
Balance sheet
Operating assets
Financial receivables
Total assets
3,000
3,500
6,500
Operating liabilities
General obligation debt
Debt related to financial products
Stockholders' equity
Total liabilities and equity
500
700
3,200
2,100
6,500
12
Customer Financing Arms
•
To analyze FinanceCo, start by constructing separate income statements and
balance sheets for the manufacturing and customer financing subsidiaries.
•
Using the returns calculated in the following exhibit, we can benchmark each of
FinanceCo’s subsidiaries against its peers. We cannot, however, aggregate the ratios
to determine a combined return for FinanceCo as a whole.
FinanceCo: Reorganized Financial Statements
Manufacturing subsidiary
Customer financing subsidiary
Operating profit
Sales of machinery
Cost of goods sold
Operating profit
1,100
(800)
300
Reorganized balance sheet
Operating assets
Operating liabilities
Invested capital
3,000
(500)
2,500
General obligation debt
Allocated equity
Invested capital
700
1,800
2,500
Return on invested capital
12.0%
Net income
Revenues of financial products
Interest expense of financial products
Net income
300
(250)
50
Reorganized balance sheet
Financial receivables
3,500
Debt related to financial products
Allocated equity
Liabilities and allocated equity
3,200
300
3,500
Return on allocated equity
16.7%
13
Other Nonoperating Assets
• The preceding items are typically the most significant nonoperating
assets. However, companies can have other forms of nonoperating
assets as well:
• Tax loss carry-forwards: Create a separate account for the accumulated tax loss
carry-forwards, and forecast the development of this account by adding any future
losses and subtracting any future taxable profits on a year-by-year basis. Discount
at the cost of debt.
• Discontinued operations: Most recent book value is a reasonable approximation
since assets and liabilities associated with discontinued operations are written
down to fair value and disclosed as a net asset on the balance sheet.
• Excess real estate and other unutilized assets: Identifying these assets is nearly
impossible unless they are specifically disclosed in a footnote. For excess real
estate, use the most recent appraisal value, an appraisal multiple such as value per
square meter, or discounting of future cash flows.
14
Session Overview
•
When you have completed the valuation of core operations, you are ready to
estimate three values: enterprise value, equity value, and value per share.
1. To determine enterprise value, add to the value of core operations the value of
nonoperating assets, such as excess cash and nonconsolidated subsidiaries.
2. To convert enterprise value to equity value, subtract short-term and long-term
debt, debt equivalents (such as unfunded pension liabilities), and hybrid
securities (such as employee stock options).
3. To estimate value per share, divide the resulting equity value by the most recent
number of undiluted shares outstanding.
•
Estimating the value per share completes the technical aspect of the
valuation, yet the entire job is not complete. It is time to revisit the valuation
with a comprehensive look at its implications. We examine this process in
the next session.
15
Overview of Nonequity Financial Claims
•
To find the value of common equity, deduct the value of all nonequity financial claims
from enterprise value. Although there are many forms of nonequity claims, these
claims fall into four primary categories:
1.
Traditional corporate debt such as corporate bonds, short-term and longterm bank loans, and credit lines.
2.
Debt equivalents such as operating leases, unfunded pension liabilities,
specific types of provisions, preferred stock, and contingent liabilities (e.g.,
outstanding claims from litigation).
3.
Hybrid financial claims such as employee stock options and convertible
bonds. Hybrid claims have an equity component, but are not controlled by
holders of common stock.
4.
Minority interests is the portion of partially owned subsidiaries owned by
other companies.
16
Valuing Corporate Debt
•
Corporate debt comes in many forms: commercial paper, notes payable,
fixed and floating bank loans, corporate bonds and capitalized leases.
•
Investment-Grade Debt—Publicly Traded
If the debt is relatively secure and actively traded, use its market value.
•
Investment Grade Debt—Privately Held
If the debt is not traded, discount the promised payments and principal
repayment at the yield to maturity to estimate current value. Book value is a
reasonable approximation if interest rates and default rates have not
significantly changed since issuance.
•
Highly Levered Companies
For distressed companies, the value of the debt will be at a significant discount
to its book value and will fluctuate with the value of the enterprise. To value
equity, create multiple performance scenarios and deduct the full value of debt
under each scenario. Weight each scenario by probability of occurrence.
17
Valuing Highly Leveraged Companies
•
For distressed companies, apply an integrated-scenario approach to value operations
as well as equity.
•
Consider a simple two-scenario example of equity valuation for a company with
significant debt. In scenario A, the company’s new owner is able to implement
improvements in operating margin, inventory turns, and so on. In scenario B, changes
are unsuccessful, and performance remains at its current level.
Valuation of Equity Using Scenario Analysis
$ million
Enterprise Face value
1
value
of debt Equity value
Scenario A
New owner successfully implements value
improvements
Scenario B
Company maintains current performance
Probability
Weighted
equity value
1,500
1,200
300
50%
150
900
1,200
−
50%
−
Equity value:
150
1
Equity value equals enterprise value less the face value of debt or zero, whichever is greater.
18
Debt Equivalents: Operating Leases
•
Because operating leases are a form of secured debt, operating leases should be
capitalized as part of invested capital and as a debt-equivalent liability.
Leasing Example: Free Cash Flow and Equity Valuation
$ million
Free cash flow (unadjusted for leases)
NOPLAT
(Increase) decrease in invested capital
Free cash flow
Reconciliation
After-tax interest
Cash flows to debt
Cash flows to equity
Reconciliation of free cash flow
Discount factor
Discounted cash flow
Valuation
Enterprise value
Debt
Equity value
Free cash flow (adjusted for leases)
Year 1
70.2
(61.3)
8.9
Year 2
86.0
(46.4)
39.5
Year 3
101.1
477.2
578.4
5.3
(9.8)
13.3
8.9
5.8
(3.1)
36.9
39.5
5.9
131.3
441.2
578.4
1.101
8.0
1.213
32.6
1.336
433.1
473.7
(118.4)
355.3
Year 1
96.8
(120.0)
(23.2)
Year 2
114.8
(65.0)
49.8
Year 3
130.7
1,265.0
1,395.7
Reconciliation
After-tax interest
After-tax lease interest
Cash flows to debt
Cash flows to lease debt
Cash flows to equity
Reconciliation of free cash flow
5.3
26.6
(9.8)
(58.7)
13.3
(23.2)
5.8
28.8
(3.1)
(18.6)
36.9
49.8
5.9
29.5
131.3
787.8
441.2
1,395.7
Discount factor
Discounted cash flow
1.063
(21.8)
1.130
44.1
1.201
1,162.0
NOPLAT
(Increase) decrease in invested capital
Free cash flow
Valuation
Enterprise value
Debt
Operating leases
Equity value
1,184.3
(118.4)
(710.6)
355.3
If NOPLAT, invested
capital, and cost of
capital are adjusted for
operating leases, you
must deduct their value
from enterprise value to
determine equity value
consistently.
19
Debt Equivalents: Unfunded Pensions
•
Today, under U.S. generally accepted accounting principles (GAAP), U.S. companies
report the market value of pension shortfalls (and excess pension assets) on the
balance sheet.
•
Since only service cost is recognized in free cash flow, existing shortfalls must be
deducted from enterprise value to determine equity value.
DuPont: Pension Note in Annual Report, Funded Status
$ million
Pension benefits
Benefit obligation at end of year
Fair value of plan assets at end of year
Funded status
2005
22,935
19,792
(3,143)
Other benefits
2006
22,849
21,909
(940)
2007
22,206
22,618
412
2005
4,089
−
(4,089)
2006
4,255
−
(4,255)
2007
3,796
−
(3,796)
1,040
−
(136)
(1,844)
−
(940)
2,187
−
(112)
(1,663)
−
412
−
−
(350)
(4,311)
−
(4,661)
−
−
(338)
(3,917)
−
(4,255)
−
−
(315)
(3,481)
−
(3,796)
Amounts recognized in the consolidated balance sheet
Other assets
Intangible assets
Other accrued liabilities
Other liabilities
Accumulated other comprehensive loss
Net amount recognized
3,280
28
(60)
(1,750)
843
2,341
Before
SFAS 158
After
SFAS 158
Before
SFAS 158
Present value of
unfunded liabilities
can be verified in
footnotes.
After
SFAS 158
Source: DuPont 2007 annual report.
20
Other Debt Equivalents
Other common debt equivalents:
• For long-term operating provisions and nonoperating provisions, the
balance sheet value offers a reasonable approximation.
• Long-term operating provisions (e.g., plant-decommissioning
costs) are typically recorded at a discounted value.
• Nonoperating provisions (e.g., restructuring charges) are
generally recorded at a nondiscounted value, but are near term
in nature.
• Contingent liabilities (e.g., pending litigation) should be valued by
estimating the associated expected (not book) after-tax cash flows
and discounted at the cost of debt.
21
Hybrid Securities: Convertible Debt
Convertible bonds differ from traditional debt in that they give the holder
the additional right to convert the bonds into common stock.
•
If the convertible bonds are actively traded, deduct their market value, but only if
estimated stock price is near the traded stock price, as the value of convertible bonds
depends on your estimate of equity value.
•
If the market price differs from your estimate of share price,
1.
Option valuation approach: The value of convertible bonds can be estimated
using an adjusted Black-Scholes convertible bond pricing model.
2.
Conversion value approach: This common approach assumes that all
convertible bonds are immediately exchanged for equity and ignores the time
value of the conversion option. The approach works well when the conversion
option is deep in the money.
22
Hybrid Securities: Convertible Debt
• Consider Hasbo, which has both
traditional debt and convertible debt
outstanding.
• The Facts: Hasbro has $250 million in
convertible debt that can be converted into
11.56 million shares. Based on a share
price of $28, among other variables, the
debt is valued at $326.4 million.
• The Solution: To determine equity value,
subtract the value of convertible debt
($326.4 million) from enterprise value.
Divide this value by the number of
nondiluted shares (142.6 million).
• Note how the conversion value method,
which assumes immediate exercise,
mirrors actual share price.
Hasbro Convertible Debt, November 2008
$ million
Capital structure
Enterprise value
Traditional debt
Convertible debt at 2.75% due 2021
Unfunded pensions
Employee options
Equity value
Number of shares (million)
Number of nondiluted shares
New shares issued
Number of diluted shares
Value per share (dollars)
Black-Scholes
value
5,050.0
Conversion
value
5,050.0
(556.3)
(326.4)
(38.3)
(134.0)
3,994.9
(556.3)
−
(38.3)
(134.0)
4,321.4
142.6
0.0
142.6
142.6
11.6
154.2
28.0
28.0
Source: Hasbro 2007 10-K, NASD TRACE system, Black-Scholes optionpricing model.
23
Employee Stock Options
• Employee stock options give the holder the right, but not the obligation,
to buy company stock at a specified price, known as the exercise price.
• If not specifically expensed as part of NOPLAT, outstanding options must be treated as a
nonequity claim:
• Option valuation models: The value of options can be estimated using optionvaluation models such as Black-Scholes or advanced binomial (lattice) models.
Under U.S. GAAP and IFRS, the notes to the balance sheet report the value of all
employee stock options outstanding as estimated by option-pricing models. This
value is a good approximation only if your estimate of share price is close to the one
underlying the option values in the footnotes.
• Exercise value approach: This common method provides only a lower bound for the
value of employee options. It assumes that all options are exercised immediately
and thereby ignores the time value of options.
24
Employee Stock Options: An Example
• Consider Hasbro, whose equity is
trading at $28 per share.
• The Facts: The company has 9.73
million options outstanding. The options
have an exercise price of $20.50 and
mature in five years. If the options are
worth $10.13 each, what is the value of
the company?
• The Solution: To determine equity value,
subtract total option value ($134 million)
from enterprise value. Divide this value
by the number of nondiluted shares
(142.6 million).
• Note how the exercise value method,
which assumes immediate exercise,
overestimates actual share price.
Hasbro Employee Options, November 2008
$ million
Company financial structure
Enterprise value
Traditional debt
Convertible debt at 2.75% due 2021
Unfunded pensions
Employee options: value
Employee options: exercise proceeds
Equity value
Number of shares (million)
Number of nondiluted shares
New shares issued
Number of diluted shares
Value per share (dollars)
Black-Scholes
Value of
outstanding
options
5,050.0
Exercise
value
approach
5,050.0
(556.3)
(334.3)
(38.3)
(134.0)
−
3,987.1
(556.3)
(334.3)
(38.3)
−
199.3
4,320.3
142.6
−
142.6
142.6
9.7
152.3
28.0
28.4
Source: Hasbro 2007 10-K, NASD TRACE system, Black-Scholes optionpricing model.
25
Minority Interest
• What is a minority interest?
When a company controls a subsidiary without full ownership, the subsidiary’s
financial position must be fully consolidated in the group accounts. The portion
of third-party ownership is classified as minority interest, and this must be
deducted as a nonequity claim.
• A minority interest is a claim only on a particular nonconsolidated subsidiary;
its valuation is related to the subsidiary, not the company as a whole.
• If the subsidiary is publicly listed, deduct the proportional market value
owned by outsiders from enterprise value to determine equity value.
• If the subsidiary is privately held, you can perform a separate valuation of
the minority interest using a DCF approach, multiples, or a tracking
portfolio, depending on the information available.
26
Session Overview
•
When you have completed the valuation of core operations, you are ready to
estimate three values: enterprise value, equity value, and value per share.
1. To determine enterprise value, add to the value of core operations the value of
nonoperating assets, such as excess cash and nonconsolidated subsidiaries.
2. To convert enterprise value to equity value, subtract short-term and long-term
debt, debt equivalents (such as unfunded pension liabilities), and hybrid
securities (such as employee stock options).
3. To estimate value per share, divide the resulting equity value by the most recent
number of undiluted shares outstanding.
•
Estimating the value per share completes the technical aspect of the
valuation, yet the entire job is not complete. It is time to revisit the valuation
with a comprehensive look at its implications. We examine this process in
the next session.
27
Calculating Value per Share
How you determine the value per share depends on how options and convertible debt are
valued. The two methods are:
Option-Based Valuation
Divide the total equity value by the number of undiluted shares outstanding.
• Use undiluted shares outstanding because the value of convertible debt and stock
options has already been deducted from the enterprise value.
• The number of shares outstanding is the gross number of shares issued, less the
number of shares in treasury.
Conversion and Exercise Value Method
Divide the total equity value by the diluted number of shares.
• Under this method, convertible debt and stock options are not incorporated as
nonequity claims, but rather through the number of shares outstanding.
• This method generates a different equity value than the option-based valuation.
28