Valuation,Valuation as a Tool,We encounter valuation in many situations: Mergers & Acquisitions Leveraged Buy-outs (LBOs & MBOs) Sell-offs, spin-offs, divestitures Investors buying a minority interest in company Initial public offerings How do we establish value of assets? Objective today: To preview valuation methods used most commonly in practice,Business Valuation Techniques,Discounted cash flow (DCF) approaches Dividend discount model Free cash flows to equity model (direct approach) Free cash flows to the firm model (indirect approach) Relative valuation approaches P/E (capitalization of earnings) Enterprise Value/EBITDA Other: P/CF, P/B, P/S Control transaction based models (e.g. value based on acquisition premia of “similar” transactions),Discounted Cash Flow Valuation,What cash flow to discount? Investors in stock receive dividends, or periodic cash distributions from the firm, and capital gains on re-sale of stock in future If investor buys and holds stock forever, all they receive are dividends In dividend discount model (DDM), analysts forecast future dividends for a company and discount at the required equity return Problem with dividends: they are “managed”,Dividends: The Stability Factor,Factors that influence dividends: Desire for stability Future investment needs Tax factors Signaling prerogatives,Dividend changes: Publicly traded U.S. Firms,Source: A. Damodaran, Investment Valuation, Wiley, 1997,Valuation: Back to First Principles,Value of the firm = value of fixed claims (debt) + value of equity How do managers add to equity value? By taking on projects with positive net present value (NPV) Equity value = equity capital provided + NPV of future projects Note: Market to book ratio (or “Tobins Q” ratio) 1 if market expects firm to take on positive NPV projects (i.e. firm has significant “growth opportunities”),Valuation: First Principles,Total value of the firm = debt capital provided + equity capital provided + NPV of all future projects project for the firm = uninvested capital + present value of cash flows from all future projects for the firm Note: This recognizes that not all capital may be currently used to invest in projects,The Valuation Process,Identify cash flows available to all stakeholders Compute present value of cash flows Discount the cash flows at the firms weighted average cost of capital (WACC) The present value of future cash flows is referred to as: Value of the firms invested capital, or Value of “operating assets” or “Total Enterprise Value” (TEV),The Valuation Process, continued,Value of all the firms assets (or value of “the firm”) = Vfirm = TEV + the value of uninvested capital Uninvested capital includes: assets not required (“redundant assets”) “excess” cash (not needed for day-to-day operations) Value of the firms equity = Vequity = Vfirm - Vdebt where Vdebt is value of fixed obligations (primarily debt),Total Enterprise Value (TEV),For most firms, the most significant item of uninvested capital is cash Vfirm = Vequity + Vdebt = TEV + cash TEV = Vequity + Vdebt - cash TEV = Vequity + Net debt where Net debt is debt - cash (note: this assumes all cash is “excess”),Measuring Cash Flows,Free Cash Flow to the Firm (FCFF) represents cash flows to which all stakeholders make claim FCFF = EBIT (1 - tax rate) + Depreciation and amortization (non cash items) - Capital Expenditures - Increase in Working Capital What is working capital? Non-cash current assets - non-interest bearing current liabilities (e.g. A/P & accrued liab.),Working Capital vs. Permanent Financing,Short-term assets,Short- term liabilities,Permanent Capital,Long-term assets,Permanent Capital,Operating assets,Working capital,Permanent capital may include “current” items such as bank loans if debt is likely to remain on the books Key: Treat items as either working capital permanent capital but not both,Uninvested capital,FCFF vs. Accounting Cash Flows,Income Statement, Hudsons Bay ($millions, FYE Jan 1999) Sales $7,075 Cost of Goods Sold $6,719 EBITDA $ 356 Depreciation $ 169 EBIT $ 187 Interest Expense $ 97 Income Taxes $ 50 Net Income $ 40 Dividends $ 53,Cash Flow Statement, Hudsons Bay, ($millions, FYE Jan 1999) Cash flow from operations Net Income $ 40 Non-cash expenses $ 169 Changes in WC ($116) Cash provided (used) by investments Additions to P,P & E ($719) Cash provided (used) by financing Additions (reductions) to debt $ 259 Additions (reductions) to equity $ 356 Dividends ($ 53) Overall Net Cash Flows ($ 64),Hudsons Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561),Cash Flow Definition Issues,How is FCFF different than accounting cash flows? Operating cash flows includes interest paid We want to identify cash flows before they are allocated to claimholders FCFF also appears to miss tax savings due to debt Key: these tax savings are accounted for in WACC,An Example,$1 million capital required to start firm Ca