010420_Valuation_Beginners_Guide_FCP007CPCONFIDENTIALValuation for ”dummies”- A beginners guide to valuation in an M&A situationPeter Bonnn CPJohn Hansen CPJrgen Rugholm CPKasper Vaala CPApril, 2001This report contains information that is confidential and proprietary to McKinsey & Company and is solely for the use of McKinsey & Company personnel. No part of it may be used, circulated, quoted, or reproduced for distribution outside McKinsey & Company. If you are not the intended recipient of this report, you are hereby notified that the use, circulation, quoting, or reproducing of this report is strictly prohibited and may be unlawful.010420_Valuation_Beginners_Guide_FCP007CP1CONTENTSIntroduction to valuationDCF valuationMultiples valuation010420_Valuation_Beginners_Guide_FCP007CP2CONTENTSDCF valuationMultiples valuationThe purpose of valuation is to estimate the net present value of a company The result of the valuation yields the accumulated value of the equity and the net debt, in total called the aggregate valueThe basis for valuation is historical and future financial parametersIntroduction to valuation010420_Valuation_Beginners_Guide_FCP007CP3OUR BELIEFS ABOUT VALUATIONValuation is not an exact scienceThere is no single value of a company, rather a range of potential valuesValuation should be carried out using more than one method, if at all possibleEach of the conventional methods (DCF, trading multiples, precedent transaction multiples, etc.) have inherent risks of biasesTechnical parameters (WACC and terminal growth rate) have great impact on value and it is paramount to allocate enough time on theseUse of multiple valuation methods opens up the negotiation spaceIt is critical to fully understand the implications of various methods to focus the negotiations in the preferred directionActual value agreed upon in a transaction usually differs from perceived valueIn many situations there may be a CF&S specialist on the team but it is still important for the whole team to have a basic understanding of valuation methodologies 010420_Valuation_Beginners_Guide_FCP007CP4THE VALUE OF A COMPANY CONSISTS OF TWO PARTS* Aggregate value is sometimes called Enterprise Value (EV), which in turn is sometimes confused with Equity value. To avoid confusion, when referring to the total value of an entity, the investment banking notation of Aggregate Value (AV) is used throughout this presentation* In principle, market value of Net debt should be used. This, however, is rarely available and, as an approximation, the latest balance sheet figures are used insteadValue belonging to shareholdersValue belonging to debt holdersAggregate value (AV)*Net debt*Equity valueIn mergers, ownership shares are based on equity-valueA DCF valuation yields the aggregate valueIf a company is listed, market capitalization equals the equity valueEquity value is the combined value of the sharesBe careful not to confuse book value of equity with Equity value= Short term interest-bearing debt+ Long term interest-bearing debt+ Minorities interest+ Preferred stock+ Capitalized leases- Cash and cash equivalents 010420_Valuation_Beginners_Guide_FCP007CP5THE CALCULATION OF AGGREGATE VALUE IS BASED ON A NUMBER OF KEY PARAMETERS ParameterDefinitionHow/where to find it?SalesIncome received in exchange for goods and servicesIncome statement (P&L)EBITDAEarnings before interest and taxes, depreciation and amortizationEBIT + depreciation and amortizationEBITEarnings before interest and taxesIncome statementDepreciationAmortization of fixed assets to allocate cost over their depreciable lifeIncome statement or cash flow statementAmortizationAmortization of intangibles assets to allocate cost over their depreciable lifeIncome statement or cash flow statementCapital expenditure (CAPEX)Outlay of money to acquire or improve capital assets such as buildings and machineryCash flow statement or notes to balance sheetWorking capitalCurrent assets (e.g. accounts receivables, inventories, other current assets) minus current liabilities (e.g. trade creditors, other current liabilities)Balance sheet or notes to balance sheetBetaA measure of the companys volatility compared to the market portfolio (systematic risk)Needs to be calculated. Described in more detail later in this documentLeverageGearing of the company. Net debt divided by market valueNet debt can be calculated from latest balance sheet. Example of leverage-ratio calculation will followWACC (Weighted Average Cost of Capital)Rate at which free cash flows are discounted back to valuation dateNeeds to be calculated. Examples will followFree Cash Flow (FCF)After tax cash flow generated by the company that is available to debt holders and shareholdersNeeds to be calculated. Example will follow010420_Valuation_Beginners_Guide_FCP007CP6EBIT IS A FUNDAMENTAL PARAMETER WHEN CALCULATING THE VALUE OF A COMPANYAggregate value (AV)Net debtEquity valueDebt holdersShareholdersGovernmentInterestTaxNet incomeSharesSharesSharesEarnings before interest and taxes (EBIT)EBIT is an earnings flow available to all capital providers010420_Valuation_Beginners_Guide_FCP007CP7VALUATION METHODOLOGIESMethodologyMarkets rationale510 year DCF modelFundamental analysis of targets economics and growth/ profitability prospectsAdherence to the theoretical principle that the value of a business depends on its future generation of after-tax cash flows.Equity research analysts invest time in building “fundamental” economic models of the companies they cover to link (to the extent possible) value to operations and to required capital expenditure for like-for-like growthDCF (Discounted Cash Flow)Precedent transactionsAverage/median of multiples paid in (recent) transactions of comparable size and nature, e.g.:AV*/SalesAV*/EBITDAAV*/EBITThe assumption is that M&A acquirers are rational decision-makers when they close deals. In essence, it is a quantitative way to guessestimate the conditions under which, should one seek an alternative solution to the one under investigation, the target would be valued on the M&A marketOnce again, the search for benchmarks. Similar transactions (in spirit, sector and geographies) may be relevant ones2.Multiples at which acquirers have closed recent actual acquisitions perceived as comparableMultiples analysis1.Average/median of “traded comparables” forward multiples, e.g.:AV*/SalesAV*/EBITDAAV*/EBITThe assumption is that stock exchanges price assets fairly (“the market is always king”) using all information available in the public domainSearch for “objective“ market-based benchmarks. Similar companies, possibly also in similar geographies, may be relevant onesMultiples at which listed companies, perceived as comparable, trade on the stock marketTrading multiplesNote that alternative methodologies exist, e.g. private equity firms often use leveraged buy-out (LBO) analysis. These methodologies are not covered in this presentation* Aggregate value010420_Valuation_Beginners_Guide_FCP007CP8OVERALL VALUATION IS BASED ON MULTIPLE VALUATION METHODOLOGIES AND SCENARIOSDCF valuationMultiples valuationSales (0.4-0.6x)EBIT (10.0-12.0x)EBITDA (6.5-7.5x)Valuation rangePrecedent transactions(10.0-12.0x)Downside case*: WACC 6.07.0%Management case*: WACC 6.07.0%1,8009001,5001,4002,1005006001,0007001,1001,400600Terminal growth rate 1.52.5%Terminal growth rate 1.52.5%* Normally, a DCF valuation will be made based on managements own forecasts. The downside case will usually be a less optimistic case1,2001,200The valuation range is based on intervals from the different methodologies and scenarios. To some extent, the range is subjectively selectedEXAMPLE010420_Valuation_Beginners_Guide_FCP007CP9KEY HISTORICAL PARAMETERS CAN BE FOUND IN ANNUAL REPORTSSales- Cost of goods sold (COGS)= Gross profit- Operating expenses= EBIT- interest= Profit before tax- tax= Net incomeEBIT+ Depreciation and amortization= EBITDA19972000Depending on statement type, depre-ciation and amortization can be “hidden” here. It can usually also be found in the cash flow statementHistorical figures are used as a base to ensure reasonable forecasts199819991,000600400200200201805013020050250(Example)010420_Valuation_Beginners_Guide_FCP007CP10OTHER PARAMETERS NEEDED IN A VALUATION PROCESS CAN BE FOUND USING VARIOUS SOURCESNecessary parameterNeeded in DCFMultiples analysisPossible sourceForecasts for EBIT for comparable companiesBroker reportsForecasts for EBITDA for comparable companiesBroker reportsForecasts for sales for comparable companiesBroker reportsMarket capitalization/value for comparable companiesBloomberg or Datastream (or share price multiplied by outstanding shares)Book value for comparable companiesBalance sheetsNet debt for comparable companiesLatest balance sheets (homepages or databases)Levered beta for comparable companiesBARRA database (consult with CF&S R&I)Capital structure for comparable companiesCalculated from market capitalization/value and net debtRisk free rateBloomberg has rates on government bondsMarket risk premiumAsk CF&S R&I for current premium (it is 5% at time of writing)Tax rateBloomberg010420_Valuation_Beginners_Guide_FCP007CP11CONTENTSBeliefs and key learnings about DCFOverview of DCF calculationThe four steps of the DCF processSample DCF calculationDCF valuationMultiples valuationIntroduction to valuation010420_Valuation_Beginners_Guide_FCP007CP12OUR BELIEFS AND KEY LEARNINGS ABOUT DCFTime consumingForecasting operational numbers 5-10 years into the future is very time consuming for most organizationsBasic data is rarely readily availableIdentifying levers/initiatives to drive improvement is difficult and requires deep understanding of businessDo not let the client do the forecasts on their ownGetting client people who know the levers and are analytical is more important than involving people with a deep understanding of the businessBeliefWhyImplicationOpen to manipulationPotential improvement can almost always be documented with reference to best practiceDCF is likely to be at high level so inconsistencies can be hiddenLink between income statement, cash flows and DCF calculation makes it possible to e.g. make conservative EBIT forecast but drive free cash flow up dramatically (and value)Test rigorously for obvious inconsistency, e.g., test for consistency between personnel numbers and salary costs Ensure that forecasts are linked to historical performanceComplement DCF with explicit assumptions (e.g. price development, market size)Ensure all parties (e.g. buyers, sellers, merger-partners) agree on format (e.g. forecasts should be comparable) before developing forecastDiscloses managements beliefs and business focusManagement is forced to quantify improvement programs Forecast will show how management thinks about the market, levers for building the business and in which areas improvements can be achievedBuild forecast and management presentation simultaneouslyUse workshops to identify levers and broad initiatives; quantify afterwards010420_Valuation_Beginners_Guide_FCP007CP13OVERVIEW OF THE DCF CALCULATIONNet debtEquity valueFor every year in the forecast period, the free cash flow is calculated and discounted back to the time of valuationThe last year of the forecast period should be a ”normalized” year with stable cash flow elements, e.g. EBIT, CAPEX, etc.WACC = XX%AVThe terminal growth rate is used to grow the free cash flow in the last year of the forecast period into perpetuityFree cash flow is discounted at WACCAV is the net present value of future free cash flows01234Terminal growth rate= XX%The last year of the forecast period is also used as the basis for the calculation of terminal valueTerminal value+010420_Valuation_Beginners_Guide_FCP007CP14THE DCF PROCES CONSISTS OF 4 STEPSDiscounting cash flowsForecastFree cash flow calculationWACC calculation and terminal value+010420_Valuation_Beginners_Guide_FCP007CP15BUILDING THE BASICS FOR A BULLET PROOF FORECASTHistorical developments for all elements of the forecasts (e.g. cost of goods sold, personnel costs) are required to demonstrate that the starting point is realisticForecasts need to be tested with key managers in a format they can relate toUse budget values for year 1 if at all possible as this normally has good supporting data and action plansKey parameters in the forecast (e.g. EBIT) should line up with published figures to reduce suspicions of manipulation and allow for consistency checksAnchor forecast to known definitions and reporting formatsIdentify 5-10 levers that will drive EBITQuantify impact of specific improvements for each lever over the full DCF period based on historical evidence or best practice within the industryDevelop short profiles of programs to drive improvements for each leverIdentify key levers to drive improvementsWork through each lever and discuss size of improvement Review ways of documenting that improvement is achievableDiscuss how to present improvement, in particular what level of detail is required to describe improvement programTest improvements with management010420_Valuation_Beginners_Guide_FCP007CP16Expand number of storesRemodel storesImprove sales per customerAssortment developmentAllocation of spaceExecution of in-store promotionsStock-out reductionEtc.Increase number of customers per storeMarketingPricingNew assortments/servicesEtc.2001Better space allocationEXAMPLE: FORECASTING REVENUES FOR A RETAILER2005EUR millionsPotential levers to drive revenuesNew storesMarket growthRevenue forecastChosen leversForecast can be broken down by lever and impact from each lever is backed by previous results and/or references to best practice010420_Valuation_Beginners_Guide_FCP007CP17SAMPLE INCOME STATEMENT FORECASTEUR millionsSales- COGS= Gross profit- Operating expenses= EBIT- interest= Profit before tax- tax= Net incomeEBIT+ Depreciation and amortization= EBITDA20062007200820092010200120022003200420054,555.64,722.24,888.95,055.65,222.23,458.03,560.33,830.34,108.34,399.33,335.43,458.33,579.23,700.03,820.82,558.22,628.42,818.73,014.23,222.31,220.11,263.91,309.71,355.61,401.4899.8931.91,011.71,094.21,177.01,111.81,152.81,193.11,233.31,273.6852.7876.1939.61,004.71,074.1108.3111.1116.7122.2127.847.155.872.189.4102.96.15.65.65.65.612.411.811.29.36.6102.2105.6111.1116.7122.234.744.060.980.196.333.634.436.237.939.614.617.322.427.731.968.671.174.978.882.620.126.738.552.464.4108.3111.1116.7122.2127.847.155.872.189.4102.960.060.661.162.863.350.155.858.459.459.3168.3171.7177.8185.0191.197.2111.6130.6148.9162.2010420_Valuation_Beginners_Guide_FCP007CP18SAMPLE FREE CASH FLOW FORECASTEUR millions- Tax* 31%= Unlevered* net income+ Depreciation and amortization (D&A)- Capital expenditure- Change in working capital= Unlevered* free cash flow2005200620072008200920102001200220032004EBIT* Note that in some countries amortization is not tax deductible, i.e., tax is paid on EBIT + amortization* Unlevered means regardless of capital structure (note that interest expense is not deducted). Capital structure affects value only through its impact on the WACC102.9108.3111.1116.7122.2127.847.155.872.189.431.933.634.436.237.939.614.617.322.427.771.074.876.780.584.388.232.538.549.861.759.360.060.661.162.863.350.155.858.459.455.055.055.055.055.055.044.483.369.461.77.25.64.44.44.44.42.42.66.76.968.174.277.882.287.792.135.78.432.152.6The free cash flow statement must reflect all cash flow items, including those not reflected in the income statement, e.g. capital expenditure. Tax is calculated on EBIT and D&A is added back. The cash flow effect of working capital is the incremental change from year to year010420_Valuation_Beginners_Guide_FCP007CP19THE TECHNICAL PARAMETERS IN THE DCF ANALYSIS HAVE A SIGNIFICANT IMPACT ON VALUECommentsWACCWACCBetaWACC is used to discount the future free cash flows back to the valuation dateWACC should be calculated (example will follow) and depends on market risk, industry risk and capital structureThe beta value is an estimate of the companys volatility compared to the market portfolio (systematic risk)Beta should be calculated based on comparable companies (examples will follow)Terminal valueTerminal growth rateFree cash flow in the terminal year (last year of the forecast period if the year is normalized)The terminal value usually accounts for more than 50% of the total valueThe terminal growth rate is the rate at which the free cash flow after the forecast period grows every year in perpetuityThe free cash flow in the terminal year forms the basis of the terminal value and should be realistic and obtainable in the forecast periodThe free cash flow should be normalized with stable operating parameters, e.g. EBIT, CAPEX, etc.Number to be calculated or estimated010420_Valuation_Beginners_Guide_FCP007CP20WEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATIONWACC Cost of equityMarket valueAggregate value*x+Cost of debtNet debtAggregate value*xRisk free rate = Rate on government bond, e.g. 10-year bondMarket risk premium = Premium that the investor requires to invest in the market portfolio instead of a risk free investment. The figure is a constant.*Aggregate value = market value + net debtCost of equityRisk free rate+Market risk premiumRelevered betax=Cost of debtBorrowing ratex(1-tax rate)=010420_Valuation_Beginners_Guide_FCP007CP21SAMPLE CALCULATION OF WACCAssumptionsRisk free rate:Market risk premium:Relevered beta:Market value:Aggregate value*:Borrowing rate*:Tax rate:5.12%5.00%0.504,8366,6365.12%30.0%CalculationsCost of equity x weight(5.12% + 5.00% x 0.50) x= 7.62% x 0.73 = 5.55%4,8366,636Borrowing rate x (1-tax rate) x weight5.12% x (1-0.3) x1,8006,636= 3.58% x 0.27 = 0.97%5.55%0.97%WACC 6.52%* Aggregate value = market value + net debt = 4,836 + 1,800 = 6,636* A risk premium may have to be added. Check with CF&S R&INet debt:1,800010420_Valuation_Beginners_Guide_FCP007CP22A DCF VALUE RANGE IS CALCULATED FROM THE FORECASTED FREE CASH FLOWSCalculations should be made in a model in ExcelA good output sheet in Excel contains DCF ranges and control-parameters for sanity checks+010420_Valuation_Beginners_Guide_FCP007CP23DCF CALCULATION SAMPLE 2281,214WACC = 7%1,442Sep. 30, 20012001200220032004Terminal growth rate = 2%201035.78.432.152.692.1In this example the valuation is at Sep. 30, 2001 which means that only 25% of the free cash flow in 2001 should be included* Refer to appendix for further explanation1,943Terminal value010420_Valuation_Beginners_Guide_FCP007CP24SAMPLE DCF SPREADSHEET OUTPUTRefer to appendix to see the underlying calculationsValues should be calculated for a range of WACCs and terminal growth ratesAggregate value is the sum of the present value of the free cash flows and the present value of the terminal valueTo get Equity value, Net debt is subtracted from Aggregate valueTerminal value should be reasonable compared to EBITDA in the last year of the forecast periodTerminal value of total value should be reasonable considering the targets situation010420_Valuation_Beginners_Guide_FCP007CP25CONTENTSDCF valuationMultiples valuationIdentification of peer group and comparable benchmarksSelection of multiple intervalsCalculation of valuation rangesIntroduction to valuation010420_Valuation_Beginners_Guide_FCP007CP26USING MULTIPLES VALUATION IS AN IMPORTANT PART OF OVERALL VALUATIONA separate valuation method Market perspectiveMultiples valuation is a method in its own right, not just a supplement to DCF analysisMultiples valuation is widely used in the market and by investment banksBased on public informationBased on the current value of publicly traded companies and valuations made in precedent transactions of comparable nature010420_Valuation_Beginners_Guide_FCP007CP27PEER GROUP AND COMPARABLE BENCHMARKS SHOULD REFLECT THE MARKETS VALUATIONIdentification of peer group and comparable benchmarksSelection of multiple intervalsCalculation of valuation rangesComparable companies are selected considering:SizeMarket positionOperational effectiveness (best practice)Etc.Benchmarks are selected considering:Actual use in the market when valuing companiesHow to capture effect of future earnings and potential for growth010420_Valuation_Beginners_Guide_FCP007CP28EXAMPLE: COMPARABLE COMPANIES IN THE RETAIL SECTOR IN EUROPE* Estimated 2001Source: Broker reports, BloombergEUR millionsCompanyCasinoDelhaize-Le LionIceland GroupWM MorrisonSafeway plc.SainsburySomerfieldTescoCarrefourAholdEBIT*7651,2663423726411,079512,0892,8772,966EBITDA*1,1931,8704865199121,7911672,8965,1774,457Market Cap9,0623,0478764,4144,96811,50478028,11645,79327,062Floor space (m2)*4,062,0004,170,000338,133351,540939,715522,3811,074,1501,983,7616,569,0005,585,968Sales*21,41021,0339,1116,06613,56528,7557,56836,48774,63761,701010420_Valuation_Beginners_Guide_FCP007CP29MULTIPLE INTERVALS FOR TARGET ARE SELECTED BASED ON THE PEER GROUPS MULTIPLESIntervals are selected based on:Average, median and distribution of peer groups multiplesLikely multiple interval for target relative to peer groupThe selection of intervals is subjective to some extentIdentification of peer group and comparable benchmarksSelection of multiple intervalsCalculation of valuation ranges010420_Valuation_Beginners_Guide_FCP007CP30EXAMPLE OF SELECTED MULTIPLE INTERVALS Source: Team analysisCompanyCasinoDelhaize-Le LionIceland GroupWM MorrisonSafeway plc.SainsburySomerfieldTescoCarrefourMinimumMaximumAverageMedianSelected interval (x)AholdAV/ 1.000 m23.11.33.412.67.426.00.915.98.30.926.08.57.02.54.06.5AV/sales0.580.250.130.730.510.470.120.860.730.120.860.500.550.400.600.59AV/EBIT16.34.23.311.910.812.618.215.119.03.319.012.412.510.012.012.3AV/EBITDA10.52.92.48.67.67.65.510.910.52.410.97.57.96.57.58.2The selection of multiple intervals depends on the target and its position relative to peer group. The interval does not necessarily have to be around the average/median of peer group010420_Valuation_Beginners_Guide_FCP007CP31SAMPLE PRECEDENT TRANSACTIONS Source: Bloomberg, team analysisTargetEBITDA multipleAcquirorYearPromodesCarrefour200017.9Comptoirs Modernes SACarrefour199810.2ICAAhold199913.5Gruppo GS SpACarrefour200011.1AverageSelected interval (x)10.0-12.013.2As with trading multiples, selected range is based on targets relative position. The interval does not necessarily have to be around the average/median of precedent transactions010420_Valuation_Beginners_Guide_FCP007CP32ESTIMATE OF VALUE IS BASED ON THE SELECTED MUTIPLES INTERVAL AND THE TARGETS OPERATING STATISTICSCalculation of valuation rangesThe targets operating statistic (e.g., EBIT 2001) is multiplied by the selected multiples interval (e.g., 10.012.0x)This yields a valuation range for each of the different operating statisticsOverall valuation range is selected based on:The valuation ranges from the different operating statisticsThe relative valuation of the different rangesOverall valuation range indicates the potential value of the target in the marketIdentification of peer group and comparable benchmarksSelection of multiple intervalsCalculation of valuation ranges010420_Valuation_Beginners_Guide_FCP007CP33SalesEBITDAEBITM2 (1,000)Precedent transactionsSAMPLE MULTIPLES VALUATION3,458974740097Operating statistic*Valuation - Rounded (EUR millions)Multiples interval (x)0.40.66.57.510.012.02.54.010.012.01,4006005001,0001,0002,1007006001,6001,200* Estimated 2001010420_Valuation_Beginners_Guide_FCP007CP34APPENDIX010420_Valuation_Beginners_Guide_FCP007CP35CALCULATION OF BETA VALUES*Levered beta (Equity beta)Predicted beta including the effect of capital structureThis beta value is used for each of the comparable companiesPredicted betas can be found in the BARRA databaseUnlevered betaThe predicted beta adjusted for the effect of capital structureThe levered betas of the comparable companies are adjusted for the effect of capital structure and an average of the unlevered betas is calculatedRelevered betaThe average unlevered beta for the comparable companies “relevered” with the targets capital structureThe beta value used in the calculation of WACC* For further reading on beta refer to “Valuation” by Copeland, Koller & Murrin or “Principles of Corporate Finance” by Brealey & Myers010420_Valuation_Beginners_Guide_FCP007CP36SAMPLE UNLEVERED BETA CALCULATION FOR COMPARABLE COMPANIESCompanyLevered betaLeverage (%)Tax (%)Unlevered beta*Delhaize Le Lion0.494540.20.39Iceland Group0.323930.00.25WM Morrison0.37 530.00.36Safeway plc0.584430.00.44Sainsbury0.192530.00.16Somerfield0.836830.00.56GIB0.462340.20.40Tesco0.501430.00.46Carrefour0.602236.70.53Ahold0.563535.00.46Average unlevered beta0.40* Unlevered beta = levered beta/(1+ leverage x (1 tax rate)Source: BARRA and Bloomberg; team analysis010420_Valuation_Beginners_Guide_FCP007CP37EXAMPLE OF UNLEVERED AND RELEVERED BETA CALCULATIONComparable companyLevered beta:0.56Net debt (MM):4,886Market capitalization (MM):27,000Leverage (4,886/27,000):18%Tax rate:35%TargetNet debt (MM):228Market value (MM):367Leverage (228/367):62%Tax rate:31%Unlevered beta=Levered beta(1 + (1 tax rate) * Leverage)Unlevered beta=0.56(1 + (1 0.35) * 0.18)Unlevered beta= 0.50Relevered beta=Unlevered beta * (1 + (1 tax rate) *Leverage)Relevered beta= 0.71Relevered beta=0.50 * (1 + (1 0.31) * 0.62)To show how to get from levered to unlevered beta, this example only uses one comparable company. When using more than one comparable company, the average unlevered beta (see page 36) is used in the calculation of the targets relevered beta010420_Valuation_Beginners_Guide_FCP007CP38CALCULATION OF MARKET VALUE TO BOOK VALUE (FOR USE WHEN TARGET IS UNLISTED)Source: Bloomberg, team analysisMarket value (MV)3,046.5551.52,778.63,127.27,241.8491.11,380.917,698.845,792.527,062.2Book value (BV)1,085.6217.6 862.82,051.54,742.0715.8327.24,769.06,433.02,092.9VirksomhedDelhaize Le LionIceland GroupWM MorrisonSafeway plcSainsburySomerfieldGIBTescoCarrefourAholdAverage MV/BVMV/BV2.812.533.221.521.530.694.223.717.1212.934.03When calculating WACC and relevered beta for an unlisted company, an estimate for market value is calculated based on the targets equity multiplied by a market/book ratio derived from comparable companies010420_Valuation_Beginners_Guide_FCP007CP39WEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATION UNLISTED COMPANYWACC Cost of equityEstimated market value*Estimated aggregate value*x+Cost of debtNet debtEstimated aggregate value*x*Estimated market value = Book value of equity x market value factor*Estimated aggregate value = Estimated market value + net debtCost of equityRisk free rate+Market risk premiumRelevered betax=Cost of debtBorrowing ratex(1-tax rate)=Risk free rate = Rate on government bond, e.g. 10-year bondMarket risk premium = Premium that the investor requires to invest in the market portfolio instead of a risk free investment. The figure is a constant.010420_Valuation_Beginners_Guide_FCP007CP40SAMPLE CALCULATION OF WACC UNLISTED COMPANYAssumptionsRisk free rate:Market risk premium:Relevered beta:Book value of equity:Estimated aggregate value*:Borrowing rate*:Tax rate:5.12%5.00%0.501,2006,6365.12%30.0%CalculationsCost of equity x weight(5.12% + 5.00% x 0.50) x= 7.62% x 0.73 = 5.55%4,8366,636Borrowing rate x (1-tax rate) x weight5.12% x (1-0.3) x1,8006,636= 3.58% x 0.27 = 0.97%5.55%0.97%WACC 6.52%* Estimated aggregate value = Book value of Equity x Market value factor (Market value/Book value) + Net debt = 1,200 x 4.03 + 1,800 = 6,636* A risk premium may have to be added. Check with CF&S R&INet debt:1,800010420_Valuation_Beginners_Guide_FCP007CP41VALUATION DATE AFFECTS THE FREE CASH FLOW IN THE FIRST YEARValuation dateIn the first year, use the portion of the year during which the target will be owned:Free cash flow (FCF) 2001: 200Valuation date: 30/9Portion of FCF received:12912X 200 = 50100% = 2001/130/931/1225% = 50Example:Note that when calculating the value, the cash flow is discounted back to 30/9 and not to 1/1010420_Valuation_Beginners_Guide_FCP007CP42MID-PERIOD CONVENTION AFFECTS THE OVERALL VALUE OF CASH FLOWSThe mid-period convention assumes that cash flows occur at the middle of the period to better approximate the time the cash is actually receivedAssuming mid-period cash flows effectively moves each cash flow closer to time zero by half a periodTo move the present value up to time zero, grow the NPV by half a periodNote that the mid-period is not necessarily the same as mid-year (e.g. if the valuation date is on September 30)0123-1Year end cash flowCash flow with mid-period conventionPV of cash flows010420_Valuation_Beginners_Guide_FCP007CP43COMBINING VALUATION DATE AND MID-PERIOD CONVENTION 1/130/9 15/11 31/1230/631/1230/631/1250100150FCF2001200220035010015030/6 15/8Valuation dateWhen calculating the present value of the above FCFs, Mid-period convention and discounting puts the received 2001 FCF of 50 at Aug. 15, 2001 and 2002-2003 FCF of 100 and 150 at Jun. 30, 2001. All 3 FCFs then have to be moved forward to the valuation date at Sep. 30, 2001010420_Valuation_Beginners_Guide_FCP007CP44CALCULATIONS FOR DCF EXAMPLEValuation at September 30, 2001. WACC = 7%, terminal growth rate = 2%PV of FCF 2001:35.7 x (3/12) / 1.07(3/12) x 1.07(1.5/12)=8.85PV of FCF 2002-2010:NPV(0.07,8.4,32.1,52.6,68.1,74.2,77.8,82.2,87.7,92.1) x1.07(1/2) / 1.07(3/12)=394.47PV of terminal value:92.1 x 1.02 / (0.07 0.02) x 1.07(1/2) / 1.07(9 + (3/12)=1,039.40Total DCF value=1,442.72FCF 2001Portion of FCF receivedWACCValuation date and mid-period conventionWACCFCF 2002-2010Mid-period conventionValuation dateFCF 2010 in perpetuityMid-period conventionValuation dateImplied terminal EBITDA multiple: 92.1 x 1.02 / (0.07 0.02) x 1.07(1/2) / 191.1=10.2xFCF 2010 in perpetuityMid-period conventionEBITDA 2010