Chapter 5 Finmod - Financial Forecasting, Analysis and Modelling A Framework for Long-Term

Forecasting

Chapter 5 - Business Valuation

Valuation Approaches
 Most Common Approaches are the following:
1. The Net Asset Approach NEA treats the business as a set of assets and liabilities where
their net difference represents its net equity. before applying it, both (A&L) should be adjust
by their fair market value
 The price, in terms of cash or its equivalent, that a buyer could reasonably be expected to
pay, and a seller could reasonably be expected to accept,
o If the business were offered for sale on the open market for a reasonable period of
time, with both buyer and seller being in possession of the pertinent facts and
neither being under any compulsion to act
 Disadvantages
o fails to capture the value of a company’s intangible assets.
o Used in cases where a business is not viable as a going concern and is about to
be liquidated (liquidation value)
 Or where there are no intangible assets and its value as a going concern
is closely related to the liquidation value of its underlying assets.
o Used as an aid to assess the risk associated with the other valuation approaches
2. The Market Approach determines the value of a business based on comparisons with
similar companies for which values are known.
 It compares the subject company to the prices of similar companies operating in the same
industry that are either publicly traded or, if privately owned, have been sold recently.
 Calculates 2 categories of multiples
o Listed comparable multiple
 (EV)/sales, EV/EBITDA and P/E multiples are derived from comparable
listed companies and are then applied to sales, EBITDA, and net income
of the subject company in order to obtain its enterprise value (EV) or its
market value (P/E method);
o Comparable transactions multiples
 EV/sales, EV/EBITDA, and P/E multiples in recent comparable
transactions are observed and then are applied to the sales, EBITDA, and
net income of the company to be valued in order to obtain its enterprise
value or its market value (P/E method)
 Disadvantages
o For privately owned businesses there is a lack of publicly available comparable
data.
o It is difficult to construct a representative and adequate benchmark set of
comparable peers in terms of size, markets, product range, and country of
operations.
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 o This approach can be used in conjunction with the other approaches in order to
affect the so-called “triangulation” of results.
3. The Income Approach estimates the value of a company by considering the income
(benefits) it generates over a period of time.
 This approach is based on the fundamental valuation principle that the value of a business
is equal to the present worth of the future benefits of ownership.
 The term income does not necessarily refer to income in the accounting sense but to
future benefits accruing to the owner.
 the most common methods under this approach are:
o Capitalization of earnings method normalized historic earnings are capitalized
at a rate that reflects the risk inherent in the expected future growth in those
earnings.
o Discounted cashflow method discounts projected cash flows back to present
value at a rate that reflects the risk inherent in the projected flows.
 This rate -sometimes called the hurdle rate, discount rate, or simply the
opportunity cost of capital- is frequently the company’s WACC (Weighted
Average Cost of Capital), which reflects the company’s financial structure
and the risk related to the sector.
 Present Value and Opportunity Cost of Capital
 The concept of present value is based on the so-called “time value of money” which
states the obvious fact that getting money today makes more sense than getting it a year
from now.

o FV = PV × (1+r) or 𝑃𝑉 =
𝐹𝑉
o Present value is closely related to future value

(1+𝑟)𝑛
1
(1+𝑟)𝑛

is called a discounting factor
 The time value of money is represented by the opportunity cost of capital, which is
fundamental to investment decisions, and is a significant input to a DCF analysis.
o is so-called because it represents the return forgone by investing in a specific
asset rather than investing in securities.
 You can think of it as the rate offered by equivalent investment alternatives
in the capital market
 commonly used valuation guidelines require careful consideration of each of the
following:
o The nature and history of the business
o Competitive Advantage
o Economic and Industry Outlook – porter’s 5 forces
o The financial condition in terms of liquidity and solvency
o Earning Capacity
o Price of stock, having their stock actively traded in a free and open market

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 Discounted Cash Flow (DCF) method is used to determine the present value of a business
on the assumption that it is a going concern.
 the basis of the going concern, we should always assume that the business under
valuation will continue its operations in the future.
 Ignores control issues
o control premium and is the premium a buyer is willing to pay in order to acquire
control of the company and be able to run it in their own way.

Steps For Applying the Discounted Cash Flow Method

 DCF objective is to determine the net present value of the Cash Flows (“CF”) arising from
the business over a future period of time (say 5years)
 this period is known as the explicit forecast period.
 Steps
1. Decide on the explicit forecast period and estimate future cash flows
 The is where the question which cash flows to estimate comes in. the most important
types of cash flow are:
o Free cash flows (cash flows available to satisfy both the shareholders’
and creditors’ return requirements)
o Equity cash flows (cashflows available to shareholders).
 The choice of cash flow determines whether you are valuing the whole
firm or just the equity of that firm.
2. Estimate the rate at which future cash flows and terminal value will be discounted back
to their present values.
 One of the advantages of DCF is that it permits the various elements that make up the
discount rate to be considered separately
o thus, the effect of the variations in the assumptions can be modelled easily
 WACC is used as the discount rate, in most valuation cases.
o The principal elements of WACC are:
 Cost of equity
 which is the desired rate of return for an equity investor given
the risk profile of the company and associated cash flows
 Post-tax cost of debt
 Target capital structure of the company
 a function of the debt-to-equity ratio
o In turn, cost of equity is derived as a function of the risk-free rat
o beta (an estimate of the risk profile of the company relative to the equity market)
o equityrisk premium assigned to the subject equity market.
3. Terminal value must be placed on both the explicit cash flows and the ongoing cash flows
 Value of a Company = {Sum of PV of Free Cash Flows} + {PV of Terminal Value}

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  The terminal value is derived from the last projected FCF of the explicit forecast period,
represents between 60% and 80% of the company’s total value.
 The accuracy of the projection determines the accuracy of the terminal value.
o In general, the further the cash flows are projected, the less sensitive the
valuation is to inaccuracies in the estimated terminal value
4. Discount -using the WACC of step 2- to the present value the FCF of the explicit
forecast period as well as the terminal value. SLIDE 14 APPLIED TO STEELCO
 Professor Damodaran states the following:
 One’s understanding of a valuation model is inversely proportional to the number of
inputs required for the model, and
 Simpler valuation models work much better than complex ones

Rewriting Financial Statements – Calculation of FCF

 Approaches
 Bottom-up approach starts from the net income of the company.
o Net income comes right off the income statement and includes any tax or interest
expense that must be paid for the period.
o To calculate FCF to the firm
 Add back any non-cash items such as amortization, depreciation, and
interest expense
 Subtract any necessary CAPEX and investment in working capital
 Top-down approach starts with the estimation of future revenues and operating
expenses (including depreciation) EBIT for each year.
o Subtract taxes to find NOPAT
 gives a clearer view of the operating efficiency of a company.
o Add back non-cash costs, that have been subtracted in EBIT
o Subtract CAPEX and increases in working capital or add back any decreases in

 𝖳 Asset, ↓ Liability → 𝖳 CAPEX, 𝖳 Working Capital = cash outflow

working capital

 ↓ Asset, 𝖳 Liability → ↓CAPEX, ↓ Working Capital = cash inflow

For working capital its

current assets and
liabilities

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 Calculation of Free Cash Flows
 WACC equation is the cost of each capital component multiplied by its proportional
weight and then summing
𝐷 𝐷
𝑊𝐴𝐶𝐶 = 𝐾𝑑(1 − 𝑇) + 𝐾𝑒
𝐷+𝐸 𝐷+𝐸
𝐸: Market value of equity
𝐷: Market value of debt


𝐺: Gearing 𝐺 =
𝐷


𝐷+𝐸

o This is the company’s capital structure, that is, the ratio of its debt to the market

𝑇: Tax rate
value of its equity.

o The tax rate reflects the effective tax rate for a company operating in a certain

𝐾𝑑: Cost of debt

country.

o The cost of debt reflects the cost that a company has to bear in order to get
access to short and long-term loans.

𝐾𝑒: Cost of equity

o The cost of debt is estimated as the projected interest on its loans

o The cost of equity can be defined as the minimum return that an investor will
require to purchase shares of the company.
o This return has been calculated according to the CAPM based on the following
formula:
𝐾𝑒 = 𝑅𝑓 + [𝑅𝑚 − 𝑅𝑓] × 𝛽
 𝑅𝑓: Risk-free
rate
o This is the amount an investor could expect from investing in securities

𝑅𝑚 − 𝑅𝑓: Market risk premium or the expected return on the market portfolio minus
considered free from credit risk, such as government bonds.

the risk-free rate.
o The market portfolio is a portfolio consisting of all the securities available in the
market where the proportion invested in each security corresponds to its relative
market value. The expected return of a market portfolio, since it is completely

𝛽: beta =
𝐶𝑂𝑉𝐴𝑅
diversified, is identical to the expected return of the market as a whole.

𝑉𝐴𝑅

o measures the risk associated with that particular stock
Check slides for  Beta > 1 = Higher risk investment
calculations  Best < 1 = Lower risk investment

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 o + Covariance = Assets return move together, Variance = 𝖳 Volatility → 𝖳 Risk

Estimating The Terminal Value

 Approaches
 Exit multiples where the terminal value is calculated using some comparable company multiple
like EBITDA or EBIT
o e.g., the terminal value of the company should be worth 5 times its EBITDA), and
 The perpetuity growth method, where terminal value is calculated using the following

𝐹𝐶𝐹𝑁 × (1 + 𝑔)
formula:
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑟−𝑔
 𝐹𝐶𝐹𝑁: is the free cash flow for the last year of the explicit forecast period.
o 𝐹𝐶𝐹𝑁+1: the FCF of the year following the end of the explicit forecast period (lasts

 𝑟: the discounted factor and is presented by the company’s WACC

for N years)

 𝑔: is a constant growth rate that cannot exceed the growth rate of the economy

DCF Summary – Enterprise Value Adjustments

 Estimated value
𝐶𝐹 𝐶𝐹
𝐸𝑉 = +⋯⋯⋯ (1 +
⋯ ⋯ + (1 + 𝑟)
1

 J Curve 𝑟)𝑛
 Is a combined graph of FCF and cumulative cash deposits over time
o Takes the letter J – startup companies
 Divided into 3 phases: Initial, Growth & Maturity Periods
o Early Stages FCF is negative then it gradually becomes positive till it finally
stabilizes
 Check pages 134 – to 136 for extra infos