Diagnostic and Valuation of Firms

1. The DCF Method

a. Informations required
y y y A precise repayment schedule and a list of cash-flow generated over time (business plan analysis) A discount rate(usually the WACC) A terminal value

b. Methodology
y y y Analysis of the business plan in order to determine future cash-flows Determination of the discount rate Computation of the terminal value: o Gordon-Shapiro :
         

o Maximum limit for g is usually the long-term growth rate of the economy Total value = Value over duration of BP + Terminal value

c. Pros and cons

y Pros: o o o Cons: o o o o Activity and profitability translated in figures Explicit method based on anticipated economic realities Often the only one applicable Sensitivity to assumptions and ability to predict Undervaluation of terminal value Reliability of the BP What discount rate should be used?

2. The Multiples Methods

a. Methodology
y y y Start with a large number of companies then keep only a limited number of genuinely comparable firms in order to form an homogenous sample Restate data for the comparables o Accounting standards Analyze the performance of the comparables o Rates of return (EBIT or ROCE) o Growth (Sales, Volume/Price)

b. Value the firm

y Enterprise value: o Price/Market capitalization for 100% of the comparable o Add the minority interests of the fully consolidated subsidiaries o Add the value of net financial debt (Listed or book value by default) o Subtract value of non-operating asset (including non-consolidated investments) Sales multiples (Implicit assumption of a normative rate of return, used by default) o o y   Possible to take account of taxation differences via a multiple of EBIT after corporate tax Depreciation of goodwill must be reintegrated

EBIT multiple (Often the preferred approach) o o o

3. Discount and premiums

Discount and premiums are retrieved (added) to the Fair Value (or standalone value) or the Investment value (Market value + expected synergies). They are used to adjust the value driven from traditional valuation methods in order to include specific elements (when comparable are not perfectly similar)

a. Majority premium: paid for acquiring enough shares to take control of the company
y y y Explained by expected synergies (the market anticipates and price the synergies) Explained by managerial improvement (more effort put into value creation) Can lead to overpayment issue : o Optimistic views on value creation through ownership o Market signaling issues o Bubble issues o Expected consequences : sharp fall in stock value

b. Minority discount
y y y y y Lack of influence on dividend policy Inability to affect manager s effort No impact on strategic decision making Less informed about the situation and the operation of the company Is not supposed to exist! o All categories of shareholders have the same rights o Classical evaluation methods are all based on minority shareholders But empirical evidences exist

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Existence of shares without voting rights Appropriation of minority shareholders benefits by majority shareholders (benefit extraction in takeovers for instance)

c. Illiquidity discount: less liquid assets bear higher transaction costs

y y y Pushing price up for buyer, pushing price down for seller Reflected by the bid-ask spread Estimating the liquidity discount in the DCF : o Add the liquidity premium to the discount rate  Constant illiquidity discount (3 to 3.5%)  Firm (or sector) specific illiquidity discount (depending on how exposed is it to illiquidity risk, the smaller the higher in general)  Relative illiquidity discount (liquidity discount usually charged for similar class of assets) Estimating the liquidity discount using multiple methods o Use companies with similar liquidity  Need of a large number of similar firms  Number of transactions available  Underlining characterics available (to isolate the liquidity premium): y Risk profile y Growth

d. Other discounts and premiums

y y y y Cluster premium (competitivity poles) Sector premium/discount (very close to liquidity premium/discount) Social premium (High value added in the long term, seldom included in Fair Value) Climatic discount (limited value, should be included in future CF)

4. Financial performance indicators: an evolution

a. Historical view
y Until mid 1980s: Companies must be profitable (accounting view) o Relevant to a time when main users of financial information were banks and the firm itself Until mid 1990s: Companies must be cost effective (economic view) o Individual shareholders in search of reasonable returns are the main users of financial information Until now: Companies must create value (financial view) o Professional investors, in search of maximum return over a very short period of time

b. Main indicator used

y Accounting: o EBITDA o EBIT o Net profit o Earnings per share (EPS) o Evolution in EPS In terms of return o ROE: Return on Equity o ROCE: Return on capital employed These indicators can be manipulated! o Increasing ROE through debt (leverage effect) o Increase risk of the firm

c. IFRS standards (Accounting information)

y y y y y Comparable accounting conceptual framework Economic rather than legal vision of the firm Appraisal of enterprise assets through impairment tests Focus on the concept of fair value rather than historical value Risk still not taken into account!

d. WACC and Economic Value Added

y y y EVA = Capital Employed * (ROCE WACC) A useful tool as an incentive, a steering tool But still not a pure economic vision! o Activation of certain expenses (R&D, financial leases) o Restatement of exceptional items o 250 restatements are necessary in theory, at least 15 must be made And not an easy to use performance indicator o Can be manipulated (through investment, Working Capital Variations ) o No clear framework of implementation

e. Financial Indicators
y Stock Market Indicators o TSR : Total Shareholder Revenue (actuarial rate of return) = Dividend Paid + Capital Gains o Measuring past performance : Marris Q  Market to Book Ratio : If Q > 1, value is created  Which book value? Historical or reassessed value? o Measuring future performance : WACC  Practical issue: How to determine the WACC?

Theoretical issue: Strong hypotheses and failure to take account of qualitative information How to calculate the rate of profitability demanded by shareholders? o  o The measures the non-diversifiable risk A correct estimation requires a prediction based on current (not past!) market trends, which is difficult Strong assumptions to make the CAPM efficient o Markets are efficient o Investors portfolio is perfectly diversified How to calculate ? o Theoretically: Observe the expected profitability of the portfolio and the market o Practically: Predictions founded on historical performance data supplemented by macroeconomics projections o For this reason, is usually very volatile  The higher the fixed costs, the higher the  The higher the debt, the higher the  The greater the quality of information, the lower the How to calculate the cost of debt? o Observed refinancing rate for the company on markets o o

f. Wrapping up: Indicators

y Problem of the WACC is its circular logic o Value of equity using WACC but needed to compute the WACC o Still the preferred method of valuation Firm corporate communication is taking advantage of the large number of indicators o External indicators preferred over internal ones o They generally do not come with their calculation methods o And can choose indicators of past or future performance depending on what is more favorable for them

5. Financial Strategies
a. Re-centering strategies
y Firm diversification strategies up to the 70 s were based on a risk-reduction logic (smoothen their business cycles using contra cyclical activities) o But diversification failed (Porter study on 1950-1986 diversification attempts) o Conglomerated companies reduced their profitability  Cross-subsidization  Acquisition of targets often costly  Risk not necessarily well diversified

Liquidity became less abundant in the 80 s, initiating a more selective approach to investment for companies o Risk diversification is ultimately a shareholder problem, not a firm problem Firm started to refocus on their core competencies, A set of technologies which allow a business to offer clients a specific advantage (Prahalad and Hamel) o Diversification is relevant only if those core competencies are transferable (Bouygues) o Liberating the potential of growth and value creation o

b. LBO and Financial Leverage

y Double advantages of debt financing o Increasing the level of control enjoyed by the shareholders o Increase the overall profitability of the action  Cost of debt < Cost of equity  Debt is without tax  Reduced WACC as a consequence Conditions of success for an LBO o Cash flows must be substantial and reliable (Should be sufficient to cover the debt repayment at the very least) o Buy-out price of the company must not be excessive (speculation or wrong valuation can distort profitability) o Managers must be involved (in order to set a convergence of interests between managers and shareholders) o Relationships maintained with banking partners must be good enough (interest rates and repayment schedule negotiations) General advantages of reducing the amount of equity engaged o Reduce the level of shareholder involvement necessary for the same economic asset o Use of lever effect o Debt is an adjustment variable that can be used to fill gaps in equity financing o Allows for tax savings o Cost of debt is lower (because reduced risk) Risks of having too much debt o Can increase the level of risk and reduce the profitability (through the Beta) o Can lower the financial rating and increase the cost of debt

6. Distribution policies
a. Theoretical framework
y Signaling Theory o Distribution is costly and is sending a positive signal to the market about the future prospects of the company Disciplining Effect on Managers

Dividend policy can be used to return free cash flows to shareholders rather than making inefficient investments (Jensen s theory of agency, empire-building managers) Maturity of the company o Growing companies will have a low distribution rate (If ROCE > WACC, free cash flows will be invested and not distributed) o Conversely, mature companies will distribute their free cash flows o

b. Practical reasons for dividend policies

y Theoretical framework: Indifference between dividends and capital gains o Preference for liquidity o Existence of transaction costs Analyzing distribution policies o Dividend payout rate (Dividends/Net Income)  Low under 20%, High over 60%  Reduction in transaction costs has encouraged a lower dividend payout rate  Signal Theory : Companies are maintaining a constant dividend payout rate when prospects are not good o Unit dividend trend  Can be reduced if growth in profit is regular  Subject to cyclical variations  Inconsistent distribution policy is sending a bad signal to the market  High and regular dividend is a good way to retain loyalty

c. Share buybacks
y Signal behind share buybacks o Lack of investment opportunities o Stock is currently undervalued o Lesser fiscal cost than dividends o One-shot signal for cyclical firms Perception of those signals o Positive for mature companies with low investment potentials (3% premium) o Negative perception for indebted companies (they should repay their debt rather than increasing their net debt, they are penalizing their rating)

7. Managers/Shareholders: An Agency Relationship

a. Stock Options
y Theoretical advantages o Management become Shareholders (Alignment of interest) o Facilitates recruitment o Builds loyalty

o Liquidity advantage for the firm (deferred pay) o Advantageous fiscal policy o Positive signal sent to the market (The stock value will go up) Drawbacks o Incentive to manipulate stock prices (Information retention) o Dilution effect for shareholders o Stock options considered as charges in IFRS Is it really an incentive? o Not if the SO is bought well under the price, because in the case the option will be in the money even if the real price falls o Solution : Price of the SO above the real price, indexed on performance objectives

b. Other type of incentive: the LMBO

8. Stakeholders and Shareholders

a. Definitions
y Shareholder theory : The one and only SR of business is to use its resources to engage in activities designated to increase its profits so long as it stays within the rules of the game Milton Friedman Stakeholder definitions: o Those groups without whose support the organization would cease to exist Stanford Research Institute o Shareholders, employees, customers, suppliers, lenders and societies o Any group or individual who can affect or is affected by the achievement of the organization s objectives R.Edward Freeman  Any person is a stakeholder!

b. Problems of stakeholder value

y y Lot of different stakeholders, each having their own interests A balance scorecard could be used to assess the impact of the firm on different stakeholders interests, but: o No incentives for managers to implement those o Multiple objectives are not an objective o Ultimately, this contradict the property rights of the shareholders Freeman s separating thesis: ultimately, ethics are not included in profit maximization, and only the law is setting the boundary

c. Why taking stakeholder value into account?

y Forgetting about stakeholder interests in the short run can be disruptive in the long run (Shareholder s myopia)

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Putting too much pressure on a key suppliers/customers can lead to bankruptcy and disrupt the firm s business Ignoring well-being of employees can be costly (lower productivity, higher turn-over) Externalities can have an impact on society as a whole, and backlash on the firm value (Pollution, global warming )

d. How to design an ethical decision model?

y y y Clarify the question o Why is this class of stakeholder important? Determine the question s relevance for the business o Will it have an impact on the long-term owner value? Identify the circumstantial constraints o Laws and regulations o Contractual, cultural, physical and economic consideration Assess the available options o Maximize long-term owner value while respecting ordinary decency and distributive justice Choose the best option