Valuation

Approaches to Valuation
Question: What is the value of firm? Relative Valuation Discounted Cash Flows Contingent Claim Valuation, Real Options

Valuation
Valuation critical in M&As Aids evaluation of acquisition candidates Helps to set goals and benchmarks Framework essential to discipline valuation estimates Comparables (Companies, Transactions) Discounted Cash Flow (Spreadsheet, Formula) Use of multiple methods offers differing perspectives Valuation should be guided by a business economics analysis of the firm and its environment

I. Relative Valuation
Relative Valuation: Use companies (or transactions) comparable in: Size and products Recent trends and future prospects Key ratios calculated for each company Key ratios are averaged for group Average ratios applied to absolute data for company of interest Applying ratios yields indicated market values Valuation judgments are made

Relative Approaches
Advantages of relatives Common sense approach Marketplace transactions are used Widely used in legal cases, fairness evaluation, etc. Allows valuation of private firms Limitations May be difficult to find companies comparable by key criteria Ratios may differ widely for comparables Different ratios may give widely different results

II. DCF Spreadsheet Methodology

Procedure Historical data for elements of financial statements are presented for 5 to 10 years Financial analysis is performed to determine ratios and patters Analysis of business economics of industry Based on analysis, relevant cash flows are forecast Cash flows are then discounted to obtain present values These present values are summed to arrive at an Net Present Value (NPV)

Discounted Cash Flows (DCF)

Determine cash flows of the asset and take discounted by the appropriate discount factor:
n CFt It NPVo t t t 1 (1 k ) t 1 (1 k ) CFt cash flows in period t n

wh ere :

k = cost of capital n = number of periods I t investment outlays in period t

DCF Spreadsheet Methodology

Advantages Spreadsheets allow great flexibility in projections Expresses calculations in recognizable financial statements Disadvantages Projected numbers may create the illusion that they are actual numbers May have a disconnect between business logic and projections Complexity of spreadsheets may obscure important driving factors

III. Contingent Valuation: Real Options Analysis

Critical point: uncertainty Payoffs are contingent on future conditions Equity holders are compensated after debt payments, residual claims Equity can be seen as an option, if the firm covers debt payments then equitys payoff is positive Otherwise, it is zero

III. Contingent Valuation: Real Options Analysis

NPV may not recognize flexibility of postponement, abandoning, etc. Value of flexibility may make some negative NPV project positive Example: Negative NPV project
Postpone $ 50 million investment until Year 2 PV of incremental cash flows = $40 million Cost of capital = 10% $50 $50 NPV $40 $40 2 (1.10) 1.21 $40 $50(0.8264)

40 $41.322 NPV $ 1.322 million

Real Options Analysis

Example: View as a call option

C S N (d1 ) Xe rF T N (d 2) C $1.3 million

Real Option Present Value of Incemental Cash Flows Investment to Create the Option Volatility of Cash Inflows Life of Option Risk-Free Rate of Return Variable S X T rF Call Option Current Stock Price Exercise Price Stock-Price Volatility Life of Option Risk-Free Rate of Return Value $40 million $50 million 20% 2 years 3.70%