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Chapter 1

Introduction to Valuation

© Cambridge Business Publishers 2014 1 Corporate Valuation by Holthausen & Zmijewski


Discussion Topics

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What is Value?
 Explain the different concepts of value
 Economic balance sheet

© Cambridge Business Publishers 2014 3 Corporate Valuation by Holthausen & Zmijewski


What is the “Value of a Company?”
 Alternative terms used when describing the value
of a company are:
 Fair market value
 Market value

 Fair value

 Intrinsic Value

 Fundamental Value

 What do they all mean?

© Cambridge Business Publishers 2014 4 Corporate Valuation by Holthausen & Zmijewski


What Is the “Value of a Company?”
 What do all of the alternative terms that describe
the value of a company mean?
 It depends on the valuation context
 Fair market value – a standard definition
 The cash equivalent value at which a willing and
unrelated buyer would agree to buy and a willing and
unrelated seller would agree to sell the company, when
neither party is compelled to act, and when both
parties have reasonable knowledge of the relevant
available information.
© Cambridge Business Publishers 2014 5 Corporate Valuation by Holthausen & Zmijewski
What is the “Value of a Company?”
 Valuation Context Characteristics
 Arms length
 Timeframe constraints
 Information available
 Specific use
 Types of financing
 Other characteristics include
 Ongoing or going concern value
 Liquidation value (forced versus orderly)
 Breakup value
© Cambridge Business Publishers 2014 6 Corporate Valuation by Holthausen & Zmijewski
What Is the “Value of a Company?”
 Different investors can have different views on
 Best way to use the assets (highest and best use)
 Expectations regarding future prospects

 Riskiness of the future prospects

 Different views result in different valuations


 A reason why many deals occur

© Cambridge Business Publishers 2014 7 Corporate Valuation by Holthausen & Zmijewski


Economic Balance Sheet
 Similar to the balance sheet in a company’s
reported financial statements but all assets and
claims on those assets are
 Valued at market value but not individually, instead
 Value of the company’s operations
 Value of excess assets

 Value created from financing

 The value of assets minus value of non-equity claims is


the residual value or residual interest, which equals the
value of the equity
© Cambridge Business Publishers 2014 8 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 The economic balance sheet equalities:

Value of Resources = Value of Claims on Resources

Value of the Firm = Value of Non-Equity Claims


+ Value of Equity (Residual Interest)

© Cambridge Business Publishers 2014 9 Corporate Valuation by Holthausen & Zmijewski


Economic Balance Sheet
 The economic balance sheet equalities also work
in changes and in dollar returns:

Δ Value Firm = Δ Value Non-Equity Claims


+ Δ Value Equity

$ Return Firm = $ Return Non-Equity Claims


+ $ Return Equity

© Cambridge Business Publishers 2014 10 Corporate Valuation by Holthausen & Zmijewski


Economic Balance Sheet
 Assets or resources include:
 The value of the company’s ongoing business
 This value includes the value of its current operations and
the value of its potential businesses or future growth
opportunities (all adjusted for uncertainty and risk)
 The value of any excess assets
 Excess assets are assets that have value but are not needed
to implement the company’s strategic plan for its business
 A common excess asset is excess cash or marketable
securities
 Another excess asset is excess or over funding of pension
liabilities or land not needed for the business
© Cambridge Business Publishers 2014 11 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 Claims on assets or resources include:
 Direct sources of financing
 Debt
 Preferred stock

 Common stock

 Warrants

 Employee stock options

 Leases

 Indirect sources of financing


 Pension liabilities
 Other post-retirement health benefits
© Cambridge Business Publishers 2014 12 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 Claims on assets in the economic balance sheet
do not include operating liabilities
 An operating liability occurs when a company does
not pay cash for goods and services purchased in the
period provided (accounts payable and accruals)
 We include the effect of operating liabilities in the
value of the firm by deducting changes in operating
liabilities when we measure free cash flow
 We treat operating liabilities in this way because we
cannot measure their implicit interest cost, even
though interest is embedded in the terms of sale
© Cambridge Business Publishers 2014 13 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 The balance sheet that companies report in their
financial statements (accounting balance sheet)
is not an economic balance sheet:
 The accounting balance sheet is prepared based on
accounting rules (Generally Accepted Accounting
Standards, GAAP), not generally market values
 The accounting balance sheet excludes various assets
(such as human capital, internally developed patents)
and various liabilities and contractual obligations
 Shareholders equity is measured using book value
not market value
© Cambridge Business Publishers 2014 14 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 Operations vs. Excess Assets
 The value of a company’s operations depends on the
expected cash flows its operations can generate, which
includes assets in place and growth opportunities
 Companies can also have excess assets, resources that
are not needed for the specific business being valued
 Assets which they could dispose of and have no effect on
the business being valued
 These could be in the form of cash, land, investments, etc.

 Value of a company’s unlevered assets is equal to the


value of the company’s operations and its excess assets
© Cambridge Business Publishers 2014 15 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 Required Cash vs. Excess Cash
 Cash usually refers to cash and other very liquid
assets like marketable securities
 Almost all businesses need some cash to manage
their operations
 This is required cash
 Required cash is like other required working capital
investments (inventory, receivables)
 Companies sometimes retain cash not needed for
their operations, called excess cash
© Cambridge Business Publishers 2014 16 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 The Value of Financing
 In the economic balance sheet, the value of the firm
is equal to the value of the unlevered assets plus the
value of the financing – in other words
VF = VUA + VFIN
 Financing can add value relative to an all equity
financing strategy either because of the tax
benefits of interest or because the company has
been able to issue debt which is subsidized in
some other way
© Cambridge Business Publishers 2014 17 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
 EBS Company
 Common equity is trading at $15 per share
 Has 1 million shares outstanding

 Debt is trading at a discount, 98.

 Excess cash of $2 mil

 Has an investment in an unrelated business that has a


value of $4 mil
 Employee stock options have a value of $1.5 mil

 Creates $1.5 in value from financing

© Cambridge Business Publishers 2014 18 Corporate Valuation by Holthausen & Zmijewski


Economic Balance Sheet
The EBS Company
Income Statement and Balance Sheet
($ in millions) Year -1 Year 0 Year -1 Year 0

Balance Sheet - Assets: Balance Sheet - Liabilities & Equity:


Cash Balance (Required) $ 4.5 $ 6.5 Accounts Payable $ 1.8 $ 2.0
Accounts Receivable 2.0 2.2 Other Current Operating Liabilities 3.6 4.0
Inventory 4.0 4.4 Total Current Liabilities $ 5.4 $ 5.9
Total Current Assets $ 10.5 $ 13.1 Debt 10.0 10.0
Net Property, Plant and Equipment 10.0 11.0 Total Liabilities $ 15.4 $ 15.9
Total Assets $ 20.5 $ 24.1 Common Stock 2.0 2.0
Retained Earnings 3.1 6.2
Income Statement: Total Shareholders Equity $ 5.1 $ 8.2
Revenue $ 26.7 $ 31.8 Total Liabilities and Equities $ 20.5 $ 24.1
Cost of Goods Sold -16.0 -19.1
Gross Margin $ 10.7 $ 12.7
Selling, General & Administrative -3.2 -3.8
Operating Income $ 7.5 $ 8.9
Interest Expense -0.8 -0.8
Income Before Taxes $ 6.7 $ 8.1
Income Tax Expense (37.5%) -2.5 -3.1
Net Income $ 4.1 $ 5.0

Depreciation in Cost of Goods Sold $2.0 $4.0


© Cambridge Business Publishers 2014 19 Corporate Valuation by Holthausen & Zmijewski
Economic Balance Sheet
The EBS Company
Economic Balance Sheet Year 0

Economic Balance Sheet - Resources / Assets:


Value of the Unlevered Business Operations
Without Excess Assets $ 18.8
Value of the Excess Assets 6.0
Value of the Unlevered Firm $24.8
Value Created from Financing 1.5
Value of the Firm $ 26.3

Economic Balance Sheet - Claims on Resources:


Value of Debt $ 9.8
Value of Employee Stock Options 1.5
Value of Equity 15.0
Value of Securities Issued $26.3

© Cambridge Business Publishers 2014 20 Corporate Valuation by Holthausen & Zmijewski


Valuation Principles
 Free cash flow (Chapter 3)
 The discounted cash flow valuation model
(Chapter 5)

© Cambridge Business Publishers 2014 21 Corporate Valuation by Holthausen & Zmijewski


Valuation Principles
 Why does an asset have value?
 Because the investor believes the asset will generate
cash flows in the future
 The value of an asset depends on the
 Magnitude of the cash flows (larger is better)
 Timing of the cash flows (quicker is better) and

 Risk of the cash flows (less risky is better)

© Cambridge Business Publishers 2014 22 Corporate Valuation by Holthausen & Zmijewski


Free Cash Flows
 Unlevered (or Asset) Free Cash Flows
 Cash flows generated by the company after
 Collection of its revenues
 Payment of its expenses, and

 After making its investments, including investments in


working capital
 The cash flows the company would generate if it was
entirely financed with equity
 They are “free” because the company is “free” to
distribute these flows to its investors without
interfering with the execution of its strategy
© Cambridge Business Publishers 2014 23 Corporate Valuation by Holthausen & Zmijewski
Free Cash Flows
FCF = EBIT  TAX + NCX  NCR  RC  NWC  CAPEX (1.1)
 Inputs:
 EBIT – earnings before interest and taxes
 TAX – income taxes paid on EBIT

 NCX – non-cash expenses

 NCR – non-cash revenues

 ΔRC – change in required cash

 ΔNWC – change in net working capital

 CAPEX – capital expenditures

 Measure the free cash flow of the EBS Company


© Cambridge Business Publishers 2014 24 Corporate Valuation by Holthausen & Zmijewski
Free Cash Flows
The EBS Company
Income Statement and Balance Sheet
($ in millions) Year -1 Year 0 Year -1 Year 0

Balance Sheet - Assets: Balance Sheet - Liabilities & Equity:


Cash Balance (Required) $ 4.5 $ 6.5 Accounts Payable $ 1.8 $ 2.0
Accounts Receivable 2.0 2.2 Other Current Operating Liabilities 3.6 4.0
Inventory 4.0 4.4 Total Current Liabilities $ 5.4 $ 5.9
Total Current Assets $ 10.5 $ 13.1 Debt 10.0 10.0
Net Property, Plant and Equipment 10.0 11.0 Total Liabilities $ 15.4 $ 15.9
Total Assets $ 20.5 $ 24.1 Common Stock 2.0 2.0
Retained Earnings 3.1 6.2
Income Statement: Total Shareholders Equity $ 5.1 $ 8.2
Revenue $ 26.7 $ 31.8 Total Liabilities and Equities $ 20.5 $ 24.1
Cost of Goods Sold -16.0 -19.1
Gross Margin $ 10.7 $ 12.7
Selling, General & Administrative -3.2 -3.8
Operating Income $ 7.5 $ 8.9
Interest Expense -0.8 -0.8
Income Before Taxes $ 6.7 $ 8.1
Income Tax Expense (37.5%) -2.5 -3.1
Net Income $ 4.1 $ 5.0

Depreciation in Cost of Goods Sold $2.0 $4.0


© Cambridge Business Publishers 2014 25 Corporate Valuation by Holthausen & Zmijewski
The EBS Company
The EBS Company
Free Cash Flow Forecasts

Earnings Before Interest and Taxes (EBIT) $ 8.9


- Income Taxes Paid on EBIT -3.4
Earnings Before Interest and After Taxes $ 5.5
+ Depreciation 4.0
- Change in Accounts Receivable -0.2
- Change in Inventory -0.4
+ Change in Accounts Payable 0.2
+ Change in Current Other Liabilities 0.4
- Change in Required Cash Balance -2.0
Unlevered Cash Flow from Operations $ 7.5
- Capital Expenditures 5.0
Unlevered Free Cash Flow $ 2.5
© Cambridge Business Publishers 2014 26 Corporate Valuation by Holthausen & Zmijewski
The Discounted Cash Flow (DCF)
Valuation Model
 DCF incorporates the basic valuation principles –
larger cash flows, sooner with less risk – with the
time-value-of money
 V0 = value of the firm at the end of period 0
 FCFt = free cash flow in period t, t = 1, …, ∞

 rUA = unlevered cost of capital

 Assuming a company does not use debt


FCF1 FCF2 FCF FCFt
 t=1 (1+r ) t

VF, 0    ...  
=
(1  rUA ) (1  rUA )
1 2
(1  rUA ) UA

© Cambridge Business Publishers 2014 27 Corporate Valuation by Holthausen & Zmijewski


The Discounted Cash Flow (DCF)
Valuation Model
 To avoid discounting cash flows into perpetuity,
discount them for C years and add the present
value of the continuing value (also called terminal
value or exit value), CVC

FCFt CVF,C
=  t=1
C
VF, 0 t
+ C
(1.2)
(1+rUA ) (1+ rUA )

© Cambridge Business Publishers 2014 28 Corporate Valuation by Holthausen & Zmijewski


The Discounted Cash Flow (DCF)
Valuation Model
 The constant growth perpetuity model:
 The growth rate is constant in perpetuity
 This formula assumes that the growth rate is less than
the discount rate
 If the growth rate is greater than the discount rate, the value
of the perpetuity is infinite
 Discount the free cash flow in period t+1 to measure
the value as of the end of period t
1
CVF,C = FCFC+1 × (1.3)
(rUA  g)
© Cambridge Business Publishers 2014 29 Corporate Valuation by Holthausen & Zmijewski
The Discounted Cash Flow (DCF)
Valuation Model
 We can measure CVC using the constant growth
perpetuity formula

1
CVF,C = FCFC+1 × (1.3)
(rUA  g)

FCFt CVF,C
=  t=1
C
VF, 0 + (1.2)
t
(1+rUA ) (1+ rUA )C

FCFt FCFC+1 1
=  t=1
C
VF, 0 + × (1.4)
(1+rUA ) t (rUA  g) (1+ rUA )C
© Cambridge Business Publishers 2014 30 Corporate Valuation by Holthausen & Zmijewski
The Discounted Cash Flow (DCF)
Valuation Model
 Assume the free cash flows of an investment, with
a 13% discount rate, are $100 in Year 1, $120 in
Year 2, $150 in Year 3, and will grow at 3% in
perpetuity after Year 3
 The value of this investment, which we can
calculate two ways, is
$100 $120 $150 $150  1.03 1
VF, 0       $1,357.19
1 2
(1.13) (1.13) (1.13) 3
(.13  .03) (1.13) 3

$100 $120 $150 1


VF, 0      $1,357.19
(1.13) (1.13) (.13  .03) (1.13)
1 2 2

© Cambridge Business Publishers 2014 31 Corporate Valuation by Holthausen & Zmijewski


The Discounted Cash Flow (DCF)
Valuation Model
 Here is a common spreadsheet format of the
previous example
Cost of Capital 13.0%
Growth Rate for Free Cash Flow for Continuing Value 3.0%

CVFirm
$ in millions Year 0 Year 1 Year 2 Year 3 Year 3
Unlevered Free Cash Flow for Continuing Value (CV) $ 154.50
Discount Factor for Continuing Value 10.000
Unlevered Free Cash Flow and CV $ 100.00 $ 120.00 $ 150.00 $ 1,545.00
Discount Factor 0.885 0.783 0.693 0.693
Present Value $ 88.50 $ 93.98 $ 103.96 $ 1,070.76
Value of the Firm $ 1,357.19

FCFg = 20.0% 25.0% 3.0%

© Cambridge Business Publishers 2014 32 Corporate Valuation by Holthausen & Zmijewski


Measuring Value
 Weighted average cost of capital and adjusted
present value valuations (Chapters 5 – 12)
 Market multiple valuations (Chapters 13 – 14)
 Leveraged buyout analysis (Chapter 15)
 Measuring the value of equity (Chapter 5)

© Cambridge Business Publishers 2014 33 Corporate Valuation by Holthausen & Zmijewski


Weighted Average Cost of Capital and
Adjusted Present Value Valuations
 A survey of large corporations and financial advisors
documented that most companies and all financial
advisors use the DCF valuation method and most use
alternative valuation methods as well
 So far, the DCF equation assume only equity financing
 Once we add debt financing to a company’s capital
structure, the DCF valuation framework has different
forms

© Cambridge Business Publishers 2014 34 Corporate Valuation by Holthausen & Zmijewski


Weighted Average Cost of Capital and
Adjusted Present Value Valuations
 The DCF methods that measure the value of the
firm are
 Weighted average cost of capital method (WACC
method)
 Sometimes called the adjusted cost of capital method
 Adjusted present value method (APV method)

© Cambridge Business Publishers 2014 35 Corporate Valuation by Holthausen & Zmijewski


Weighted Average Cost of Capital and
Adjusted Present Value Valuations
Value of the Firm = Value of the Unlevered Firm
+ Value Created from
Financing
VF, t = VUA, t + VFIN, t
 WACC method – incorporates the value created
from financing by adjusting the discount rate
 APV method – incorporates the value created
from financing by discounting incremental cash
flow created by financing (e.g., interest tax shields)
© Cambridge Business Publishers 2014 36 Corporate Valuation by Holthausen & Zmijewski
Weighted Average Cost of Capital and
Adjusted Present Value Valuations
 WACC method
 Typically used when the company will finance
itself using a constant target capital structure
(constant proportionate capital structure
defined in terms of market values)
 Difficult to implement if capital structure is
changing – must know the capital structure
ratios for all future periods in terms of market
values
© Cambridge Business Publishers 2014 37 Corporate Valuation by Holthausen & Zmijewski
Weighted Average Cost of Capital and
Adjusted Present Value Valuations
 APV method
 Assumes we know the incremental cash flows
created by financing (e.g., interest tax shields)
for every future period
 Typically used when we forecast specific levels
of debt from which we can measure the tax
savings from interest

© Cambridge Business Publishers 2014 38 Corporate Valuation by Holthausen & Zmijewski


Weighted Average Cost of Capital and
Adjusted Present Value Valuations
 An alternative but equivalent DCF valuation
method is the excess earnings method
 The most common form is the residual earnings
 Stern Stewart’s EVA® is based on this approach.

 In this approach, instead of discounting free cash


flows, we discount excess or residual earnings
 Excess earnings are the difference between required and
forecasted earnings
 Required earnings are equal to the cost of capital
multiplied by the beginning balance of invested capital
© Cambridge Business Publishers 2014 39 Corporate Valuation by Holthausen & Zmijewski
Market Multiple Valuation Methods
 Two standard market multiple valuation methods are
 Using multiples from publicly traded comparable companies
 Using multiples from comparable transactions
 Simplistic description of the process
 Measure a market multiple – the relation between value and
usually an earnings-based or cash flow-based denominator (such
as EBITDA) for comparable companies with known values of
the numerator and denominator
 Measure the value of the company you want to value – multiply
the company’s measure of the chosen denominator by the
market multiple of the comparable companies (comps)
Valuecompany = Denominatorcompany x Market Multiplecomps
© Cambridge Business Publishers 2014 40 Corporate Valuation by Holthausen & Zmijewski
Market Multiple Valuation Methods

Value = Earnings X Earnings Multiple


(company being valued) (from Peer Companies)

$2.5 bil = $200 mil X 12.5

© Cambridge Business Publishers 2014 41 Corporate Valuation by Holthausen & Zmijewski


Market Multiple Valuation Methods

 How can this work? Think “twin” company


 AXP Co. is publicly traded, $500 value, all equity
 Future FCFs = $10, 16, 26, 40, 70, 100, 120, 130, then
g=2%
 EXP Co. has an unknown value
 Future FCFs = $5, 8, 13, 20, 35, 50, 60, 65, then g=2%
 EXP Co. has exactly the same risk as AXP Co.

 What is the value of EXP Co.?

© Cambridge Business Publishers 2014 42 Corporate Valuation by Holthausen & Zmijewski


Market Multiple Valuation Methods
 Enterprise value-based (EV = firm value minus cash) market
multiples
 EV/Free Cash Flow
 EV/Unlevered Earnings
 EV/EBIT (earnings before interest and taxes)
 EV/EBITDA (earnings before interest, taxes, depreciation and
amortization)
 EV / Revenue
 EV/Total Invested Capital
 Equity value or stock price (P)-based market multiples
 P/Equity FCF per share
 P/EPS
 P/BVE per share (book value equity)
 P/Revenue per share
© Cambridge Business Publishers 2014 43 Corporate Valuation by Holthausen & Zmijewski
Market Multiple Valuation Methods
 Used to value a company or its equity as well as measure
continuing or terminal values
 Although the arithmetic is simplistic, market multiple
valuation is complex
 Identifying comparable companies
 Choice of value driver
 Measuring the value driver that represents the long run
performance of the companies (adjusting financial statements)
 The same survey on valuation methods documented that
all financial advisors use market multiple valuation
methods based on comparable companies & transactions
© Cambridge Business Publishers 2014 44 Corporate Valuation by Holthausen & Zmijewski
Leveraged Buyout Analysis
 Involves buying a company and taking it private using a
substantial amount of financial leverage, for example
 Take a public company private (buy back publicly traded shares)
 Buy a private company or division of a company from owners
 Also used to assess an offer in an acquisition – what
would the company sell for as an LBO?
 Key factors to consider
 Cash flows – magnitude, timing and ability to service debt
 Excess assets or non-core business assets that can be sold
 Calculate IRRs to various investors
 Credit market conditions affect viability of LBOs
© Cambridge Business Publishers 2014 45 Corporate Valuation by Holthausen & Zmijewski
Measuring the Value of Equity
 Value of the common equity is equal to the value of the
firm minus the value of non-common equity securities
 Non-common equity securities include debt, preferred
stock, options, warrants, off-balance sheet liabilities
 Includes all non-common equity securities we would include on
the economic balance sheet
 Do not subtract operating liabilities because the value of the
firm is measured net of operating liabilities (includes working
capital)
 Can measure the value of equity directly
 Discount equity free cash flows (equity DCF method)
 Market multiples such the P/E multiple
© Cambridge Business Publishers 2014 46 Corporate Valuation by Holthausen & Zmijewski
Real Options in Valuation
 An option provides the investor the right (but not an
obligation) to buy or sell the underlying security at a set
price
 The option is a derivative security because its value
depends in part on the value of another asset.
 Two basic options – call and put options
 A call option is an option to purchase an underlying security at a
certain price for a specified period.
 A put option is an option to sell the underlying security at a
certain price for a specified period

© Cambridge Business Publishers 2014 47 Corporate Valuation by Holthausen & Zmijewski


Real Options in Valuation
 Real options exist when an investment contains an embedded
option if it can be changed during its life as an investor learns more
about it
 For example, if an investment can be deferred, contracted, expanded, or
abandoned before completion
 Common settings include
 Research and development valuations
 Patent valuations and
 Natural resource investments
 Discounted cash flow approaches cannot always capture all of the
value derived from the embedded options
 An option-pricing framework can be more appropriate if the
necessary information is available to utilize this approach
© Cambridge Business Publishers 2014 48 Corporate Valuation by Holthausen & Zmijewski
How Are Valuations Used?
 Control transactions such as mergers and
acquisitions (Chapter 16)
 Asset and financial restructuring
 Strategic analysis
 Fundamental analysis for portfolio selection

© Cambridge Business Publishers 2014 49 Corporate Valuation by Holthausen & Zmijewski


Transactions
 Merger and acquisition transactions
 What is the maximum value to the acquirer?
 What is the maximum value to other bidders?

 Assuming market prices are approximately


correct, what changes in performance
(improvements and synergies) are needed in
expected cash flows to justify the premium?
 Leveraged buy-out transactions
© Cambridge Business Publishers 2014 50 Corporate Valuation by Holthausen & Zmijewski
Transactions
 Going public
 IPO for privately held corporation
 IPO of a subsidiary

 Privatization of government entity

 Financial advisor fairness opinions for


transactions
 Provide confirmation of value in a M&A transaction
for the board of directors
 Key issue is legal liability (Van Gorkom case)

© Cambridge Business Publishers 2014 51 Corporate Valuation by Holthausen & Zmijewski


Asset and Financial Restructuring
 Asset restructuring
 Asset sales (selling off assets)
 Divestitures (selling off a division or unit)
 Corporate downsizing
 Spinoffs (distribute shares of a subsidiary to existing shareholders on a pro-
rata basis)
 Subsidiary IPO
 Liquidations (extreme form of sell-off)
 Financial restructuring
 Debt recapitalization (refinancing and paying out a one time dividend or
repurchasing stock with the proceeds)
 Default workouts
 Leveraged buyout

© Cambridge Business Publishers 2014 52 Corporate Valuation by Holthausen & Zmijewski


Strategic Analysis
(Value-Based Management)
 Understand the effect of alternative strategies on value
 The DCF model can help quantify the abstract and
qualitative strategic concepts – strategic fit, competitive
advantage, market power
 Three overarching questions:
 How does (or did) the strategic action affect the magnitude of
the free cash flows?
 How does (or did) the strategic action affect the timing of the
free cash flows?
 How does (or did) the strategic action affect the underlying risk
of the cash flows?
© Cambridge Business Publishers 2014 53 Corporate Valuation by Holthausen & Zmijewski
Other Uses of Valuation Models

 Raising capital (debt, VC, private equity…)


 Contracts between company, employees &
investors
 Legal and regulatory uses
 Estate Valuation (death and divorce)

© Cambridge Business Publishers 2014 54 Corporate Valuation by Holthausen & Zmijewski


Fundamental Analysis for Portfolio Selection

 Identify over and undervalued stocks?


 Do such stocks exist?
 Will valuations identify such stocks if they do
exist?
 Do you have superior ability/information relative
to the market?
 Will the market ultimately recognize your view and
re-price the security appropriately?
© Cambridge Business Publishers 2014 55 Corporate Valuation by Holthausen & Zmijewski
Facebook Inc.
$500

Value of Facebook Free Cash Flows (May 2012)


- Market Capitalization = $81.3 Bil; Price = $38
$400 - 2011 FCF = $470 mil
- Discount rate = 10%
- Perpetual growth rate beginning in 2032 = 3%
- Required annual growth rate for 20 years = ???%
$300

What does Facebook need to achieve


to justify its value in May 2012?
$200

What happened to its value?


$100

$0
2007

2008

2009

2010

2011
-$100
Facebook Free Cash Flows in $ millions

© Cambridge Business Publishers 2014 56 Corporate Valuation by Holthausen & Zmijewski


Facebook Inc.
$23,000
Value of Facebook Free Cash Flows (May 2012)
- Market Capitalization = $81.3 Bil; Price = $38
$20,000 - 2011 FCF = $470 mil
- Discount rate = 10%
- Perpetual growth rate beginning in 2032 = 3%
$17,000 - Required annual growth rate for 20 years = 21.5%

$14,000 What does Facebook need to achieve


to justify its value in May 2012?
$11,000

What happened to its value?


$8,000

Facebook Free Cash Flows in $ millions


$5,000

$2,000

-$1,000
2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032
© Cambridge Business Publishers 2014 57 Corporate Valuation by Holthausen & Zmijewski
Facebook Inc.
$25,000

Value of Facebook Free Cash Flows (May 2012):


- Market Capitalization = $81.3 Bil; Price = $38
- 2011 FCF = $470 mil
$20,000
- Discount rate = 10%
- Perpetual growth rate beginning in 2032 = 3%
- Required annual growth rate for 20 years = 21.5%

$15,000 Value of Facebook Free Cash Flows (August 2012):


- Market Capitalization = $41.7 Bil; Price = $19
- 2011 FCF = $470 mil
- Discount rate = 10%
- Perpetual growth rate beginning in 2032 = 3%
$10,000 - Required annual growth rate for 20 years = 16.6%

$5,000

Facebook Free Cash Flows

$0
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032

© Cambridge Business Publishers 2014 58 Corporate Valuation by Holthausen & Zmijewski


Steps in the Valuation Process
 Identify competitors and comparable
companies (Chapter 2)
 Analyze historical performance (Chapter 2)
 Forecast future performance (Chapters 3 – 4)
 Use several alternative valuation methods to
measure value (Chapters 5 – 15)

© Cambridge Business Publishers 2014 59 Corporate Valuation by Holthausen & Zmijewski


Steps in the Valuation Process

 Valuing a company requires judgment, but


 Judgment is informed judgment – based on conceptual
frameworks, empirical knowledge, and data
 The valuation is systematic and structured

 When practicable, examine the valuation through


different lenses
 Use more than one valuation method
 Test the reasonableness of the models

© Cambridge Business Publishers 2014 60 Corporate Valuation by Holthausen & Zmijewski


Steps in the Valuation Process

© Cambridge Business Publishers 2014 61 Corporate Valuation by Holthausen & Zmijewski


Step 1 – Identify Competitors and Comps

 Identify the company’s lines of business and


geographic regions served
 Identify a set of competitor companies covering
all lines of business and geographic areas
 Assess the strategies of the company being valued
and the competition
 Collect financial statement and market data for the
company and comparable firms

© Cambridge Business Publishers 2014 62 Corporate Valuation by Holthausen & Zmijewski


Step 2 – Analyze Strategy, Performance, in
the Context of the Competition
 Develop an understanding of the company’s operations,
asset structure and financing structure over time and
relative to competition.
 Assess strategies and competitive advantages of the
company and its competition; are assessments of strategy
and competitive advantage apparent in the data?
 Assess which companies are most comparable to our firm
for assessing discount rates, growth prospects, margins,
and price multiples
 Identify key factors to use for forecasting financial
statements – what are the value drivers?
© Cambridge Business Publishers 2014 63 Corporate Valuation by Holthausen & Zmijewski
Step 3 – Value the Firm and Equity Using a
DCF Valuation Model
 Identify which DCF model to use to value the firm
 WACC valuation method – constant capital structure ratios
 APV valuation method – forecasts of debt levels
 Develop a financial model to forecast free cash flows
 Measure the necessary costs of capital
 Use the chosen DCF valuation method to measure the value of the
firm
 Adjust valuation for excess assets and possible optionality
 Value the equity
 Measure the value of the equity by subtracting the value of non-common
equity claims from the value of the firm
 Equity DCF valuation method – this method is often difficult to implement
 Consider using the excess flow (residual earnings) model

© Cambridge Business Publishers 2014 64 Corporate Valuation by Holthausen & Zmijewski


Step 3a – Develop a Financial Model
 Decide what to forecast (financial statements, free cash flows, and
supporting schedules) and over what horizon
 Identify the forecast drivers and forecast revenues and capacity
requirements
 Identify forecast drivers and forecast operating expenses and
balance sheet operating assets and liabilities; create the basic
structure of model ignoring capital structure
 Stress test the model’s ability to handle alternative forecasts
 Analyze the reasonableness of the forecasts
 If needed for the valuation, forecast capital structure based on the
capital structure strategy
 Stress test the model’s ability to handle alternative operating and
financing assumptions

© Cambridge Business Publishers 2014 65 Corporate Valuation by Holthausen & Zmijewski


Step 3b – Estimate Costs of Capital

 Estimate cost of capital for


 Debt
 Preferred stock
 Other financing (direct and indirect)
 Equity
 Unlevered
 Weighted average cost of capital as needed

© Cambridge Business Publishers 2014 66 Corporate Valuation by Holthausen & Zmijewski


Step 4 – Market Multiple Valuation

 Decide what you will value and at what point in


time
 Firm or equity or both
 Valuation date or continuing value date or both
 Use the market multiple valuation method
 Comparable companies
 Comparable transactions
 Select comparable companies and measure market
multiples
 Apply comparable company market multiples to
the company being valued
© Cambridge Business Publishers 2014 67 Corporate Valuation by Holthausen & Zmijewski
Step 5 – Consider Other Valuation Methods

 Leveraged buy-out transaction


 Breakup value

 Liquidation value (not used for going


concerns)

© Cambridge Business Publishers 2014 68 Corporate Valuation by Holthausen & Zmijewski


What We Covered

© Cambridge Business Publishers 2014 69 Corporate Valuation by Holthausen & Zmijewski


Key Concepts and Takeaways - 1
 What is the value of a company?
 Economic balance sheet, which includes all
resources and claims on resources even if they are
not on the accounting balance sheet
 Firm value =
 Value from operations (unlevered)
 Value from excess assets (unlevered)
 Value from financing (interest tax shields)
 Cash flow is king!
 Free cash flow – more (magnitude), now (timing), for
sure (risk)
© Cambridge Business Publishers 2014 70 Corporate Valuation by Holthausen & Zmijewski
Key Concepts and Takeaways - 2
 Free cash flows - a key value driver
FCF = EBIT  TAX + NCX  NCR  RC  NWC  CAPEX (1.1)

 DCF valuation models are a primary valuation method


FCFt FCFC+1 1
=  t=1
C
VF, 0 + × (1.4)
(1+rUA ) (rUA  g) (1+ rUA )C
t

 Details on DCF valuation model


 Weighted average cost of capital
 Adjusted present value
 Equity DCF
 Excess flows or residual earnings
© Cambridge Business Publishers 2014 71 Corporate Valuation by Holthausen & Zmijewski
Key Concepts and Takeaways - 3
 Market multiple valuation is usually a better
complement than substitute for DCF valuation
model
 Very simple conceptually yet very complex to
implement
 Need to find that “twin” or set of “twins”
 Leveraged buyout analysis is an alternative way to
value a company
 Breakup valuation and liquidations are alternatives
 Optionality is real and can be valuable
© Cambridge Business Publishers 2014 72 Corporate Valuation by Holthausen & Zmijewski
Key Concepts and Takeaways - 4
 The valuation process is not random
 Valuing a company requires informed judgment
 Based on conceptual frameworks, empirical
knowledge, and data
 The valuation process is systematic and structured

 When practicable, examine the valuation through


different lenses

© Cambridge Business Publishers 2014 73 Corporate Valuation by Holthausen & Zmijewski


***END***
Chapter 1
Introduction to Valuation

© Cambridge Business Publishers 2014 74 Corporate Valuation by Holthausen & Zmijewski