CHAPTER TWO
CORPORATE VALUATION
2.1. Describe the meaning of Corporate Valuation
Valuation is a process of appraisal or determination of the value of certain assets, i.e., tangible or
intangible, securities, liabilities and a specific business as a going concern or any company listed or
unlisted or other forms of organization, partnership or proprietorship. ‘Value’ is a term signifying the
material or monetary worth of a thing, which can be estimated in terms of medium of exchange. In other
words, it is an assessment resulting in an expression of opinion rather than arithmetical exactness.
Business valuation requires a working knowledge of a variety of factors, and professional judgment and
experience. This includes recognizing the purpose of the valuation, the value drivers impacting the
subject company, and an understanding of industry, competitive and economic factors, as well as the
selection and application of the appropriate valuation approaches and method(s).
Recently, valuation has become a source of political and economic debates in the wake of privatization of
state-owned enterprises. Many owners and managers often ask,” How much is our business worth? And
how much is theirs?” Due to increasing sophistication in business and changing economic and social
environment of business, professional valuers face questions like.
Corporate valuation is a process and a set of procedures used to estimate the economic value of an
owner's interest in a business. Valuation is used by financial market participants to determine the price
they are willing to pay or receive to perfect the sale of a business. An accurate valuation of a closely held
business is an essential tool for a business owner to assess both opportunities and opportunity costs as
they plan for future growth and eventual transition.
When valuing a company as a going concern, there are three main valuation methods used by industry
practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions. The
purpose of a valuation is to track the effectiveness of your strategic decision-making process and provide
the ability to track performance in terms of estimated change in value, not just in revenue.
These are the most common methods of valuation used in investment banking, equity research, private
equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas
of finance.
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A. DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the
business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted
Average Cost of Capital (WACC). A DCF analysis is performed by building a financial model in Excel
and requires an extensive amount of detail and analysis. It is the most detailed of the three approaches
and requires the most estimates and assumptions. However, the effort required for preparing a DCF
model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast
value based on different scenarios and even perform a sensitivity analysis.
Steps in the DCF Analysis
1. Project unlevered FCFs (UFCFs)
2. Choose a discount rate.
3. Calculate the TV.
4. Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present
value.
5. Calculate the equity value by subtracting net debt from EV.
6. Review the results.
1. Free Cash flow (FCF): Free cash flow (FCF) is the cash flow generated by a firm's operations
that is available to pay its financial obligations to those that have provided its funding. These
include its equity shareholders and its lenders. Free cash flow (FCF) is the cash a company
generates after taking into consideration cash outflows that support its operations and maintain its
capital assets. In other words, free cash flow is the cash left over after a company pays for its
operating expenses and capital expenditures (CapEx).
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2. Terminal Value: Terminal value (TV) is the value of an asset, business, or project beyond the
forecasted period when future cash flows can be estimated. Terminal value assumes a business
will grow at a set growth rate forever after the forecast period. Terminal value plays a crucial role
in discounted cash flow (DCF) analysis. A key principle of the DCF method is to discount a
businesses’ future cash flows to arrive at its enterprise value.
Methods To Calculate Terminal Value
a. Growing Perpetuity
The company will grow at a low consistent rate during the steady state period. One of the elements of
this analysis is the Weighted Average Cost of Capital (WACC), which calculates the cost of capital based
on their proportionate weights (e.g., 60% equity, 40% debt.) Here is the formula to calculate the terminal
value using the growing perpetuity approach:
Terminal Value (TVn) = Free Cash Flow (FCF)n * (1+g)/(w-g)
• Were,
• TV = Terminal value
n
• FCF = Free cash flows in the final year of forecasting
n
• w = Weighted Average Cost of Capital (WACC)
• g = Growth rate in perpetuity
• Let us understand this with an example:
• Using the formula above, you get the following:
b. EV Multiple
In this method, you take the company’s EBIT or EBITDA in the final year of the forecast period (year
6 or 11) and multiply that by a comparable company’s Enterprise Value (EV) to EBITDA multiple.
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The EV/EBITDA is a useful ratio for comparing companies within a sector or peer group. The
formula used in this approach is:
Terminal Value (TVn) = LTM EBITDAn * Multiple
• Were
• TV = Terminal value
n
• LTM EBITDA = Last 12 months EBITDA until year 5
n
Multiple = Based on EV/EBITDA ratio from a company (within the same industry) that has
reached a steady state.
Let us understand this with another example. Suppose the business has an LTM EBITDA
n of
500,000. And using data from comparable companies, assume you get an EV/EBITDA multiple
of 9.0x.
Example of DCF Analysis
Normailsed input Data 2012
EBIT growth rate for 1-5 Years 10%
EBIT growth rate for 6-10 Years 8%
Taxes as a % of EBIT 23%
Deprecati on as a % of EBIT 8%
Capital Expenditure as a % of EBIT 7%
Working Capital Change as a % of EBIT 10%
Terminal Growth Rate: 2%
Discount rate (WACC): 12%
Net Debit Levels (Long term Borrowing-cash309.81
Current Market Price of Shares (Rs.) 1246
No of Outstanding Shares (in Corores) 13.60
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Operating Assumptions 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
EBIT Growth Rate% 10% 10% 10% 10% 10% 8% 8% 8% 8% 8%
Taxes as a % of EBIT 23% 23% 23% 23% 23% 23% 23% 23% 23% 23%
Deprecation as a % of EBIT 8% 8% 8% 8% 8% 8% 8% 8% 8% 8%
Capital Expenditure as a % of EBIT 7% 7% 7% 7% 7% 7% 7% 7% 7% 7%
Working Capital Change as a % of EBIT 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
FCFF Calculation Last Year First Stage of valuation Second Stage of Valuation
2012 (A) 2013 (E) 2014 (E) 2015 (E) 2016 (E) 2017 (E) 2018 (E) 2019 (E) 2020 (E) 2021 (E) 2022 (E)
EBIT (Operating income) 579 637 701 771 848 932 1,007 1,088 1,175 1,269 1,370
Less: Taxes 142 146 161 177 195 214 232 250 270 292 315
Add: Depreciation $ Amoritazation 39 51 56 62 68 75 81 87 94 101 110
Less: Capital Expenditure 102 45 49 54 59 65 70 76 82 89 96
Less: WOrking Capital Change 94 64 70 77 85 93 101 109 117 127 137
Terminal value of FCF
Free Cash Flow Avaliable for Firm 280 433 476 524 576 634 685 740 799 863 932 950
DCF Valuation 2012 (A) 2013 (E) 2014 (E) 2015 (E) 2016 (E) 2017 (E) 2018 (E) 2019 (E) 2020 (E) 2021 (E) 2022 (E)
WACC (%) 12%
Year form the date of Valuations 1 2 3 4 5 6 7 8 9 10
Discount Factor 1.12 1.25 1.40 1.57 1.76 1.97 2.21 2.48 2.77 3.11
Present Value of Free cash Flow 386.69 379.78 373.00 366.34 359.80 346.95 334.56 322.61 311.09 299.98
Present Value of 1-10 Year free cash flow 3,480.80
Present Value of Terminal Cash flow 2,951.55
Total present value of Free cash flow 6,432.35
Net Debt Level 309.81
Value of Equity 6,742.16
No of Shares Outstanding (in crores) 13.60
Value of Equity per share (Rs) 495.75
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B. Comparable Analysis (“Comps”)
Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity
comps” or “public market multiples”) is a relative valuation method in which you compare the current
value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or
other ratios. Multiples of EBITDA are the most common valuation method.
The “comps” valuation method provides an observable value for the business, based on what other
comparable companies are currently worth. Comps are the most widely used approach, as they are easy
to calculate and always current. The logic follows that if company X trades at a 10-times P/E ratio, and
company Y has earnings of $2.50 per share, company Y’s stock must be worth $25.00 per share
(assuming the companies have similar attributes).
c. Precedent Transaction Analysis
Precedent transaction analysis is a method of company valuation where past M&A transactions are used
to value a comparable business today. Commonly referred to as “precedents,” this method of valuation is
common when trying to value an entire business as part of a merger/acquisition and is commonly
prepared by analysts working in investment banking, private equity, and corporate development.
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2.2. Identify Methods to Compute Enterprise Value (EV)
Enterprise Value means the value of the company’s CORE BUSINESS OPERATIONS (Net Operating
Assets, or Operating Assets – Operating Liabilities), but to ALL INVESTORS (Equity, Debt, Preferred,
and possibly others). Enterprise value (EV) is a financial matrix reflecting the market value of the entire
business after taking into account both holders of debt and equity. EV, also called firm value or total
enterprise value (TEV), tells us how much a business is worth.
Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive
alternative to equity market capitalization. Enterprise value includes in its calculation the market
capitalization of a company but also short-term and long-term debt as well as any cash on the company's
balance sheet. It represents the true cost/fair value of acquiring the company which includes the value of
debt and equity. The key concept in corporate valuation is enterprise value.
The enterprise value (EV) of the firm is the value of the firm’s core business activities and forms of the
basis of most corporate valuation models. We distinguish between approaches to computing the
enterprise value:
a. The accounting approach: Although most academics sneer at this approach, it is often a useful
starting point for thinking about the enterprise value.
b. The efficient markets approach: An obvious revaluation is to replace the firm ’s book value of
equity with the market value of the equity. To the extent that we know the market value of other
firm liabilities— debt, pension obligations, etc.—this market value will also replace the book
values.
c. The discounted cash flow (DCF) approach values to EV as the present value of the firm ’s
future anticipated free cash flows (FCFs) discounted at the weighted average cost of capital
(WACC). The FCFs can best be thought of as the cash flows produced by the firm’s productive
assets—its working capital, fixed assets, goodwill, etc.
a. Using Accounting Book Values to Value a Company: The Firm’s Accounting Enterprise
Value
In Accounting, book value is the value of an asset in accordance with its balance sheet account balance,
while we would rarely use accounting numbers to value a company, the balance sheet of a company is a
useful starting framework for the valuation process. Enterprise value is determining by adding a
corporation's market capitalization, preferred stock, and outstanding debt together and then subtracting
the cash and cash equivalents found on the balance sheet. As a starting point, consider the balance sheet
for XYZ Corp.
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We rewrite this balance sheet:
We separate the operational versus financial items in short-term assets and short-term liabilities. We
move the operational current assets to the left side of the balance sheet. We move all the debt (short-term
debt, current portion of long-term debt, and long-term) into one debt item.
In the next step we subtract liquid assets (cash and marketable securities) from financial debts, to get the
firm’s net financial debt. When we finish this step, we have all of the firm’s productive assets on the left
side of the balance sheet and all of its financing on the right side.
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The left-hand side of the resulting balance sheet is the firm’s enterprise value, defined as the value of the
firm’s operational assets: These are the assets that provide the cash flows for the firm’s actual business
activities:
Example 2
b. Compute Corporate Valuations by using Efficient Market Approach.
The efficient markets hypothesis (EMH) argues that markets are efficient, leaving no room to make
excess profits by investing since everything is already fairly and accurately priced. This implies that there
is little hope of the market, although you can match market returns through passive index investing.
Market efficiency refers to how well current prices reflect all available, relevant information about the
actual value of the underlying assets. A truly efficient market eliminates the possibility of beating the
market, because any information available to any trader is already incorporated into the market price.
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To get to the enterprise value balance sheet for Caterpillar, we move financial items from the left side of
the balance sheet to the right, and we move operating current liabilities from the right side of the balance
sheet to the left. Notice that we netted out liquid assets (cash and marketable securities) from the financial
debts of the company. The assumption is that these assets are not needed for the core business activities of
Caterpillar. The book value of Caterpillar’ s enterprise value is $59,476,000:
The Caterpillar example above assumes that the book value is a correct valuation of the company. But a
simple calculation shows how problematic this is: At the end of 2011 Caterpillar had 624.72 million
shares outstanding, and the market price per share was $90.60. This suggests that the Caterpillar’ s
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enterprise value is $102.720 billion—a far cry from the book value of the enterprise value of $59.476
billion.
The efficient markets approach to the valuation of Caterpillar’s equity and financial liabilities assumes
that the market value of a company’s shares or debt is simply the market value at the time of valuation.
This approach is better than the accounting approach of the previous section and much simpler than the
DCF valuations. Moreover, it has the power of logic and much academic research behind it. If markets
work—in the sense that there are many participants trading the corporate securities, that there is a lot of
information about the company in question, and that the valuator has no special information—why not
accept the market price as the true value of the company?
Applying the efficient markets approach to the Caterpillar Enterprise Value Balance sheet gives
102,719,878 for the right-hand side of the enterprise value balance sheet. This means, of course, that we
have to revalue the left-hand side of the balance sheet. One approach to bringing this enterprise value
balance sheet into balance is to assume that the networking capital’s book value is a reasonable
approximation to its market value. We can then recompute the market value of the firm’s long-term
assets to bring the balance sheet into balance.
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C. Compute Enterprise Value (EV) as the present value of the Free Cash Flow: DCF “Top
Down” Valuation.
In this section we concentrate on the left-hand side of the enterprise value balance sheet. The discounted
cash flow (DCF) method focuses on two central concepts: The firm’s free cash flows (FCFs) are defined
as the cash created by the firm’s operating activities. The firm’s weighted average cost of capital
(WACC) is the risk-adjusted discount rate appropriate to the risk of the FCFs.
The difference between the two DCF approaches is in the derivation of the future FCFs. In this chapter
we examine the firm’s consolidated statement of cash flows (CSCFs) and use it as a basis for estimating
the future FCFs. We then discuss issues related to estimating the short-term growth rate (8% above), the
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long-term growth rate (5%), how to compute the weighted average cost of capital (WACC) (11% above).
We focus on a number of important technical issues:
Defining the Free Cash Flow (FCF)
The free cash flow (FCF) is a measure of how much cash is produced by the firm’s operations. There are
two accepted definitions of the FCF (both of which, of course, ultimately boil down to the same thing).
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2.3. Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
The consolidated statement of cash flows is part of every financial statement. It is the accountant’ s
explanation of how much cash was generated by the business, and how this cash was generated. The
consolidated statement of cash flows (CSCF) is composed of three sections: Operating cash flows,
investment cash flows, and financing cash flows.
a. CSCF, Section 1: Operating Cash Flows
The operating cash flows adjust the firm’s net income for non-cash deductions to the income and for
changes in the firm’s operating net working capital. Because modern accounting statements include
many non-cash items, translating the firm’s accounts to a cash basis necessitates many adjustments. A
classic adjustment is to add back depreciation to the firm’s income: Since depreciation is a non-cash
charge on the firm’s income, it must be added back when making the adjustment for cash. But
depreciation is just the tip of the non-cash iceberg:
b. SCF, Section 2: Investment Cash Flows
These investments include both investments in securities and investments in operating assets of the firm.
Investment in securities can refer to the sale or the purchase of securities held by the firm. Investment in
securities is not part of the firm’s free cash flows, which are intended to measure solely cash flows related
to the firm’s core business activities. Investments in fixed assets are usually related to the firm’s FCFs.
For purposes of computing the firm’s free cash flows, we need to distinguish between financial
investment cash flows (not part of the FCF) and investment in assets used to produce the firm’s business
income (part of the FCF).
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c. CSCF, Section 3: Financing Cash Flows: The last section of the CSCF deals with changes in
the firm’s financing for FCF purposes, we can ignore this section.
To turn these CSCF into free cash flows:
We keep all the items under operating activities. In the section for Investing Activities, we delete items
that are not related to operations. For example, we would delete “short-term investments, net” under
Investing Activities—these represent the purchase and sale of financial assets. We completely ignore the
cash flows under Financing Activities We add back after-tax net interest to the sum of the remaining
items to neutralize the subtraction of interest from the net income.
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2.4. Determine Free Cash Flow based on Pro Forma Financial Statements.
Another way to project free cash flows is to build a set of predictive financial statements based on our
understanding of the company and its financial statements. A typical model might look like the
following:
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*Cash and marketable security= Total liabilities and equities- current asset-net fixed asset
*Interest earned on cash and marketable securities = Interest paid on cash and marketable
securities*average cash and marketable securities.
• Using the definition of free cash flows from section 2.5:
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We can now use these free cash flows to compute the enterprise value of the firm (row 62 below) and the
value of its shares (cell B67):
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