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Business Valuation Methods Explained

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14 views23 pages

Business Valuation Methods Explained

Uploaded by

sidwiz350
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Module 7: Business

Valuation:
Approaches and
Methods
1. So What do you see while
investing in a financial asset?

2. How do you see the valuation


then?
Extremes in Valuation Views

•Extreme Views: Components Often Overlooked in


• Science Perspective: Valuation as a Valuation
precise, data-driven exercise with Key Components:
minimal room for analyst interpretation. • Bias: Analyst biases influence
• Art Perspective: Valuation as a valuation outcomes.
subjective exercise where analysts can • Uncertainty: Dealing with inherent
manipulate inputs to achieve desired uncertainties in forecasting.
outcomes. • Complexity: Impact of technology
• Middle Ground: Reality lies between and information accessibility on
these extremes. valuation methodologies.
Bias in Valuation

Sources of Bias
Starting Point Bias:

• Analysts often begin with preconceived notions


about companies before valuing them.
• Sources of bias include media perception,
management narratives, and market
sentiments.
Information Collection:

• Annual reports and financial statements may Reward Structure:

have management manipulation. • Analyst compensation tied to buy/sell

• Market sentiment and analyst consensus recommendations.

influence perceived value. • Example: Acquisition valuations

• Institutional pressures such as sell-side bias biased towards justifying higher

towards buy recommendations. prices.


Manifestations of Bias

• Post-Valuation Tinkering • Qualitative Adjustments


• Input Assumptions • Using premiums or
• Biases influence • Analysts may adjust
assumptions post- discounts to justify
optimistic or pessimistic valuation disparities (e.g.,
assumptions. valuation to align with
desired outcomes. synergy in acquisitions).
What to do about Bias
• Reduce Institutional Pressures

• De-link Valuations from Reward/Punishment

• No Pre-commitments

• Self-Awareness

• Honest Reporting
Types of Uncertainty
Estimation Uncertainty
Errors in data conversion and modeling.
Impact on valuation accuracy despite reliable data
sources.

Firm-specific Uncertainty
Variances from expected firm performance.
Effects of internal and market-driven changes.

Macroeconomic Uncertainty
External economic shifts.
Influence on overall market conditions and firm valuations .
Information will evolve over time (Internet companies)
Responses to Uncertainty

Analysts who value companies confront uncertainty at


every turn in a valuation and they respond to it in both
healthy and unhealthy ways. Among the healthy responses
are the following:

Positive Responses to Uncertainty


1. Better Valuation Models: The Unhealthy Responses to Uncertainty
2. Valuation Ranges:
• Best case scenario and worst case scenario
1. Passing the buck:
3. Probabilistic Statements
• to reflect the uncertainty that they feel 2. Giving up on fundamentals
What to do about Uncertainty
a. Types of Uncertainty
Estimation Uncertainty: Manageable through improved models and better data.
Firm-specific Uncertainty: Focus on estimating firm-specific factors like growth and
profitability.
Macroeconomic Uncertainty: Avoid incorporating personal macroeconomic views to
maintain neutrality.
b. Managing Uncertainty
Model Improvement: Enhance models to reduce estimation uncertainty.
Information Access: Seek superior information sources to bolster accuracy.
Focus
Payoff to on Firm-specific Factors: Concentrate on forecasting firm-specific variables rather
Valuation
than macroeconomic
• Reasonable conditions.
Expectations: Absolute certainty in valuation is unrealistic due to
inherent estimation errors.
• Relative Precision: Value is not in absolute precision but in relative accuracy
compared to other valuations.
• Strategic Advantage: Analysts can gain a competitive edge by persisting through
Costs of Complexity
•Information Overload
• Quality vs. Quantity: More information can lead to decision paralysis
and poor input choices.
• Time Pressure: Analysts often under pressure to deliver valuations
quickly, risking accuracy.
• Input Quality: Output quality hinges on input accuracy; erroneous inputs
lead to flawed valuations.
•Black Box Syndrome
• Complexity Issues: Analysts may lose understanding of complex
models' inner workings.
• Proprietary Models: Inaccessible or proprietary model segments limit
analyst control and understanding.
• Impact: Shift from collaborative valuation process to reliance on model-
generated results.
•Big vs. Small Assumptions
Valuation Approach
Phillips Co. is growing quickly. Dividends are expected to grow at a rate of
20 percent for the next three years, with the growth rate falling off to a
constant 5 percent thereafter. If the required return is 12 percent and the
company just paid a dividend of $2.80, what is the current share price?
2. Goldman Sachs is one of the leading investment banks in the world. Assuming that it can
maintain its brand name edge for a few years, we value Goldman using a two-stage dividend
discount model, with five years of high growth and stable growth thereafter.

For the first five years, we assume that Goldman Sachs will maintain its existing payout ratio of
9.07% and current return on equity of 18.49%. the current year EPS is $11.03. Beyond year 5,
we assume that competitive pressures will bring the return on equity down to 12%. Assuming a
growth rate of 4%.

To compute the cost of equity, we assume that Goldman Sachs will have a beta of 1.2 for the first
five years of high growth and a beta of 1.0 beyond that period. With a risk-free rate of 4.5% and
a risk premium of 4%.

You need:

[Link] dividend
[Link] rate in current phase and growth rate in stable phase
[Link]-out ratio in current and stable phase
[Link] of equity in current and stable phase
EPS at year 0 = 11.03, growth rate in growing phase = 16.82
Year EPS DPS @9.07%
Present Value @ 9.30%
1 $12.88 $1.17
$1.07
2 15.05 1.36
1.14
3 17.58 1.59
1.22
4 20.54 1.86
1.30
5 23.99 2.18
1.39
Sum
$6.12
3. Suppose a firm has both a current and a target debt–equity ratio of .6, a cost of
debt of 5.15 percent, and a cost of equity of 10 percent. The corporate tax rate is 34
percent. What is the firm’s weighted average cost of capital?

Suppose the firm is considering taking on a warehouse renovation costing $60


million that is expected to yield after tax cost savings of $12 million a year for six
years. You calculate the worth of the project and make the decision.
Free Cash Flow

Free Cash Flow to Firm Free Cash Flow to Equity

EBIT (1-T) Net Profit


-(Capital Expenditure - Depreciation) -(Capital Expenditure - Depreciation)
- Change in noncash working Capital - Change in noncash working Capital
+ (New debt issued – Debt repayment)
4. The Good Food Corporation, a public company headquartered in Barstow, California, that is currently a leading
global food service retailer. It operates about 10,000 restaurants in 100 countries. Good Food serves a value-based
menu focused on hamburgers and French fries. The company has $4 billion in market valued debt and $2 billion in
market valued common stock. Its tax rate is 20 percent. Good Food has estimated its cost of debt as 5 percent and
its cost of equity as 10 percent.
Good Food is seeking to grow by acquisition and the investment bankers of Good Food have identified a potential
acquisition candidate, Happy Meals, Inc. Happy Meals is currently a private firm with no publicly tradable common
stock but has the same product mix as Good Food and is a direct competitor to Good Food in many markets. It
operates about 4,000 restaurants mostly in North America and Europe. Happy Meals has $1,318.8 million of debt
outstanding with its market value the same as the book value. It has 12.5 million shares outstanding. Since Happy
Meals is a private firm, we have no stock market price to rely on for our valuation. Happy Meals expects its EBIT (150
million) to grow 10 percent a year for the next five years. Increases in net working capital and capital spending are
both expected to be 24 percent of EBIT. Depreciation will be 8 percent of EBIT. The perpetual growth rate in cash
flow after five years is estimated to be 2 percent. Show the valuation of the happy meals if Good Food hires you to
make the acquisition decision.
Nintendo was a pioneer in the video gaming business with its proprietary Nintendo

consoles and games. As the video gaming market grew, it attracted intense competition

from Sony and Microsoft. These cash-rich giants introduced their own proprietary formats

(Sony with PlayStation and Microsoft with Xbox), putting pressure on Nintendo to update

its system. In 2004, Nintendo reported pretax operating income of 99.55 billion yen,

translating into an after-tax return on capital of 8.54%, based on capital invested at the

start of 2004 (based on a 33% tax rate). The conservative management at the firm has

not reinvested much back into the business, resulting in a reinvestment rate of only 5%

over the past few years. The bottom-up beta for the firm is 1.2 (reflecting the risk of video

gaming companies), the yen risk-free rate is 2%, and a market risk premium is 4%.
Growth Rate with the help of Reinvestment rate

Growth in Net Income Growth in Operating Income


Operating Income Adjustment

Capital Expenses Treated as Operating Expenses

Adjustments for Financing Expenses


APV (Adjusted Present Value)
Approach:

In this method, we calculate the value of a firm as if it has no debt


(the "unlevered" value) and then add the net benefits and costs of
debt separately.
•Steps in APV:
• Calculate the firm's value without debt.

• Add the effects of debt, like tax savings (since interest on debt
is tax-deductible).

• Subtract costs associated with debt, such as potential


bankruptcy costs.
Inputs to Discounted Cash Flow Models
•Discount Rates
• Risk Considerations: Reflects default risk for debt and
market risk for equity.
• Calculation: Weighted average cost of capital (WACC)
combines cost of equity and after-tax cost of debt.
•Expected Cash Flows
• Definitions: Dividend models (DDM), FCFE models, and
FCFF models.
• Calculation: Adjusting for reinvestment needs and cash
flow distributions.
•Expected Growth
• Determinants: Reinvestment rates and returns on
equity or capital.
• Significance: Determines future cash flow growth,
DCF Valuation: Advantages and Limitations
•Benefits
• Analytical Rigor: Encourages deep understanding of businesses and
sustainability of cash flows.
• Contrarian Perspective: Focuses on intrinsic value rather than market
perceptions.
•Challenges
• Manipulation Risk: Vulnerable to manipulation if inputs are inaccurately
estimated.
Conclusion
• Data Intensity: Requires substantial data inputs for accurate valuation.
•Strategic
• MarketApplication
Sensitivity: May indicate overvaluation if market perceptions outpace
• Critical Thinking: Use DCF with caution, ensuring rigorous
fundamentals.
analysis and accurate inputs.
• Market Adaptation: Balance intrinsic value calculations with
market realities to inform investment decisions effectively.

Common questions

Powered by AI

The weighted average cost of capital (WACC) plays a crucial role in investment decisions by acting as a hurdle rate for evaluating new projects. For firms like Good Food Corporation, WACC represents the average expected return required by all investors, both debt and equity holders. It determines the minimum return that a new project, such as acquiring Happy Meals, would need to earn to be considered a worthwhile investment, by factoring in the cost of debt and cost of equity, adjusted for the corporate tax rate .

Key components of bias influencing valuation outcomes include starting point bias from preconceived notions, biases from media perceptions and market sentiments, and manipulation of input assumptions to reflect optimistic or pessimistic outcomes. Complexity arises from the challenges of dealing with an abundance of information, distinguishing critical from non-critical assumptions, and the potential disconnect caused by the 'Black Box Syndrome' when proprietary model segments obscure understanding .

Absolute certainty in valuations is unrealistic due to inherent estimation errors that occur despite utilizing reliable data. Analysts can achieve a strategic advantage by focusing on relative accuracy compared to other valuations rather than absolute precision. By persisting through uncertainties and leveraging improved valuation models, analysts can gain a competitive edge in the market .

Discounted Cash Flow (DCF) valuation offers the benefits of analytical rigor and the advantage of focusing on a company's intrinsic value rather than market perceptions, supporting a contrarian perspective . However, it involves challenges such as vulnerability to input manipulation, data intensity, and sensitivity to market perceptions that may diverge from fundamental values. Analysts need to balance intrinsic calculations with market realities to effectively guide investment decisions .

In asset valuation, analysts must contend with bias and uncertainty, which are often overlooked components. Bias arises from preconceived notions influenced by media perceptions, management narratives, and market sentiments. Analysts attempt to mitigate bias by reducing institutional pressures, avoiding pre-commitments, and practicing honest reporting . Uncertainty, categorized into estimation, firm-specific, and macroeconomic, is intrinsic to valuation. Analysts can manage this through improved models, focusing on firm-specific factors, and avoiding personal macroeconomic views . Healthy responses to uncertainty include using better valuation models, providing valuation ranges, and making probabilistic statements .

In a two-stage dividend discount model, the current growth phase for a company like Goldman Sachs can be determined by maintaining existing payout ratios and assessing current return on equity. For Goldman Sachs, this involves a high growth phase for five years with a beta of 1.2 and a stable growth phase assuming a lower return on equity due to competitive pressures, with a beta reduced to 1.0 . This guides the growth rate calculation through the specific assumptions of company performance during each phase.

Complexity in valuation processes leads to issues like information overload, decision paralysis, and the 'Black Box Syndrome,' where analysts may lose an understanding of complex models' inner workings. Managing these impacts may require simplifying models, prioritizing critical assumptions, and ensuring that analysts have a clear understanding of proprietary models to foster a collaborative valuation process rather than relying solely on model-generated outcomes .

Uncertainty in valuation manifests as estimation uncertainty in data conversion and modeling, firm-specific uncertainty due to performance variances, and macroeconomic uncertainty from external economic shifts. Analysts manage it by improving valuation models, ensuring access to better information for more accurate data, focusing forecasts on firm-specific variables, and maintaining neutrality by avoiding personal macroeconomic views . This approach reduces the detrimental effects of uncertainty on valuation outcomes.

The Adjusted Present Value (APV) approach differs from traditional discounted cash flow (DCF) methods by evaluating a company's value in two segments: the unlevered value (as if it has no debt) and the net benefits or costs associated with debt separately. APV separately adds effects like tax savings from debt and subtracts potential costs such as those from potential bankruptcy. This approach enables more precise handling of financing side effects compared to the traditional WACC-based DCF method .

Proprietary models and 'Black Box Syndrome' can have significant effects on the financial valuation process. Proprietary models limit analyst control and understanding, creating a reliance on model-generated outcomes rather than a collaborative valuation process. 'Black Box Syndrome' leads to a detachment from the model's workings, potentially causing analysts to lose track of critical model assumptions and inputs, thereby affecting the accuracy and reliability of valuations . Addressing these effects involves ensuring model transparency and fostering a collaborative environment for valuation analysis.

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