38_Valuation by Prof. Groh

8/7/2019 38_Valuation by Prof. Groh

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Alexander Groh 2

Structure

Introduction

Fundamentals of Valuation

Tax Shields and Cost of Capital

Multiples and Hurdle Rates

Free Cash Flow Valuation and the LBO Model

Modelling a Companys Free Cash Flows

Summary

Recommended Literature:

Koller/Goedhart/Wessels: Valuation, New Jersey, Wiley, 2005

Arzac: Valuation for Mergers, Buyouts, and Restructuring, New Jersey, Wiley,

2005


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Alexander Groh 3

Meaning of Valuation for

Financial Investors

Finding a Bidding-Range in transaction processes It is not the point to find the fair value

If the bid is too low you are out!

If the bid is too high youll have problems with built expectations and

with your own companys governance

Finding a price for expected Exit


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Alexander Groh 4

Meaning of Valuation for

Financial Investors

Deal

Valuation

Negotiation

Reputation Deal Structure

Tax-Modell

Atmosphere

Luck

Essentials of Deal-Making:


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Alexander Groh 5

Valuation Methods

Value

Comparing Market Values

of quoted companies

Comparing similar

recent M&A-Transactions

Liquidation Value

Net Asset Value

Discounting expected

Cash Flows

Real Options-Approach


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Alexander Groh 6

Fundamental Valuation Principle

for a Financial Investor

Calculate Present Value of future Cash Flows !!!

V 10=

Example:

( )rV += 111( ) ( ) ( ) ( ) 2

12111111 rrrrVV +=++=+=

( ) ( ) ( ) ( )nnn rrrrVV +=++=+= 1111111


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Alexander Groh 7

( )505

1100 rVmnV +==

Example

What is the Present Value of 100 mn to be received

by redemption of a Zero-Bond in five years?

r = 5%

V0 = 78,35 mn

r = 10%

V0 = 62,09 mn

r = 15%

V0 = 49,72 mn

( )50

1

100

r

mnV

+

=


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Alexander Groh 8

Valuing Perpetuities

A Perpetuity is a Cash Flow that is payed (annually) inequal amounts until infinity

( ) ( ) ( ) ( )

+

++

+

+

+

+

+

=

r

CF

r

CF

r

CF

r

CFV

1111

3

3

2

21

0

r

CFV =

0

results in


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Alexander Groh 9

Perpetuities and Multiples

The valuation of a Perpetuity can be transferred into aMultiple-Valuation

rCF

r

CFV

1

0==

Multipler=

1

MultipleCFV =0


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Alexander Groh 10

Example

Calculate the Net Present Value of a 10 mn Perpetuity !!!

Multiplemnr

mn

r

CFV === 10

10

0

Multiple = 20

r = 5%

V0 = 200 mn

Multiple = 10

r = 10%

V0 = 100 mn

Multiple = 6,7

r = 15%

V0 = 67 mn


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Alexander Groh 11

Growing Perpetuities

Imagine a Perpetuity that grows every year at a constantgrowth rate g

( ) ( ) ( ) ( )

+

++

+

+

+

+

+

=

r1

CF

r1

CF

r1

CF

r1

CFV

3

3

2

210

( )( )

( )

( )

( )

( )

( )

( )

+

+++

+

++

+

++

+

+=

r1

g1CF

r1

g1CF

r1

g1CF

r1

g1CFV 0

3

3

0

2

2

000

( )

( ) ( )

2g1CFg1CFCF

g1CFCF

012

01

+=+=

+=


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Alexander Groh 12

Growing Perpetuities

( )( )

( )( )

( )( )

( )( )

+

+++

+

++

+

++

+

+=

r1

g1CF

r1

g1CF

r1

g1CF

r1

g1CFV 0

3

30

2

200

0

gr

g1

CFV0

+=

Multiple of a

Growing Perpetuity


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Alexander Groh 13

Growing Perpetuity Multiples

grg1PerpetuityGrowingaofMultiple

+=

g = 5% g = 7% g = 10%

r = 15%

Be realistic: What can grow forever at a rate of 5% ???

Multiple = 10,5 Multiple = 13,8 Multiple = 22


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Alexander Groh 14

The Principle Valuation Tasks

1. Estimating future Cash Flows (Modelling)

2. Determining Discount Rates (Comparables

and Structuring)


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Alexander Groh 15

Discount Rates

Discount Rates are also referred to as the Cost ofCapital and have to reflect the uncertainty of the

Cash Flow Stream.

Discount Rates are the Cost of Capital for foregone

Investments of equal Risk!!!

Economic risk Subject to changes

Leverage risk Definitely changes through debt redemption in Buyout

Transactions

Cost of Capital change !!!


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Alexander Groh 16

Common

Pref.

C-Class

B-Class

Cost of Capital

Equity

Entity

Value,Paid to

Seller

Debt

Senior

Cost

of

Debt

Cost

ofEquity

Weighted

AverageCost

of

Capital

(WACC)

Remind the InterestTax Shield


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Alexander Groh 17

Cost of Debt

r

Maturity T

inverse Yield-Structure

flat Yield-Structure

normal Yield-Structure

The base is the Zero Cupon Yield Curve of riskfree debt:


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Alexander Groh 18

Credit Spread-Term Structure

1 35 7

9 11 1315 17

190,01%

0,10%

1,00%

10,00%

B

A

AAA

Rating

Maturity

Added

Spreads


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Alexander Groh 19

Tax Shield of Debt

PAT

EBIT

Tax(on PBT)

PBT

Companyall Equity

financed

=

Equity

Newco

Assets


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Alexander Groh 20

Debt

Tax Shield of Debt

PAT

EBITTax(on PBT)

PBT

Interest

Debt finance included

Newco

Assets

Equity

Tax Savings =

Interest X Corporate Tax Rate


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Alexander Groh 21

Leverage and Tax Shield

Equity

Newco

Assets

Debt

Newco

Assets

Equity

PAT Equity PAT Equity


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Alexander Groh 22

Cost of Equity

Academics estimate Cost of Equity with Capital Market Models

CAPM (Capital Asset Pricing Model)

APT (Arbitrage Pricing Theory)

Models can surely help to find benchmarks !

To use the models correctly you will need many information, calculations and

experience !

Betas Return of Market Portfolio

Models are sensitive to time horizon and basis-effects !

We are valuing non quoted companies generally !

It is questionable to find Equity Costs for Private Equity Investments by

models that assume fully diversified portfolios and perfect markets !


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Alexander Groh 23


We often use Multiples and Hurdle Rates

PAT

EBIT

Depre-

ciations

SalesCore

ActivitiesTax

Interest

EBITDA

Operating

Costs

Banks

State

PE Investor


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Alexander Groh 24


P/E Ratio

PAT

Tax

Interest Banks

State

PE Investor X P/E Multiple = 1/Hurdle Rate

results in Equity Value !!!


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Alexander Groh 25


EBIT

PAT

Tax

Interest Banks

State

PE Investor

EBIT Multiple

X EBIT Multiple

Results in

Entity Value

But what about Taxes ???


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Alexander Groh 26


EBITDA Multiple

Results in

Entity Value

This Entity Value is hard to justify !!!

X EBITDA Multiple

Depre-

ciations

EBITDA

PAT

EBIT Tax

Interest Banks

State

PE Investor


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Alexander Groh 27

A Correct Multiple

PAT

EBIT Interest Banks

PE Investor

Tax State

X PBIAT Multiple

Cash Flow Definition and


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Alexander Groh 28

Cash Flow Definition and

Investments for Growth

EBIT

Depre-

ciations

SalesCore

ActivitiesEBITDA

OperatingCosts

Cash

Flow(generated by

the Company)

NetInvestments

+

Corrections


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Alexander Groh 29

Free Cash Flow Definition

Cash

Flow(generated by

the Company) Free

Cash

Flow

Tax(as if the

company

had no

debt)

Could flow to the Investors

if the company had no debt!!!

Sets all companies equal disregarding

different Degrees of Leverage!!!


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Alexander Groh 30

Entity vs. Equity Valuation

Entity-

Value =

Equity-Value

Value

of

Net Debt

Intellectual foundation: 1963 by Franco Modigliani and Merton Miller


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Cash Flow Definitions

Cash

Flow(generated bythe Company) Free

Cash

Flow

Tax(as if thecompany

had no

debt) Cash

Flow(generated bythe Company)

Tax(real

payment)

CashFlow for

Debt

Service

Cash

Flow(generated bythe Company)

Tax(realpayment)

Cash

Flow for

Redemption

Interest

Alexander Groh

Typical Buyout Model Cash Flows

Linking FCF and


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Alexander Groh 32

Linking FCF and

PE Cost of Capital

FreeCash

Flow

Flows to banks but the cost are less

than the nominal interest rate

due to the tax savings!!!

Interest

Cash

Flow

to

Equity

The residual can flow to

the equity investors at their

Cost of Equity

resp. Hurdle Rate


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Alexander Groh 33

PE Cost of Capital

Debt

Newco

Assets

EquityHurdle

Rate

(constant)

Debt/

Equity Tax Rate

Cost

of

Debt WACC

30% 1 40% 8% 17%

30% 2 40% 8% 13%

30% 3 40% 9% 12%

30% 4 40% 10% 11%

30% 5 40% 11% 11%

30% 6 40% 12% 10%

30% 7 40% 13% 11%30% 8 40% 14% 11%

( )VEr

VDrWACC ED += 1

Return Determinants of Private


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Alexander Groh 34

Equity

Return Determinants of Private

Equity Investments

Entity

Value,

Paid to

Seller

Year 0

Debt

Equity

Debt

Equity

Debt

Equity

Debt

Equity

Debt

Transaction

Structure

1 2 3 4

Market Value Added

Dele

ve

rage


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Alexander Groh 35

Changing Cost of Capital

Equity

Entity

Value,Paid to

Seller

Year 0

Debt

Equity

Debt

Equity

Debt

TransactionStructure

1 2

WACC0 WACC2WACC1

WACC

is notConstant!!!


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Alexander Groh 36

Changing Cost of Capital

Should we use different Discount Rates then in ourtransaction model ???

Pros and cons

To be precise we should!

It is not necessary because bandwidth of expected Cash Flows isvery broad anyway!


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Debt Capacity

Alexander Groh 37


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Equivalent Multiples

Alexander Groh 38

Modelling a Corporations


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Alexander Groh 39

10

12

15 15 15 15

0

2

4

6

8

10

1214

16

2009 2010 2011 2012 2013 2014

Year

mn

Modelling a Corporation s

Free Cash Flows

...

Variable Cash Flows Perpetuity

Growth rates could be considered !!!

Duplicating a Corporations


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Alexander Groh 40

Duplicating a Corporation s

Free Cash Flows

Present Value = Present Value of Variable Cash Flows +Present Value of Perpetuity

( ) ( ) ( ) rmn15

r1

1

r1

mn12

r1

mn10V

220

+

+

+

+

+

=

r = 5%

NPV(Perp.) = 272 mn

V0 = 293 mn

r = 10%

NPV(Perp.) = 124 mn

V0 = 143 mn

r = 15%

NPV(Perp.) = 76 mn

V0 = 93 mn

Using an Average of


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Alexander Groh 41

Using an Average of

Free Cash Flows ???

No satisfying results !!!

r

mnmnmn

VAverage 3151210

0

++

=

%86143

3,123

V

V

0

Average0

==

mn,,

mn,3123

10

3312==


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Alexander Groh 42

Modelling Free Cash Flows

Modelling the Free Cash Flows is the only way to come to a

fair bid: Analyze historical performance first !!!

Calculate Key Value Drivers

Understand strategic position

Develop performance scenarios Forecast individual line items

Check overall forecast for reasonableness


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Alexander Groh 43

Calculate Key Value Drivers

Use (part of the) ROIC-tree for example:

Operating Margin

= (EBIT/Revenues)

Cost of Goods Sold/

Revenues

Depreciation

Expenses/

Revenues

Selling, General and

Administrative

Expenses/Revenues

= 1- (...)

+ +

Key Value Drivers can be further broken down to operational

levels !!!


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Alexander Groh 44

Develop Performance Scenarios

Get as many research reports as possible !

Read the businessplan critically !

Get information from consultants, market researchers,

competitors and professionals !

Perform best-, worst- and most likely scenarios !

Perform sensitivity analysis !

Interpret the result of different scenarios and sensitivity analysis

carefully !

Discuss possible scenarios in your management team !

Get Help by


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Alexander Groh 45

Get Help by

Mathematical Tools

Monte Carlo Simulation with Crystal Ball

2005 2006 2007 2008 2009

Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate

Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues

SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)

Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)

EBIT 14,00 14,89 15,34 15,80 16,28

Get Help by


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Alexander Groh 46

Get Help by

Mathematical Tools

Play with the assumptionsfor sensitivity analysis !!!


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Alexander Groh 47

Simulation of Possible Scenarios

Frequency Chart

Euro

Mean = 112,65,000

,008

,015

,023

,030

0

7,5

15

22,5

30

100,00 106,25 112,50 118,75 125,00

1.000 Trials 4 Outliers

Forecast: Revenues 2004

Frequency Chart

Euro

Mean = 60,31,000

,008

,015

,023

,030

0

7,5

15

22,5

30

52,50 56,25 60,00 63,75 67,50


Forecast: COGS 2004

Si l d EBIT


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Alexander Groh 48

Simulated EBIT

Frequency Chart

Euro

,000

,007

,015

,022

,029

0

7,25

14,5

21,75

29

12,00 13,25 14,50 15,75 17,00


Forecast: Ebit 2001

Frequency Chart

Euro

,000

,006

,013

,019

,025

0

6,25

12,5

18,75

25

12,00 13,50 15,00 16,50 18,00


Forecast: Ebit 2002

Frequency Chart

Euro

,000

,006

,013

,019

,025

0

6,25

12,5

18,75

25

12,00 13,75 15,50 17,25 19,00


Forecast: Ebit 2003

Frequency Chart

Certainty is 80,80% from 15,01 to +Infinity Euro

Mean = 16,29,000

,005

,011

,016

,021

0

5,25

10,5

15,75

21

12,00 14,00 16,00 18,00 20,00


Forecast: EBIT 2004

Calculating FCFs


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Alexander Groh 49

Calculating FCFs

and Entity Values

2005 2006 2007 2008 2009Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate

Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues

SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)

Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)

EBIT 14,00 14,89 15,34 15,80 16,28

Taxes on EBIT 5,60 5,96 6,14 6,32 6,51 40% assumed marginal Tax Rate

Operating Cash Flow 8,40 8,93 9,20 9,48 9,77

Net Investments 2,00 2,06 2,12 2,19 2,25 3% est. Growth Rate

Free Cash Flow 6,40 6,87 7,08 7,30 7,51

Net Present Values 5,98 5,35 4,80 32,94 15% Discount Rate

Entity Value 49,1

P ibl Biddi R


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Alexander Groh 50

Possible Bidding Range

Frequency Chart

Certainty is 50,40% from 44,84 to 52,48 Euro

Mean = 49,10,000

,021

,042

,063

,084

0

21

42

63

84

35,00 41,88 48,75 55,63 62,50


Forecast: Entity Value

P tti All T th !!!


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Alexander Groh 51

Putting All Together !!!

Use your Valuation-Spreadsheet

Forecast future Earnings

and Free Cash Flows

Perform Scenario-Planning

and Sensitivity Analysis

Build a transaction

structure

(Taxes!)

Calculate IRRs for

financing layers

(reversed DCF-

Valuation)

Find company market value

Compare IRRs with

Hurdle Rates of each investor

Adjust leverage

Formulate your bid !!!

38_Valuation by Prof. Groh

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