Company & Project Valuation - Wisdify...(๐+ )( โ.๐) Step #3: Discount each of the cash flows...
Transcript of Company & Project Valuation - Wisdify...(๐+ )( โ.๐) Step #3: Discount each of the cash flows...
Company & Project
Valuation
Valuation Techniques
Discounted Cash Flow (DCF) Approach
The DCF approach is the most โpreciseโ method to value a company. The value is equal to the present value of the companyโs future cash it will generate.
DEFINITION: Time value of money (present value)
A dollar today is worth less than a dollar tomorrow due to inflation.
Discounted Cash Flow (DCF) Approach
The DCF approach is the most โpreciseโ method to value a company. The value is equal to the present value of the companyโs future cash it will generate.
โข Pro: DCF is theoretically more โpreciseโ than other valuation methods.
โข Con: Even though itโs more โpreciseโ, it doesnโt mean itโs more accurate. Method relies on many assumptions that are difficult to accurately predict.
Multiples Approach
The multiples approach uses metrics of a particular industry or comparable companies and applies those metrics to the company being valued.
โข Pro: Can be a more โaccurateโ method of valuation. The multiples reflect the latest industry trends and growth prospects.
โข Con: No two companies are exactly alike and finding proper comparable companies can be difficult, if not impossible.
Discounted Cash Flow (โDCFโ)
Approach
STEP #1Calculate the unlevered free cash flow (FCF)
Free cash flow (FCF): FCF shows the amount of money a company generates after taking into account asset expenditures. FCF is the lifeblood of a company. Without it, a company canโt payoff debt, invest in innovation, etc.
Unlevered: The cash flow before taking into consideration debt (interest, etc.)
Unlevered FCF: = EBIT x (1-tax rate) + Depreciation/Amortization - Capital Expenditures โ Working Capital
Step #1: Calculate the unlevered free cash flow (FCF)
STEP #2Determine the appropriate discount rate
Discount rate: The cost of capital (of both debt and equity) for the business. This rate is used to convert future cash flows into current dollar equivalents.
For a DCF analysis, use the weighted average cost of capital (โWACCโ) as the discount rate. If the company has no debt, just use the cost of equity.
Step #2: Determine the appropriate discount rate
WACC = ๐น๐ โ๐ฌ
๐ฌ+๐ซ+ ๐น๐ โ
๐ซ
๐ฌ+๐ซโ (๐ โ ๐)
Re = Cost of equity (usually derived using the capital asset pricing model (CAPM) discussed in a bit)
Rd = Cost of debt
E = Market value of firmโs equity
D = Market value of firmโs debt, net of cash
t = Corporate tax rate
WACC = ๐น๐ โ๐ฌ
๐ฌ+๐ซ+ ๐น๐ โ
๐ซ
๐ฌ+๐ซโ (๐ โ ๐)
Step #2: Determine the appropriate discount rate
WACC Example
A company has a total enterprise value of $20MM, debt of $7MM, and cash of $2MM. The debt has an interest rate of 5% and the companyโs tax rate is 25%. The cost of equity at the firm is 10%.
WACC
8.44%
Re โ๐ฌ
๐ฌ+๐ซ
Enterprise value ($20MM)= Market value of equity ($15MM) + market value of debt ($7MM) โ cash ($2MM)
Step #2: Determine the appropriate discount rate
=
10.0% * $15
$20= +
+
5.0% * $5
$20* (1-.25)
Rd โ๐ซ
๐ฌ+๐ซโ (1 โ ๐ก)
Re = Cost of equity (derived using the capital asset pricing model (CAPM))
Rd = Cost of debt
E = Market value of firmโs equity
D = Market value of firmโs debt
t = Corporate tax rate
WACC = ๐น๐ โ๐ฌ
๐ฌ+๐ซ+ ๐น๐ โ
๐ซ
๐ฌ+๐ซโ (๐ โ ๐)
Step #2: Determine the appropriate discount rate
Calculating the cost of equity (Re) using the Capital Asset Pricing Model (CAPM)
Rf = Risk free rate (usually the current 10yr Treasury interest rate).
ฮฒ = Beta of the company. Measures the relationship between the change in the price of a companyโs stock and the change in the value of an overall stock market.
Rm = Overall market return. (Rm-Rf) measures the return investors expect to receive for owning a stock, rather than a risk-free investment (such as a government bond).
Re (Cost of equity) = ๐น๐ + ๐ท (๐น๐โ๐น๐)
Step #2: Determine the appropriate discount rate
For a public company, beta can easily be found on Yahoo! Finance or any other finance website. Weโll discuss private companies in a minute.
CAPM Example
A companyโs stock has a beta of 1.25. The 10-year US treasury currently has a yield of 3.0% and the market return over the past 10 years has been 8%.
Cost of Equity
9.25%
Step #2: Determine the appropriate discount rate
=
3.0%= +
๐ ๐ + ๐ฝ (๐ ๐ โ ๐ ๐)
1.25 (8.0% - 3.0%)
But how do you calculate beta if your company is not public?!
Step #2: Determine the appropriate discount rate Use the beta of public companies that are similar to
yoursโฆ.but itโs not quite that straightforwardโฆ
Every company has a different amount of leverage which makes comparing companies a bit difficult.
To โnormalizeโ a companyโs beta, we need to unlever the beta (change the beta so it assumes the company has no debt) and then relever the beta based on our companyโs capital structure.
Calculating the beta of a private company
Beta (unlevered) = ๐ฉ๐๐๐ (๐๐๐๐๐๐๐ )
๐+ ๐โ๐๐๐ โ(๐ซ๐๐๐
๐ฌ๐๐๐๐๐)
Step #2: Determine the appropriate discount rate
1) Find all the publicly traded comparable companiesโ betas
2) Unlever each companyโs beta
3) Take the average beta of the comparables
4) Relever the beta based on the private companyโs capital stack
Beta (levered) = Beta(unlevered) * [๐ + ๐ โ ๐๐๐ โ (๐ซ๐๐๐
๐ฌ๐๐๐๐๐)]
STEP #3Discount each of the free cash flows
Discounting a cash flow: A dollar today is worth more than a dollar tomorrow.
Given this, we need to adjust a future cash flow so we are looking at it in todayโs dollars.
This adjustment is made by discounting each cash flow.
Step #3: Discount each of the cash flows
Present value of cash flow =๐ญ๐๐๐๐๐ ๐๐๐๐ ๐๐๐๐
(๐+๐)(๐โ.๐)
1962 2018
$0.49 $4.79
Present value of cash flow =๐ญ๐๐๐๐๐ ๐๐๐๐ ๐๐๐๐
(๐+๐)(๐โ.๐)Step #3: Discount each of the cash flows
r = Discount rate (which we just calculated using the WACC)
n = The time in terms of years. We usually subtract ยฝ year from this number to have a โmid-yearโ discount. This makes the discount more accurate. Without this adjustment, the cash flow is discounted too much.
Discount Example
In year 5, the company has free cash flow of $100,000. The companyโs cost of capital is 9%.
$67,854 = $100,000
(1 + .09)(5โ.5)
Present value of cash flow =๐ญ๐๐๐๐๐ ๐๐๐๐ ๐๐๐๐
(๐+๐)(๐โ.๐)
Step #3: Discount each of the cash flows
Step #4Calculate the terminal value and discount it
Terminal value: The value of a companyโs expected cash flow beyond the forecast date.
The terminal value is critical as it accounts for a large portion of the companyโs value.
Given this, make sure your exit multiple assumption is very conservative.
After calculating the terminal value, make sure you discount that value back to todayโs value.
Step #4: Calculate the terminal value and discount it
Terminal value = Final Year EBITDA x Exit MultipleStep #4: Calculate the terminal value and discount it
Exit Multiple = Use the exit multiple that was used in a similar transaction that has occurred in the past 1-2 years. Exit multiple is the acquisition price divided by the last 12 months of EBITDA.
In year 5, the company has EBITDA of $100,000. A similar company was recently sold at an EBITDA multiple of 6.5x.
$650,000 = $100,000 x 6.5
Terminal Value Example
Donโt forget to discount the terminal value!
Step #5Add up all the discounted cash flows
Multiples Approach
STEP #1Find the appropriate multiple for your company
Enterprise Multiple: The most common multiple used in valuation is EV/EBITDA. You might use EV/Revenue if the company is not yet profitable.
This multiple is so popular because it takes into consideration the companyโs debt.
You should research which multiple is commonly used in your companyโs industry just in case EV/EBITDA is not used (like when valuing a bank).
Step #1: Find the appropriate multiple for your company
EV (Enterprise value) = Market value of equity + market value of debt โ cash. This is NOT the market cap.
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Enterprise multiple = ๐ฌ๐ฝ
๐ฌ๐ฉ๐ฐ๐ป๐ซ๐จ
Step #1: Find the appropriate multiple for your company
Most industry investment research reports will include the industry EV/EBITDA multiple. You can also gather a sampling of public companiesโ multiples.
STEP #2Multiply next yearโs EBITDA by the appropriate multiple
Enterprise value = Market value of equity + market value of debt โ cash. This is the value we also calculated using the DCF method
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Multiple = The appropriate multiple (usually EV/EBITDA)
Enterprise value (company value) = EBITDA * MultipleStep #2: Multiply next yearโs EBITDA by the appropriate multiple
Useful Return Metrics
Return on investment (ROI): Measures the efficiency of an investment by measuring the return on an investment relative to the investmentโs cost.
Return on Investment (ROI)
๐๐๐ =๐ฎ๐๐๐ ๐๐๐๐ ๐๐๐๐๐๐๐๐๐๐ โ ๐ช๐๐๐ ๐๐ ๐๐๐๐๐๐๐๐๐๐
๐ช๐๐๐ ๐๐ ๐๐๐๐๐๐๐๐๐๐
Example: A new machine saved a company $1,000 but cost $400 to purchase and set up the machine.
ROI = ($1,000 - $400) รท $400 = 150%
IRR: The return generated on an investment, expressed as an annual rate.
โข Unlevered IRR: Return assuming no debt
โข Levered IRR: Return assuming debt
IRR takes into consideration the timing of cash flows. The calculation uses time-value of money principle: a dollar today is worth more than a dollar tomorrow.
Internal Rate of Return (IRR)
IRR RulesInternal Rate of Return (IRR) IRR > Discount Rate -> Project will add value to firm
IRR = Discount Rate -> Project will add not value to firm
IRR < Discount Rate -> Project will decrease firm value
Net present value (NPV)
Net present value (NPV): The sum of the present value (i.e. discounted) of cash inflows and outflows, similar to a DCF analysis. The discount rate used to discount the cash flows is the same as the discount rate we used in the DCF analysis.
NPV Rules
NPV > 0 -> Project will add value to firm
NPV = 0 -> Project will add not value to firm
NPV < 0 -> Project will decrease firm value
Break even analysis
Break even units = $10,000 รท ($5-$1) =2,500 units
Example: A company wants to start producing solar eclipse glasses. The machine to make them cost $10,000. Each pair will cost $1 to make and will be sold for $5.
Break even=๐ญ๐๐๐๐ ๐๐๐๐๐
๐ผ๐๐๐ ๐ฎ๐๐๐๐ ๐๐๐๐๐๐
Break even analysis: How long it takes to recover the cost of an initial investment. Alternatively, it can show you how many units you need to sell to cover all your expenses.
To calculate the number of units to break even, use the below formula: