VALUATION: Valuation, discount rate, discount rate, growth rate and project selection
LECTURE 3
2
$45?
$35?
$55?
Business Valuations
1
We know the cost of
everything but the value of
nothing.
Learning Goal
Lecture outline
Introduction Value creation Valuation models Discount rates Growth rates Project selection
Value creation
Firms make various value-increasing decisions New venture New project
Product innovation Process innovation
Need to value those projects/ventures well for better management
Lecture 5 looks at valuation of Technologies/IP
Valuation Framework
1. Gather latest information/data
2. Estimate expected revenue growth (past rates, mkt. rates, other factors )
3. Sustainable operating margin (CVP analysis)
4. Reinvestment (plough-back rate = g/ROC)
5. Risk parameters (discount rates)
6. Start-up valuation (EPS)
7. Project selection
Valuation Measures
Approach DescriptionSubjective/Personal
Accounting Book
Replacement
Deprival
Market
Breakup Liquidation
Fair Value
Intrinsic/Economic
Enterprise Value
Many different valuation methods…….
5
Valuation Measures
Approach Description
Subjective/Personal Based on unique individual preferences
Accounting Book Historical cost from the financial reporting model
Replacement Cost to buy asset in the purchase market
Deprival Cost to compensate for the loss of an asset
Market Equilibrium price amongst actively traded parties
Breakup Liquidation Net realizable value in the sales market
Fair Value A “reasonable” value given information at hand
Intrinsic/Economic A estimate of value basing on earning potential
Enterprise Value The intrinsic value of a firm’s operating assets
Many different valuation methods…….
5
In general
Cost approach (accounting book) Income approach (Present value or
discounted cash flow (DCF); Market approach
Example: Valuing a second hand car
Accounting valuation vs. DCF valuation
1. Cost Approach
measures the future benefits of ownership by quantifying the amount that would be required to replace the future service capability of the asset
assumes that the cost of replacement commensurate with the value of the service that the asset can provide during its productive life
1. Cost Approach
1. Research and Development Expenditures: involves the capitalisation of R&D or product launch
expenses has the double effect of reducing expenses in the
income statement and building up the asset side of the balance sheet
capitalisation of R&D expenditure is to recognise its future benefit and therefore should be amortised against future sales
1. Cost Approach
Research and Development Expenditures:
empirical evidence has failed to ‘find significant correlation between research and development expenditures and increased future benefits as measured by subsequent sales, earnings, or share of industry sales’.
1. Cost Approach
Research and Development Expenditures:
The professional practice is to take a conservative approach to R&D expenses and to remove intangible assets unless there is a history of profits and sales as justification (i.e. brand names)
1. Cost Approach
2. Tobin’s q combines the market value and the replacement
cost methods for valuing assets in a way very similar to the market-to-book (M/B) value ratio
expectations of future profits are the basic determinant of investment activity and these expectations are supposed to be reflected in a firm’s market value
1. Cost Approach
2. Tobin’s q
Compare Tobin’s Q with 1.
tstreplacemen
assetsMV
KP
VsQTobin
i cos
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1. Cost Approach
Tobin’s q market value of the firm exceeds the value of its
existing capital when investors’ perceive its expected earnings as high or increasing
firm can be worth less than its existing capital when its prospects are considered uncertain or low
investment in new real capital is profitable if q exceeds one
1. Cost Approach
Tobin’s q Firms with high q ratios are normally those with
attractive investment opportunities or a significant competitive edge, as would the case with most technology start-ups
Tobin’s q ratio differs from the M/B ratio q ratio utilises market value of the debt plus equity It also uses the replacement value of all assets
instead of the historical cost value
3. Adjusted Net Assets Method - One of the Cost Approaches
i. The balance sheet is restated from historical cost to market valueii. A valuation analysis is performed for the fixed, financial, other
assets, and liabilitiesiii. The aggregate value of the assets is “netted” against the estimated
value of existing and potential liabilities to estimate the value of the equity
iv. This value represents the minimum, or “floor,” value the company at liquidation
1. Cost Approach
Income Approach: Discounted cash flows method
Focuses on the income-producing potential of the asset
The value of the asset can be estimated from the present worth of the net economic benefit generated over the life of the asset
The DCF approach captures the essence of the time value of money and risk.
N
tt
t
i
CFValue
1 1
The present value of all future cash flows discounted at a rate that reflects the time value of money and the certainty of cash flows.
=
Discounted cash flows method
Discounted cash flows method
Value of firm =
t
t WACC
CFf
1 1
Who knows what future cash flow &
discounts rate to use?
The complexity of modeling an enterprise
is daunting!
Nice Idea But…
Step 1: Estimate Cash flows Cash flows are pre-financing, i.e.,
independent of the capital structure of the firm. Do not take out interest expense from cash flows
Estimating Cash flows
CFt = EBITt*(1 - T) + DEPRt – CAPEX - WKt + othert
Where CF = Cash flow; EBIT = Earnings before interest and taxes; T = Corporate tax rate; DEPR = Depreciation; CAPEX = Capital Expenditure; WK = Increase in working capital, and other = Increases in taxes payable, wages, payable, etc.
Industry based understandingCash flow
Time
Cash flow diagram for an airline company
Cash flow
Time
Cash flow diagram for a newsletter company
Multiple cash flow curvesCash flow
Invest
Harvest
Growth option
Time
This occurs when after the first project, the firm has options to introduce related products/services to the market.
This presents new growth opportunity to the company.
Projection vs. reality
Reality
Cash flow
projection
Time
Cash flow
Scenario 1 original projection
Time
Scenario 2 More time & money, succeeded
Scenario 3: More time & money, failed
Need to understand the industry Group discussion exercise
The following common sized Financial statements were taken from 4 companies in 4 different industries. Could you please match the numbers to the companies? Utility Banking Grocery Pharmaceutical
Step 2: Estimate growth rate and discount rate Using CAPM to work out the cost of equity
Need risk free rate (note the matching principle) Firm beta (leveraged vs. unlevered) Market risk premium Note on beta. Use this as the discount rate for all equity firm
)(* fmfa rrrr
Estimating accounting beta The private firm’s accounting earnings can be used to regressagainst changes in earnings for a market equity index such asthe S&P/ASX 200 to estimate an accounting beta.
Earningsf = + S&P/ASX200 +
where
Earningsf = the change in earnings of the firm; = the intercept or constant; = the beta of the market equity index;S&P/ASX200 = the market equity index, and = the random error term.
Bottom-up Betas This method involves breaking down betas into their business risk and financial leverage components to enable us to estimate betas without having to rely on past prices on a technology start-up
Unlevered Betas (u): The systematic risk of a firm assuming that it is 100% equity financed and has no debt.
L
U = [1 + (D/E)]
Bottom-up Betas
Levered Betas (u): Where the firm’s capital structure
consists of both equity and debt financing.
L = U [1 + (D/E)]
The use of operating income (i.e. EBIT) would yield an unlevered beta while using the net income would yield the equity or levered beta.
The limitations with this type of beta are the distortion of data caused by accounting adjustments and the lack of a long time series for earnings given the short history of most technology start-ups
Cost of Debt
The best practices for estimating the cost of debt are to use the marginal borrowing rate and a marginal tax rate or the current average borrowing rate and the effective tax rate.
The after-tax cost of debt, Kd(1 – T), is used
to calculate the weighted average cost of capital.
WACC as the discount rate
DDL
EEWACC rwrwr *)1(**
Note:
Weight of Debt and Weight of Equity are based on Market value
Venture Capital Rates of Return The required rates of return for venture capital
at different development stages are illustratedbelow (Smith and Parr 2000): Venture Capital Rates of Return
Stage of Development Required Rate of Return (%)Start-up 50First Stage 40Second Stage 30Third Stage 25
Venture Capital Rates of ReturnThe pharmaceutical industry provides aspecific industry example, Hambrecht & Quist(Smith and Parr 2000)Development Stage Required Rate of Return (%)Discovery 80Pre-Clinical 60Clinical Trials – Phase I 50 – Phase II 40 – Phase III 25New Drug Application 20Product Launch 17.5 – 15
Growth Rates
Damodaran (2002) suggests three ways of
estimating growth for any firm as follows:
Historical growth rate
Market analysts’ estimates
Firm’s fundamentals
Valuing cash flows with the CCF method All equity (unlevered firm)
Ta
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aaU r
TVCF
r
CF
r
CFPV
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gr
gCFTV
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Valuing cash flows with the CCF method (cont.) Leveraged firm
Tax shield advantage when debt is taken as interest payment are tax deductible.
Value of tax shield, TS (time period t)
DrTS dt **
Valuing cash flows with the CCF method (cont)
The tax shields are discounted to PV to get PVTS
Assuming D stays constant for simplicity WACC can be used as a discount rate
Ta
TdTd
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d
a
d
r
DrTVDr
r
Dr
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DrPVTS
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21
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TdTd r
DrDrTV
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Valuing cash flows with the CCF method (cont)
InvestmentPVNPV
PVTSPVPV
CCF
UCCF
Practice with NSK case
Please work out the value of NSK company basing on the information of NSK and comparable companies provided in the case.
Next class
Valuation with market based approach. Case: Tutor Time (A) (p. 131)
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