Download VALUATION

VALUATION:
Valuation, discount rate, discount rate,
growth rate and project selection
LECTURE 3
Business
Valuations
$55?
$45?
$35?
2
1
Learning Goal
We know the
cost of
everything but
the value of
nothing.
Lecture outline
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Introduction
Value creation
Valuation models
Discount rates
Growth rates
Project selection
Value creation
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Firms make various value-increasing decisions
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New venture
New project
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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
Many different valuation methods…….
Valuation Measures
Approach
Description
Subjective/Personal
Accounting Book
Replacement
Deprival
Market
Breakup Liquidation
Fair Value
Intrinsic/Economic
Enterprise Value
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Many different valuation methods…….
Valuation Measures
Approach
Subjective/Personal
Accounting Book
Description
Based
on unique individual preferences
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
Breakup Liquidation
Equilibrium
Net
price amongst actively traded parties
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
5
In general
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Cost approach (accounting book)
Income approach (Present value or
discounted cash flow (DCF);
Market approach
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Example:
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Valuing a second hand car
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Accounting valuation vs. DCF valuation
1. Cost Approach
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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:
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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
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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
V
MV (assets)
Tobin ' sQ  i 
P K replacement cos ts
Compare Tobin’s Q with 1.
1. Cost Approach
Tobin’s q
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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
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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
1. Cost Approach
3. Adjusted Net Assets Method - One of the Cost Approaches
i. The balance sheet is restated from historical cost to market value
ii. A valuation analysis is performed for the fixed, financial, other
assets, and liabilities
iii. 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
Income Approach:
Discounted cash flows method
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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.
Discounted cash flows method
N
CFt
Value  
t
t 1 1  i 
=
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
CFf
t 1 1  WACC
t 
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Value of firm =
Nice Idea But…
Who knows what
future cash flow &
discounts rate to use?
The complexity of
modeling an enterprise
is daunting!
Step 1: Estimate Cash flows
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Cash flows are pre-financing, i.e.,
independent of the capital structure of the
firm.
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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;
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WK = Increase in working capital, and
 other = Increases in taxes payable, wages, payable, etc.
Industry based understanding
Cash
flow
Cash
flow
Time
Cash flow diagram for an
airline company
Time
Cash flow diagram for a
newsletter company
Multiple cash flow curves
Cash
flow
Harvest
This occurs when after the first
project, the firm has options to
introduce related products/services
to the market.
Time
Invest
Growth
option
This presents new growth
opportunity to the company.
Projection vs. reality
Cash
flow
Cash
flow
projection
Scenario 1
original
projection
Scenario 2 More
time & money,
succeeded
Reality
Time
Time
Scenario 3: More
time & money,
failed
Need to understand the industry
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Group discussion exercise
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The following common sized Financial statements
were taken from 4 companies in 4 different
industries. Could you please match the numbers
to the companies?
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Utility
Banking
Grocery
Pharmaceutical
Step 2:
Estimate growth rate and discount rate
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Using CAPM to work out the cost of equity
ra  rf   * (rm  rf )
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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
Estimating accounting beta
The private firm’s accounting earnings can be used to regress
against changes in earnings for a market equity index such as
the 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 startup
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
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Levered Betas (u): Where the firm’s capital structure
consists of both equity and debt financing.
L = U [1 + (D/E)]
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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
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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
rW ACC  wE * r  wD * (1   ) * rD
L
E
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 illustrated
below (Smith and Parr 2000):
Venture Capital Rates of Return
Stage of Development
Start-up
First Stage
Second Stage
Third Stage
Required
Rate of Return (%)
50
40
30
25
Venture Capital Rates of Return
The pharmaceutical industry provides a
specific industry example, Hambrecht & Quist
(Smith and Parr 2000)
Development Stage
Required Rate of Return (%)
Discovery
80
Pre-Clinical
60
Clinical Trials – Phase I
50
– Phase II
40
– Phase III
25
New Drug Application
20
Product Launch
17.5 – 15
Growth Rates
Damodaran (2002) suggests three ways of
estimating growth for any firm as follows:
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Historical growth rate
Market analysts’ estimates
Firm’s fundamentals
Valuing cash flows with the CCF method
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All equity (unlevered firm)
CF1
CF2
CFT  TVT
PVU 
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 ... 
2
1  ra (1  ra )
(1  ra )T
CFT * (1  g )
TVT 
ra  g
Valuing cash flows with the CCF
method (cont.)
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Leveraged firm
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Tax shield advantage when debt is taken as
interest payment are tax deductible.
Value of tax shield, TS (time period t)
TSt   * rd * D
Valuing cash flows with the CCF
method (cont)
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The tax shields are discounted to PV to get PVTS
PVTS 
 * rd * D1
1  ra

 * rd * D2
(1  ra )
2
 ... 
 * rd * DT  TV ( * rd * D)T
(1  ra )T
TV ( * rd * D)T 
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Assuming D stays constant for simplicity
WACC can be used as a discount rate
 * rd * DT
ra
Valuing cash flows with the CCF
method (cont)
PVCCF  PVU  PVTS
NPVCCF  PV  Investment
Practice with NSK case
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Please work out the value of NSK company
basing on the information of NSK and
comparable companies provided in the case.
Next class
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Valuation with market based approach.
Case: Tutor Time (A) (p. 131)