Company & Project

Valuation

Valuation Techniques

Discounted Cash Flow (DCF) Approach

The DCF approach is the most “precise” method to value a company. The value is equal to the present value of the company’s 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 “precise” method to value a company. The value is equal to the present value of the company’s future cash it will generate.

• Pro: DCF is theoretically more “precise” than other valuation methods.

• Con: Even though it’s more “precise”, it doesn’t mean it’s 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.

• Pro: Can be a more “accurate” method of valuation. The multiples reflect the latest industry trends and growth prospects.

• Con: No two companies are exactly alike and finding proper comparable companies can be difficult, if not impossible.

Discounted Cash Flow (“DCF”)

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 can’t 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 – 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 (“WACC”) as the discount rate. If the company has no debt, just use the cost of equity.

Step #2: Determine the appropriate discount rate

WACC = 𝑹𝒆 ∗𝑬

𝑬+𝑫+ 𝑹𝒅 ∗

𝑫

𝑬+𝑫∗ (𝟏 − 𝒕)

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 firm’s equity

D = Market value of firm’s debt, net of cash

t = Corporate tax rate

WACC = 𝑹𝒆 ∗𝑬

𝑬+𝑫+ 𝑹𝒅 ∗

𝑫

𝑬+𝑫∗ (𝟏 − 𝒕)

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 company’s tax rate is 25%. The cost of equity at the firm is 10%.

WACC

8.44%

Re ∗𝑬

𝑬+𝑫

Enterprise value ($20MM)= Market value of equity ($15MM) + market value of debt ($7MM) – cash ($2MM)

Step #2: Determine the appropriate discount rate

=

10.0% * $15

$20= +

+

5.0% * $5

$20* (1-.25)

Rd ∗𝑫

𝑬+𝑫∗ (1 − 𝑡)

Re = Cost of equity (derived using the capital asset pricing model (CAPM))

Rd = Cost of debt

E = Market value of firm’s equity

D = Market value of firm’s debt

t = Corporate tax rate

WACC = 𝑹𝒆 ∗𝑬

𝑬+𝑫+ 𝑹𝒅 ∗

𝑫

𝑬+𝑫∗ (𝟏 − 𝒕)

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).

β = Beta of the company. Measures the relationship between the change in the price of a company’s 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) = 𝑹𝒇 + 𝜷 (𝑹𝒎−𝑹𝒇)

Step #2: Determine the appropriate discount rate

For a public company, beta can easily be found on Yahoo! Finance or any other finance website. We’ll discuss private companies in a minute.

CAPM Example

A company’s 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%= +

𝑅𝑓 + 𝛽 (𝑅𝑚 − 𝑅𝑓)

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

yours….but it’s not quite that straightforward…

Every company has a different amount of leverage which makes comparing companies a bit difficult.

To “normalize” a company’s 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 company’s capital structure.

Calculating the beta of a private company

Beta (unlevered) = 𝑩𝒆𝒕𝒂 (𝒍𝒆𝒗𝒆𝒓𝒆𝒅)

𝟏+ 𝟏−𝒕𝒂𝒙 ∗(𝑫𝒆𝒃𝒕

𝑬𝒒𝒖𝒊𝒕𝒚)

Step #2: Determine the appropriate discount rate

1) Find all the publicly traded comparable companies’ betas

2) Unlever each company’s beta

3) Take the average beta of the comparables

4) Relever the beta based on the private company’s capital stack

Beta (levered) = Beta(unlevered) * [𝟏 + 𝟏 − 𝒕𝒂𝒙 ∗ (𝑫𝒆𝒃𝒕

𝑬𝒒𝒖𝒊𝒕𝒚)]

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 today’s dollars.

This adjustment is made by discounting each cash flow.

Step #3: Discount each of the cash flows

Present value of cash flow =𝑭𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘

(𝟏+𝒓)(𝒏−.𝟓)

1962 2018

$0.49 $4.79

Present value of cash flow =𝑭𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘

(𝟏+𝒓)(𝒏−.𝟓)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 ½ year from this number to have a “mid-year” 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 company’s cost of capital is 9%.

$67,854 = $100,000

(1 + .09)(5−.5)

Present value of cash flow =𝑭𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘

(𝟏+𝒓)(𝒏−.𝟓)

Step #3: Discount each of the cash flows

Step #4Calculate the terminal value and discount it

Terminal value: The value of a company’s expected cash flow beyond the forecast date.

The terminal value is critical as it accounts for a large portion of the company’s 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 today’s 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

Don’t 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 company’s debt.

You should research which multiple is commonly used in your company’s 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 – cash. This is NOT the market cap.

EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization

Enterprise multiple = 𝑬𝑽

𝑬𝑩𝑰𝑻𝑫𝑨

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 companies’ multiples.

STEP #2Multiply next year’s EBITDA by the appropriate multiple

Enterprise value = Market value of equity + market value of debt – 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 year’s 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 investment’s cost.

Return on Investment (ROI)

𝐑𝐎𝐈 =𝑮𝒂𝒊𝒏 𝒇𝒓𝒐𝒎 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 − 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

𝑪𝒐𝒔𝒕 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

Example: A new machine saved a company $1,000 but cost $400 to purchase and set up the machine.

ROI = ($1,000 - $400) ÷ $400 = 150%

IRR: The return generated on an investment, expressed as an annual rate.

• Unlevered IRR: Return assuming no debt

• 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 ÷ ($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=𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕𝒔

𝑼𝒏𝒊𝒕 𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕

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: