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Market vs Intrinsic Value
Market Value
Determined by the consensus of market
participants
Observed in the market
Intrinsic value
Present value of expected future cash flows
Not observed
Estimated using valuation methods
Investment Decisions
If MV = IV; fairly valued (Hold?)
If MV < IV; undervalued (Buy?)
If MV > IV; overvalued (Sell?)
Valuation Methods
Valuation Methods
Relative Valuation
Multiples
DCF
Dividend Discount
FCF Discount
Assets Value
Liquidation Value
Replacement Value
Asset Based Valuation
Valuation at adjusted net worth
Adjusted net worth = adjusted assets –adjusted liabilities
Adjustments are in respect of market values
Not commonly used other than as a cushion for other valuation or in a liquidation or winding up
Cash/earnings generating capabilities are ignored
Dividend Based Valuation
Constant Dividend Growth Model
Constant Dividend Growth Model
Supernormal Dividend Growth
Supernormal Dividend Growth
Supernormal Dividend Growth
Supernormal Dividend Growth
Valuation – Discounted FCF
Key Components of DCF valuation
Forecasting unlevered Free Cash Flow
Discount Rate - WACC
Forecasting Terminal Value
Computing Enterprise Value (EV) and deriving
Equity Value
Free Cash Flow
FCF is the cash flow available to all the
capital providers of a company after all the
operating expenses, taxes and capital
investments (both WC and fixed)
EBIT – Taxes = NOPAT
NOPAT + NCE – CapEx – Inc WC = FCF
WACC
WACC represents the required rate of return to all forms of capital providers
Cost of Equity – CAPM and Beta Ke = Rf + ß (Rm – Rf)
ßLevered = ßUnlevered x [1+ D(1-t)/E)
Cost of Debt – Post tax YTM
Cost of Equity > Cost of Debt
Don’t penalise equity heavy companies with high WACC as low debt reflects ability to leverage in the future
Terminal Value Terminal value captures the firm’s value
for the time beyond the explicit period, which can be theoretically extended into perpetuity
Ideally at least 1/4 of DCF value should be captured by the explicit forecast period
Popular methods
Liquidation/Salvage value (multiple of BV)
‘Exit multiple’ (multiple of NI/ EBITDA/ EBIT
Perpetuity Capitalisation of final FCF (static or growth)
Enterprise Value
EV = OA + NOA(incl. Cash) OA = PV of FFCF
EV = DFCF + NOA(incl. Cash)
EV = Market Cap + PS + NCI + Debt
Market Cap + PS + NCI + Debt
= DFCF + NOA(incl. Cash)
Market Cap = DFCF+ NOA – PS – NCI – Net Debt
Common DCF Errors
Inappropriate forecasts Short forecast horizon
Hockey sticks – Rapid trend changes
Internal inconsistencies (Contradictory assumptions - Expanded output and reduced Cap-Ex)
Aggressive or conservative: How many good things have to happen simultaneously
Terminal Value manipulation
Improper cost of capital
Non operating assets
Discounting discounted cash flow
SOTP Valuation
Sum Of The Parts (SOTP) valuation is a
methodology used to arrive at the total
value of an entity by valuing each
segment of the business separately and
adding the segment values to arrive at
the value of the total entity
Case Study
Case Observations
TSE – Observations Margins are under pressure – declining margins
Revenue growth but with declining margins
Cash rich in spite of healthy dividend payments
YVC – Observations Good operating margin (~20%)
Margins maintained with sales growth
Margin improvements may be due to operating leverage
PPE appears to be very old (low depreciation)
Heavy cap-ex during the last few years
Except the spike from 1999 to 2000, rest of the growth rates are not aggressive
Valuation TSE is going to be a strategic investor, therefore
absolute valuation (DCF) is appropriate.
Comparable P/E Multiple may be done for a comparison
Simple average of P/E multiples
If the valuation is for the whole business based on ‘unlevered’ basis EV/EBIT basis may be used instead of standard P/E multiple
Exit price for Terminal Value
Exit price of TV may be assessed at 10x EBIT which is quite reasonable for an average growth entity.
Even if the acquirer is making a strategic investment (where DCF is preferred) the exit price of TV may be used for negotiation purposes.
Valuation of YVC
Absolute value of $132Mn net of cash is 9x trailing P/E (1999A) and 6x forward P/E (2000F)
Interest income on treasury securities should have been adjusted as non operating income
Control premium to be added on P/E value of $57Mn (@ mkt cap 21.98)
The value of (457Mn + control premium) is still at a good discount to the absolute value of $132Mn
The seller may argue for a higher price on the basis of excellent growth prospects in the future
Compare valuations using P/E and other multiples given on page 15 of the case
Liquidation and Replacement cost
valuation Matters for attention
US Treasury investments can be assumed to have been M2M
Due from US Govt. may have to be discounted due to delay in receipt (consider materiality)
Accounts receivable – consider if further discounting is required (DD matter)
Inventories – usability and relevance, any further provisions? (DD matter)
Deferred assets – may have to be even zeroed
Comments
The current market value appears to be just at the liquidation value. Thus it appears to be under valued
Replacement cost appears higher than equity value based on current market values (based on market multiples)
Therefore it is a good potential candidate for a LBO/MBO
Relative Valuation
Relative Valuation utilises market prices from observed transactions to impute the value of a target investment opportunity
Process
Identification of appropriate comparable firms
Identification of the relevant valuation metric(s)
Computation of valuation metric multiples for the comparable firm(s)
Apply to the target firm (with adjustments for specific attributes)
Multiples
Multiples are driven by
Risk
Growth
Cash generating potential / Profitability
Popular Multiples
P/E; P/EBIDTA
P/BV
P/Sales
P/Cash Flow
EV/EBITDA
Identification of Comparable Firms
- Dimensions of Comparability
Business Product / Service Offerings
Delivery / Distribution Mode
Size Investability
Liquidity
Geography
Profitability
Growth prospects
Capital Structure Financing growth – availability of internally generated
funds
Identification of Valuation Metric
Balance Sheet Metrics Book Value (Net worth)
Net Asset Value
Income Statement Metrics Net Income (EPS)
Yield
Dividend Discount Model (DDM)
The Economic Metrics Revenues
EBITDA / EBIT
Identification of Valuation Metric
- “Hot Button” Profile
Mature – Net Income (EPS), BV
Capital Intensive – EBIT, EBITDA, CEPS, FFO
Thin Margins - EBIT, EBITDA, CEPS, FFO
High Leverage - EBIT, EBITDA, CEPS, FFO
Slow Growth - EBIT, EBITDA, CEPS, FFO
Financially distressed – Revenues, BV, NAV
Emerging – Revenues, EBITDA
Identification of Valuation Metric
- Some sector specific examples
Financial Services, Constructions
Book Value
Utilities
EBIT
Energy, Automobile, Mature Technology
Net Income (EPS)
Grocers, Telecoms, Media
EBITDA, CEPS, FFO
Real Estate
NAV, FFO
Multiple Sectors / Diversified
Net Income
Identification of Valuation Metric
- Some operational metrics
EV / Unit of resource
Natural resources, Metals
EV / Unit of capacity
Logistics, Manufacturing, Real Estate, Retail
EV / Customer
Utilities, Technologies, Cable TV, Telecoms, Financial
Services
Case Study
Screening and initial analysis
Quaker Oats
Just after a very bad acquisition and disposal
New management team
Pepsi Co
Under pressure to push P/E up (31x vs 41x in Coca-Cola)
Many low margin business segments
Target EPS growth 12%-13% (ref. p3 of the case) – need a growth vehicle
Case observations Pepsi Co (Addition by subtraction – ref. Table 1)
Downsizing in terms of revenue and assets – low margin low return segments have been dropped
Increase in ROIC and margins
Higher multiples are attached to quality assets generating higher cash flows
From Pepsi Co., POV this ‘dog’ (OATS) could be turned around to a ‘cash cow’ and may even be spun off later to a private equity
Boot strapping – an entity with high multiples could achieve accretion of value by acquiring low multiple stock
Questions to be answered
Fairness of the deal to the target: Is the price fair and a suitable premium awarded
Is the % control premium comparable to premiums in past comparable transactions? (Historic control premiums in public companies are 20%-40%)
Do the acquisition multiples represent a premium to public company comparable multiples?
Are the acquisition multiples comparable to multiples in past comparable multiples?
Attractiveness of the deal to acquiring shareholders (Accretion vs dilution)
Is the acquisition accretive or dilutive and over what time horizon?
Fairness of the Deal to the Target
Is the control premium comparable?
2.3 PEP shares for each share of Oats
26% premium on Nov 2nd price
Even higher premium on pre
announcement price which is >40%
There is a fair control premium
Fairness of the Deal to the Target Acquisition Multiples
Compare the above multiples with the highest of values
among the 6 comparable companies given in the case
Compare the above multiples with those of Kellogg which
appears to be the most comparable of the 6 comparable
companies given in the case as far as the business segment
is concerned
However in terms of profitability and capital structure
Hershey may be a better comparable
EV / EBITDA 14.156
0.920
EV / Revenue 14.156
5
P/E 97.46
3.35
EBITDA / Revenue 920
5000
2000
= 29.09
= 18.4%
= 15.39
= 2.83
Comparability to comparable transactions (Ref. p.6 of the case)
EBITDA Multiples
Phillip Morris / Nabisco 14.0x
Unilever / Best Foods 13.5x
Kellogg / Keebler 10.3x
Average 12.0x
PEP / Oats transaction is at 15.38x which is at a premium of 26%
Average net income multiple is 27.5x and PEP/Oats transaction is also at similar multiples
Based on the above analysis the offer appears to be fair for the target Oats.
Attractiveness to the acquirer
Synergies Revenue synergies to be: 1 + 1 > 2
Cost synergies: 1 + 1 < 2
PV (Synergies) > Control Premium
PV(Synergies) computation should consider any Cap-ex, if material needed to realize the synergies
Discount rate for synergies
No relationship to COC of PEP or Oats
If probability of synergies is high, even the risk free rate could be used
If the synergies are very aggressive a rate as high as 20% may be used
If the synergies are moderate a rate in between may be used