Valuation Handbook

Valuation HandbookValuation HandbookA Practitioner's Guide

By Punish Oberoi, CFA

1. Cash Flow Valuation - Dividend Discount Model (DDM)

- Free Cash Flow to the Equity (FCFE) - Free Cash Flow to the Firm (FCFF)

2. Residual Income Valuation

3. Relative Valuation or Comparable Analysis

4. Other Valuation Approach - Real Option Valuation

- Alternative approach to Bank Valuation

INDEX

DISCOUNTED CASH FLOWDISCOUNTED CASH FLOWUSED FOR SECTORS:

ENGINEERINGINFRASTRUCTUREMANUFACTURING

RESIDUAL INCOME OTHERSDCF RELATIVE VALUATION

DISCOUNTED CASH FLOW

The purpose of DCF-Valuation is to determine the value of a company in terms of its future cash flows. The cash flows are adjusted with certain items (e.g. those not related to company´s core businesses or those with no cash effect) in order to make sure the flows reflect the actually generated cash as good as possible.

FCFF FCFE DDM


PROS

• Earnings are susceptible to different accounting decisions. FCF on the other hand is a true measure of a firm’s cash.

• Easy to see key drivers of share value

• Focused on intrinsic value

• Backwards calculation

Cons

• The greater the number of inputs, the higher the possibility for errors in the valuation

• Projecting the future performance of a company

• Small changes in inputs have a high magnitude effect on the valuation.

• Not for short term investments

• Negative free cash flow.

THREE VARIANTS

for firms which have leverage which is too high or too low, and expect to change the leverage over time.

for firms for which you have partial information on leverage (eg:interest expenses are missing)

in all other cases, where you are more interested in valuing the firm than the equity.

WHEN TO USE FCFFWHEN TO USE FCFE

• for firms which have stable leverage, whether high or not, and

• if equity (stock) is being valued

WHEN TO USE DDM

• the company is dividend-paying.

• the board of directors has a dividend policy that has an understandable relationship to profitability.

• the investor has a non-control perspective.


Cash Flows

To Equity To Firm

The Strict ViewDividends +Stock Buybacks

The Broader View (FCFE) Net Income- Net Cap Ex (1-Debt Ratio)- Chg WC (1 - Debt Ratio)= Free Cashflow to Equity

EBIT (1-t)- ( Cap Ex - Depreciation)- Change in Working Capital= Free Cashflow to Firm (FCFF)

WHAT CASH FLOW TO USE?

The steps:

1. Project operating results and free cash flows

2. Estimate the terminal value of the business by 1 of 2 methods:

- perpetuity formula

- exit multiple

3. Calculate appropriate discount rate

4. Discount the annual cash flows and the terminal value to present

5. Determine range of values

6. Interpret the results and perform sensitivity analysis

STEPS IN DISCOUNTED CASH FLOW


Cashflow to EquityNet Income- (Cap Ex - Depr) (1- DR)- Change in WC (!-DR)= FCFE

Expected GrowthRetention Ratio *Return on Equity

FCFE1 FCFE2 FCFE3 FCFE4 FCFE5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFEn+1/(ke-gn)

FCFEn.........

Cost of Equity

Financing WeightsDebt Ratio = DR

Discount at Cost of Equity

Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

EQUITY VALUATION WITH FCFE


Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever


Terminal Value= FCFFn+1/(r-gn)

FCFFn.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets

= Value of Firm- Value of Debt

= Value of Equity




Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

EQUITY VALUATION WITH FCFF


DividendsNet Income * Payout Ratio= Dividends

Expected GrowthRetention Ratio *Return on Equity

Dividend 1 Dividend 2 Dividend 3 Dividend 4 Dividend 5

Forever


Terminal Value= Dividend n+1/(ke-g n)

Dividend n.........

Cost of Equity

Discount at Cost of Equity

Value of Equity




Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

EQUITY VALUATION WITH DIVIDENDS


DISCOUNTED FREE CASH FLOW TO THE FIRM

Valuation date Aug 09Next year-end Dec 09

COST OF CAPITAL CONTINUING GROWTH ASSUMPTIONSRisk free rate (%) 9.5 Long-term GDP growth (%) 5.0 Equity risk premium (%) 4.9 Long-term inflation (%) 5.0 Beta (x) 0.7 Long term growth rate 10.0 Cost of equity (%) 13.0 Sustainable ROE (%) 11.5 Cost of debt (%) 9.6 Sustainable payout ratio 13.0 Tax rate (%) 22.7

DISCOUNTED FREE CASH FLOW TO THE FIRMYear to Dec (NGNm) FY09F FY10F FY11F FY12F FY13F Cont. valueOperating profit 8,526,730 10,760,797 13,361,162 15,316,903 18,116,534

add: depreciation 2,497,702 2,542,651 2,641,089 2,932,186 3,179,064add: other non-cash items 733,995 804,540 910,451 789,174 803,044change in working capital inv 506,561 (990,075) (948,987) (120,756) (629,323)less: capex (6,832,013) (9,673,643) (12,952,689) (15,182,595) (17,149,151)less: notional cash tax (1,932,201) (2,438,452) (3,027,708) (3,470,888) (4,105,299)

Free cash flow 3,500,774 1,005,818 (16,682) 264,024 214,868 7,768,130Beta (x) 0.7 0.7 0.7 0.7 0.7 0.7 Debt/(debt + equity) (%) 10.7% 7.4% 4.6% 2.6% 1.1% 1.1%Weighted cost of capital (%) 13.0 13.0 13.0 13.0 13.0 13.0Discount period 0.38 1.38 2.38 3.38 4.38 4.38Discount factor @ WACC 0.99 0.96 0.94 0.91 0.89 0.89Present value of free cash flow 3,465,480.8 969,717.9 (15,663.7) 241,446.2 191,369.4 6,918,586.8

Value of operations 11,770,937 add: net cash (5,081,412) add: net nonoperating assets 45,324,475

Equity value 52,014,000 No. of shares (k) 1,280,576

Fair value (NGN/share) 40.6

TOTAL RETURN SENSITIVITY ANALYSISTarget price (NGN/share) 45.9Current price (NGN/share) 37.0 Fair value 40.6 12.0 12.5 13.0 13.5 14.0 Expected capital gain (%) 24.1 9.0 40.6 39.8 39.2 38.8 38.4

9.5 41.7 40.6 39.8 39.3 38.8 Dividends (NGN/share) 2.2 10.0 43.3 41.7 40.6 39.8 39.3 Dividend yield (%) 6.1 10.5 46.0 43.3 41.7 40.6 39.9

11.0 51.2 46.0 43.3 41.7 40.6 Expected total return 30.2 G

DP

Gro

wth

ra

te (

%)

Cost of equity (%)

AN EXAMPLE OF FCFE


Beta adjusted for drift

Long term average ROE of the company

-- Estimating the terminal value (the value of all future cash flows after the explicit forecast period of 5 years)

1. Perpetuity growth method (Gordon growth formula):

Terminal value = FCF (n+1) / (r-g) assumption

- forecast 5 explicit years of FCF

- grow Year 5 FCF and obtain estimate of FCF in Year 6

- “r”, the discount rate is either Er or WACC (depending on whether we are discounting FCFE or FCFF)

- “g” is the perpetuity growth rate (the growth forever) and in many models is often equal to GDP growth rate

- discount the Terminal Value to present using the appropriate discount rate

THE TERMINAL VALUE



2. Exit multiple method:

Terminal value = Statistic x Multiple assumption

- forecast 5 explicit years of FCF, EBITDA, Net Income

- grow Year 5 FCF and obtain estimate of FCF in Year 6

- apply an “exit” multiple

- multiply and estimate Terminal Value

- discount the Terminal Value to the present using the appropriate discount rate

THE TERMINAL VALUE (CONTD.)

-- Discount Free Cash Flows to the Equity at the cost of equity:Er = Rf + levered β x (Rm – Rf)

Risk-free rate Reflecting the risk of debt Market Risk premium

Levered β = Unlev. x (1+(1-Tax rate) x D/E)

-- Discount Free Cash Flows to the Firm at the cost of capital:

WACC = After tax cost of Debt x D/C + Er x E/C

The tax deductibility of interest expense provides a “tax shield”

THE DISCOUNT RATES


RESIDUAL INCOME VALUATIONRESIDUAL INCOME VALUATION

USED FOR SECTORS:

BANKS AND FINANCIAL SERVICESMANUFACTURING


RESIDUAL INCOME VALUATION

Residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income.

• A firm is not paying dividends of if it exhibits an unpredictable dividend pattern.

• A firm has negative free cash flow many years out, but is expected to generate positive cash flow at some point in the future (for example, a young or rapidly growing firm where capital expenditures are being made to fuel future growth.

• There is a great deal of uncertainty in forecasting terminal values.

In the Residual Income Model (RIM) of valuation, the intrinsic value of the firm has two components:

The current book value of equity, plusThe present value of future residual income

In the model, B0 is the current book value of equity, Bt is the book value of equity at time

t, RIt is the residual income in future

periods, r is the required rate of return on

equity, Et = net income during period t, RIt = Et – rBt-1.

1

10

100 )1()1( t

ttt

tt

t

r

rBEB

r

RIBP

WHEN TO USE CALCULATION METHODOLOGY


Valuation date Sep 09Next year-end Jun 10

COST OF CAPITAL

Risk free rate (%) 10.8 Long-term GDP growth (%) 5.0Equity risk premium (%) 7.7 Long-term inflation (%) 5.0Beta (x) 1.0 Long term growth rate 10.0Cost of equity (%) 18.5

RESIDUAL INCOMEFY10F FY11F FY12F FY13F FY14F Cont. value

Beginning book value of equity 18,574.0 21,508.1 25,006.8 29,217.4 34,144.9Cost of equity (%) 18.5 18.5 18.5 18.5 18.5Equity cost 3,442.0 3,985.8 4,634.1 5,414.4 6,327.6Net income 4,279.0 5,102.1 6,140.4 7,185.8 8,529.6Excess equity return 837.0 1,116.3 1,506.2 1,771.3 2,202.1Perpetuity value of excess equity return 28,392.1Discount period 0.80 1.80 2.80 3.80 4.80 4.80Discount factor @ cost of equity 0.87 0.74 0.62 0.52 0.44 0.44Present value of excess equity return 730.2 821.6 935.3 928.0 973.3 12,548.5

Equity invested 18,574.0Add: net adjustment to book value - Add: excess equity return 16,936.8

Equity value 35,510.7 No. of shares (m) 250.3

Fair value (MUR/share) 141.86

TOTAL RETURN SENSITIVITY ANALYSISTarget price (MUR/share) 162.48Current price (MUR/share) 139.0 Fair value 141.9 16.5 17.5 18.5 19.5 20.5 Expected capital gain (%) 16.9 9.0 179.2 155.1 136.2 120.9 108.3

9.5 185.2 159.1 138.9 122.7 109.5 Dividends (MUR/share) 5.67 10.0 192.3 163.7 141.9 124.7 110.8 Dividend yield (%) 4.1 10.5 200.4 168.9 145.2 126.9 112.2 Expected total return 21.0 11.0 210.1 174.8 149.0 129.3 113.8

Cost of equity (%)

Lon

g-t

erm

gro

wth

ra

te

(%)

DISCOUNTED EXCESS EQUITY RETURN

CONTINUING GROWTH ASSUMPTIONS

AN EXAMPLE OF RESIDUAL INCOME

Yield on 10 year Govt. Bond

Beta adjusted for drift

Average Real GDP Growth for 10

Years

Adjusted PAT


BALANCE SHEET ADJUSTMENTS FOR FAIR VALUE

NON-RECURRING ITEMS

Often companies report non-recurring charges as part of earnings or classify non-operating income (e.g., sale of assets) as part of operating income. These misclassifications can lead over-estimates and under-estimates of future residual earnings if no adjustments are made. Note that adjustments to book value are not necessary for these items since non-recurring gains and losses do impact the value of assets in place. Non-recurring items sometimes result from accounting rules and at other times result from “strategic” management decisions.

An analyst should examine the financial statement notes and other sources for potential items that may warrant adjustment in determining recurring earnings such as:

• Unusual items• Extraordinary items• Restructuring charges• Discontinued operations• Accounting changes

CONSIDERATIONS IN RESIDUAL INCOME VALUATION


PROS

• Terminal value does not make up a large portion of the total value

• The model can be used for companies that do not pay dividends and/or firms that have near-term negative free cash flows

• The model can be used when cash flows are unpredictable or difficult to forecast. This can be particularly true for financial institutions.

CONS

• The model relies on accounting data that can be subject to manipulation

• When book value and ROE are unpredictable, the resulting estimate is less valid.


RELATIVE VALUATIONRELATIVE VALUATION

USED FOR BENCHMARKING THE COMPANY VALUATION TO ITS PEERS AND CLOSELY RELATED COMPANIES


1. Determine the peer group (comps universe)

2. Gather the appropriate financial information

3. Enter the financial information into your spreadsheet

- normalize for non-recurring items

4. Calculate relevant historical or forward multiples (P/E; EV/EBITDA)

5. Forecast your company’s future financial performance (EBITDA, EPS, Cash Flow, etc.)

6. Apply appropriate multiples to your company’s financial stats and derive implied valuation range

STEPS IN RELATIVE VALUATION

“Comparable” or “similar” in terms of:

-- Operations

- products / services; distribution; costs structure; geography; interest exposure; customers, etc.

-- Financial Aspects

- size (sales, mkt cap); capital structure; margins / profitability; management experience, etc.


-- Why?

- items not expected to be part of the normal course of business in the future should be adjusted for restructuring charges, gains/losses on sale of assets, legal settlements, asset impairments.

- the goal is to evaluate the ongoing business, earnings and cash flows

-- Where is it?

- separate line on IS (other income/expense, COGS, SG&A)

- add back in the CF

- MD&A section

WHY NORMALIZE? WHERE IS THE INFORMATION?


-- Multiples will vary by industry:

- Retail: Price/EPS, Price Earnings ratio/Growth (PEG)

- Industrials: EV/EBITDA, Price/EPS

- Internet: EV/Revenues, EV/Subscribers, EV/Page views

- Banks/Financial institutions: Price/EPS, Price/Book Value

- REITS: Funds from operations, Net asset value

- Telecommunication: EV/EBITDA, Average revenue per user (ARPU)

WHAT ARE THE RELEVANT MULTIPLES?


Advantages:◦ Earnings power is the chief driver of

investment value◦ Main focus of security analysts◦ The P/E is widely recognized and used

by investors Drawbacks

◦ If earnings are negative, P/E does not make economic sense

◦ Reported P/Es may include earnings that are transitory

◦ Earnings can be distorted by management

Assumption:◦ Required rate of return, retention ratio

(with DDM) and growth rates are similar among comparable firms

ADVANTAGES AND DRAWBACKS OF P/E


PE VALUATION

Valuation date Aug 09Next year-end Dec 09

COST OF CAPITALRisk free rate (%) 9.8

Equity risk premium (%) 5.3Beta (x) 1.2

Cost of equity (%) 16.1

NGN Current 1 yr fwdForecast EPS 2.2

Est. exit P/E multiple 9.25 - Est. terminal ROE (%) 16.1

Est. exit price 20.0 Cost of equity 16.1 Discount period 0.4

Discount factor @ cost of equity 1.0 1.0 Present value 19.8

Fair value 19.8 Share price 14.7

Upside/(downside) (%) 34.9

TOTAL RETURNTarget price (NGN/share) 21.4Current price (NGN/share) 14.7Expected capital gain (%) 45.4

Dividends (NGN/share) 1.6Dividend yield (%) 11.1

Expected total return 56.5

Advantages◦ Since book value is a cumulative

balance sheet amount, it is generally positive

◦ BV is more stable than EPS, therefore P/BV may be more meaningful when EPS is abnormally low or high

◦ P/BV is particularly appropriate for companies with primarily liquid assets (financial institutions)

Disadvantages◦ Differences in asset age among

companies may make comparing companies difficult

Assumption:◦ Required rate of return, return on

equity, retention ratio (with DDM) and growth rates are similar among comparable firms

ADVANTAGES AND DRAWBACKS OF P/BV


PRICE BOOK VALUATION

Valuation date Sep 09Next year-end Jun 10

COST OF CAPITAL CONTINUING GROWTH ASSUMPTIONS

Risk free rate (%) 10.8 Long-term GDP growth (%) 5.0Equity risk premium (%) 7.7 Long-term inflation (%) 5.0Beta (x) 1.0 Long term growth rate 10.0Cost of equity (%) 18.5 Sustainable ROE (%) 22.3

MUR 1 yr fwdForecast DPS 5.7Forecast NAV 85.9Est. exit P/BV multiple 1.4 - Est. terminal ROE (%) 22.33Est. exit price 124.1Cost of equity 18.5 Discount period 0.80 Discount factor @ cost of equity 0.90 Present value 116.38 Fair value 116.38 Share price 139.00 Upside/(downside) (%) (16.3)

TOTAL RETURNTarget price (MUR/share) 132.3Current price (MUR/share) 139.0Expected capital gain (%) (4.8)

Dividends (MUR/share) 5.7Dividend yield (%) 4.1

Expected total return (0.8)

Advantages◦ This represents a valuation

indicator for the overall company and not just equity.

◦ It is more appropriate for comparing companies that have different capital structures since EBITDA is a pre-interest measure of earnings.

◦ Appropriate for valuing companies with large debt burden: while earnings might be negative, EBITDA is likely to be positive.

Disadvantages◦ Differences in capital investment is

not considered.

Assumption:◦ Required rate of return, growth

rates, working capital needs, capital expenditures and depreciation are similar among comparable firms

ADVANTAGES AND DRAWBACKS OF EV/EBITDA


EV/EBITDA MULTIPLEMethodology Target price

Valuation Metrics - FY2009 estimatesEV/EBITDA multiple 6.70x

FY09 EBITDA (NGNm) 34,916.1 FY09 EV (NGNm) 233,938.0 FY09 Debt (NGNm) 12.3 FY09 Cash (NGNm) 14,621.8 FY09 Market Capitalization (NGNm) 248,547.5

No. of shares outstanding (millions) 12,000.0 Target price 20.7

P/E multiple Target Price 21.4

on Depreciati and Taxes Interest, before Earnings

Cash -Debt of ValueMarket +Equity of ValueMarket

EBITDA

Value Enterprise

Public Comps Valuation Analysis

Market Data Valuation Multiples

Closing Market Enterp. Price / Earnings Price / Cash Flow

EV / Revenues EV / EBITDA EV / EBIT P/B

Price Value Value (Diluted) (Diluted) (Diluted) (Diluted) (Diluted) (Diluted)

29-Oct-09 High Low (Diluted-TS) (Diluted) 2002 2002 2002 2002 2002 2002 2002 2002 2002 2002 LTM

CRM Companies

Convergys Corp (CVG) $10.00 $12.00 $8.00 $1,552,349 $1,281,449 9.4x 8.7x 5.0x 4.7x 0.6x 0.6x 3.0x 2.7x 4.6x 4.1x 1.5x

Minacs Worldwide Inc. (MXW) $10.00 $12.00 $8.00 $1,257,783 $1,273,145 nmf nmf 286.2x 303.4x 15.4x 14.4x 258.3x232.0x nmf nmf 74.7x

Sitel (SWW) $10.00 $12.00 $8.00 $830,086 $935,220 46.8x 38.5x 11.9x 12.1x 1.2x 1.2x 10.5x 10.6x 22.0x 20.5x 4.4x

Teletech Holdings (TTEC) $10.00 $12.00 $8.00 $645,820 $582,069 20.0x 17.2x 9.9x 8.4x 0.9x 0.8x 6.4x 5.3x 10.4x 8.4x 2.1x

West Teleservices Corp (WT) $10.00 $12.00 $8.00 $645,034 $621,920 11.8x 10.8x 7.0x 6.4x 1.0x 0.9x 4.7x 4.4x 6.7x 6.4x 1.6x

APAC Customer Services (AP)$10.00 $12.00 $8.00 $498,916 $583,097 40.8x 32.3x 10.9x 11.5x 1.3x 1.2x 8.7x 8.8x 17.4x 15.8x 7.2x

Sykes Enterprises (SYKE) $10.00 $12.00 $8.00 $414,406 $328,072 16.5x 16.0x 6.6x 6.5x 0.5x 0.5x 3.9x 3.7x 7.1x 6.7x 1.7x

Telespectrum (TLSP) $10.00 $12.00 $8.00 $357,935 $494,854 nmf nmf 17.3x 11.9x 1.5x 1.6x 18.5x 16.1x 73.6x nmf 2.3x

ICT Group (ICTG) $10.00 $12.00 $8.00 $129,134 $142,298 24.5x 18.1x 9.3x 8.1x 0.9x 0.7x 7.9x 6.8x 15.1x 11.4x 2.4x

RMH Teleservices (RMHT) $10.00 $12.00 $8.00 $89,391 $86,397 33.3x 25.2x 19.5x 16.7x 0.7x 0.6x 12.9x 9.8x 17.9x 12.3x 3.0x

Mean 25.4x 20.8x 38.3x 39.0x 2.4x 2.3x 33.5x 30.0x 19.4x 10.7x 10.1x

Mean - adjusted 21.2x 17.4x 10.8x 9.6x 1.0x 0.9x 8.5x 7.6x 12.6x 10.2x 2.9x

Median 22.2x 17.6x 10.4x 10.0x 1.0x 0.9x 8.3x 7.8x 15.1x 9.9x 2.3x

Median - adjusted 20.0x 17.2x 9.9x 8.4x 0.9x 0.8x 7.9x 6.8x 12.7x 9.9x 2.3x

52

Week

AN EXAMPLE OF RELATIVE VALUATION


OTHER VALUATION OTHER VALUATION APPROACHAPPROACH

Real Option ValuationAlternative approach to Bank Valuation


Valuation under real option method is based on decision tree analysis. We can value the company using the call option model.

REAL OPTION VALUATION

We can use an example to explain the valuation technique.

Forecast Discounted Cash Flow of a company

DCF Value: 10,597

STEP: 1


STEP: 2

Calculate the value of d1 and d2

Inputs Used Outcome

STEP: 3

Compare the Call value with the DCF value. If DCF value> Call value, go ahead with the project.

DCF VALUE > CALL VALUE10,597>9824


ALTERNATIVE APPROACH TO BANK VALUATION

The implied price / book value multiple for a bank is calculated comparing the bank’s profitability to its cost of equity capital adjusted for the growth rate.

Implied or Target P / BV = ( ROE – g ) / ( CoE – g )

The implied price of a banking stock is derived through the followingequation:

Fair Price of a Banking Stock = Target P / BV times Current BV


Documents

Valuation Handbook