Valuation

2

Discounted Cash Flow Analysis

3

Valuation: Methodology

Value Range

Comparable Companies

Analysis

Comparable Acquisitions

Analysis

Discounted Cash Flow Analysis

Other

• “Public Market Valuation”

• Value based on market trading multiplies of comparable companies

• “Private Market Valuation”

• Value based on multiples paid for comparable companies in sale transactions

• Present value of projected free cash flows

• “Inherent” value of business

• Value an LBO buyer can afford to pay for business and repay debt borrowed for the acquisition

•Liquidation analysis

•Break-up analysis

Adjusted Present Value

Analysis

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Valuation: Enterprise Value versus Equity Value

Enterprise Value = Value of all business’ assets

Equity Value = Value of the shareholders’ equity

Equity Value = Enterprise Value – Net Debt 1

Enterprise Value

Assets

Net Debt

Equity Value

Enterprise Value

Liabilities and Shareholders’ Equity

1 Net Debt equals total debt + minority interest + preferred stock + capitalized leases + “out of the money” convertible debt – cash and cash equivalents.

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Definitions

� Equity Value (also referred to as Market Value)

- The market value of a company’s equity :

(Number of fully diluted shares x current stock price) – option/warrant proceeds)

- Number of fully diluted shares =“What the market th inks is outstanding”= Primary shares + “in the money” exercisable options/warrants + shares from

the conversion of “in the money” convertible debt/convertible preferred stock- What to do with option/warrant proceeds? Subtract from market value. (Options valued at intrinsic value).

� Enterprise Value (also referred to as Adjusted Market Value)- The market value of the total enterprise:Market value + net debt

- Net Debt = Long-term debt (including current portion) + short-term debt + “out of the money” convertible debt + minority interest + preferred stock + capitalized leases – (Cash + cash equivalents)

Note: As with equity values, net debt should be valued at its market value, not book value. Where market values are not easily discernible, we use book values as a proxy.

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DCF Analysis: Overview

Enterprise Value = Present value today of (i) projected free cash flows of business in Years 1-10, plus (ii) projected terminal value in Year 10.

Today Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

$10.0$15.0 $20.0

$22.0 $25.0$30.0

$35.0$37.0

$40.0$43.0

$98.0

$0.0

$20.0

$40.0

$60.0

$80.0

Annual Free Cash Flow (Dollars in Millions)

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DCF Analysis: Definitions

Present Value� The concept of present value assumes that “a dollar today is worth more than a dollar tomorrow.” For

example, $1.00 in a savings account today earning 5% will be worth $1.05 one year from today. Similarly, $1.05 one year from today, assuming a 5% investment rate is equal to $1.00 today.

Present Value of Single Flow = where N = number of years over whichflow is discounted

Present Value of Cash Stream = Sum of present values of individual cash flow

(P = Cash Flow Amount; r = discount rate)

Discount Rate� The discount rate is the rate of return required by an investor for the level of risk associated with any

investment. It is the rate at which the buyer of the business discounts its projected future cash flows.

Terminal Value� Terminal value is the projected value of the company at the end of the forecast period. Terminal values are

most often derived by assuming the business is sold for some multiple of earnings or cash flow. Alternatively, terminal values can be calculated based on the ongoing “perpetual” value of the company’s cash flows beyond the forecast period.

N

Cash Flow Amount

(1+ Discount Rate)

101 21 2 10

P P P .............

(1+ r) (1+ r) (1+ r)+ + +

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DCF Analysis: Definitions

Free Cash Flow� Unlevered after-tax net income plus depreciation and amortization,

deferred taxes and other non-cash charges less capital expenditures, increase in working investment and other cash charges that do not run through the income statement.

Working Investment� [Current assets less cash and marketable securities] less [current

liabilities less current debt/notes]. If working investment increases from one year to the next, it is a use of cash and the amount of the increase is deducted from Free Cash Flow. If working investment decreases, this decrease is added to Cash Flow.

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Measurement of Free Cash Flows

Cash Flows to Equity for an Unlevered Firm

Revenues- Operating ExpenseEBITDA- Depreciation & AmortizationEBIT- Taxes_______________Net Income+ D & A_______________Cash flows from operations- Cap. Ex± Change W/C

Free Cash Flow to Equity

Cash Flows to Equity for an Levered Firm

Revenues- Operating ExpenseEBITDA- Depreciation & AmortizationEBIT- Interest Expense________EBT- Taxes______________Net Income+ D & A________________Cash flows from operations- Preferred Dividends± Change W/C- Cap Ex- Principal Repayments+ Proceeds from New Debt IssuesFree Cash Flow to Equity

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DCF Analysis: The Process

Step 1

Step 2

Step 3

Step 4

Step 5

Projections

Terminal Value

Discount Rate

Present Value

Adjustments

Project the operating results and free cash flows of a business over the forecast period (typically 10 years).

Estimate the exit multiples of the business at the end of the forecast period.

Use the weighted average cost of capital to determine the appropriate discount rate range.

Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present.

Adjust your valuation for all assets and liabilities not accounted for in cash flow projections.

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Step 1: Projections

� The free cash flows from a business can be projecte d using information about the industry in which a business operates and information specif ic to the business. A variety of sources can be used, such as: investment bank research repo rts, S&P industry surveys, industry journals and manuals, and other miscellaneous sourc es. Information specific to the company being analyzed can be found in Value Line, Wall Street research reports, equity analyst reports from other firms as well as “inside ” projections from the company.

� DCF analysis is an attempt to look at the company’s pure operating results free and clear of extraordinary items, discontinued operations, one-t ime charges, etc. It is also extremely important to look at the historical performance of a company or business to understand how future cash flows relate to past performance.

� A company’s discounted free cash flows represent th e returns to both sources of its capital – debt lenders and equity investors. As a result, f ree cash flows are projected on an unlevered bases – before subtracting interest expens e.

� In summary, DCF projections should be based on:

- Historical performance- Company projections- Equity research analyst estimates- Industry data- Common sense

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Step 1: Projections

Extract Historical Financials• Sales• Operating cash flow• Depreciation & amortization• Deferred taxes• Capital expenditures• Working investment (receivables, inventories & prepaid expense – current payables

and current operating liabilities)

Analyze Numbers• How relevant are historicals?

- Major changes in business or industry- Management’s discussion of results

• Are numbers “clear”?- Extraordinary items- Acquisitions/divestitures

• Is there anything excluded?- Compare to Statement of Cash Flow

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Step 1: Projections

� Make Operating Assumptions

� Sales� Operating cash flow (% sales)� Operating income (OCF minus depreciation)� Taxes (realistic rate)� Deferred taxes (% taxes or derived from depreciation matrix)� Depreciation (% capital expenditures, or derived from depreciation

matrix)� Capital expenditures (% sales)� Working investment (% sales, receivable days, inventory days,

payable days)

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Step 2: Determination of Terminal Value

� Since DCF analysis is based on a limited forecast period, a terminal value must be used to capture the value of the company at the end of the period. The terminal value is added to the cash flow in the final year of the projections and then discounted to the present.

� Terminal values can be calculated based on:

Comparable company multiples- Assumes the business is sold in the private market in Year 10- Calculates value based on Year 10 operating cash flow,

operating income, etc., multiplied by relevant comparable acquisition multiples

Perpetual value- Assumes the business continues to operate as a “going concern”- Calculates value as the present value in Year 10 of the company’s free

cash flows after Year 10:

(Year 11 free cash flow)/(discount rate – projected annual growth rate in cash flows after Year 10

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Step 3: Determination of Discount Rate

Definitions

• Risk-free rate = The minimum required by investors for a risk-free investment (typically the 30-year U.S. government bond rate)

• Company beta = A statistical measure of the variability of a company’s stock price relative to the stock market overall. Use historical betas (Source: Value Line and other reference publications).

• Market premium= The historical return premium required by equity investors above the risk-free rate.

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Step 3: Determination of Discount Rate

� The discount rate is a function of the risk inherent in any business and industry, the degree of uncertainty regarding the projected cash flows, and the assumed capital structure. In general, discount rates vary across different businesses and industries. The greater the uncertainty about the projected cash stream, the higher the appropriate discount rate and the less the cash stream is worth.

� The best measure of the riskiness of projected cash flows – and the best way to determine the correct range of discount rates – is the weighted average cost of capital (WACC) of similar businesses.

� WACC analysis assumes that capital market investors (both debt and equity) in any given industry require returns commensurate with the perceived riskiness of their investment.

� A company’s WACC is calculated as follows:

A. Cost of Debt = Company borrowing cost (after-tax)B. Cost of Equity = Risk-free rate + Company beta x (Equity market premium)C. Weights = Debt/(Debt + Equity) Equity/Debt + Equity)

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Step 4: Arriving at Value Range

� To calculate the value of a business using DCF analysis, the projected free cash flows over the forecast period are discounted to the present at the appropriate range of discount rates. A range of terminal values of the business is added to the cash flows in the last year of projections and discounted to a present value.

� The resulting values represent the total or “enterprise” value of the business, including both debt and equity. To calculate the value of a company’s equity alone, subtract the company’s net debt from its enterprise value.

� In addition, the enterprise value should be adjusted by adding other unusual assets or subtracting liabilities to reflect the company’s fair value. These adjustments include underfunded pension liabilities, etc

DCF Pointers� Assumption Summaries: Write up summaries of the key assumptions

underlying your cash flow projections.� Sensitivity Analysis: It is useful to vary some of the important assumptions

(sales growth rate, margins) to determine how sensitive your value range is to key determinants of future results.

� Calculator Check: Always check Excel numbers with a calculator

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Comparable Companies Analysis

19

Valuation: Methodology

Value Range

Comparable Companies

Analysis

Comparable Acquisitions

Analysis

Discounted Cash Flow Analysis

Other

• “Public Market Valuation”

• Value based on market trading multiplies of comparable companies

• “Private Market Valuation”

• Value based on multiples paid for comparable companies in sale transactions

• Present value of projected free cash flows

• “Inherent” value of business

• Value an LBO buyer can afford to pay for business and repay debt borrowed for the acquisition

•Liquidation analysis

•Break-up analysis

Adjusted Present Value

Analysis

20

Comparable Companies Analysis: Overview

� Comparable companies analysis values a company by reference to other publicly-traded companies with similar operating and financial characteristics.

� Comparable companies values do not incorporate the “control” premiums reflected in comparable acquisitions. Depending on market conditions, these comparable companies multiples may or may not be higher than comparable acquisitions multiples.

� The trick to comparable company analysis is to find good comparables:- The bad news: No two companies are really comparable- The good news: It doesn’t matter, because everybody else (equity

research analysts, traders, arbitrageurs, etc.) has to deal with the same problem.

� Once you have chosen the comparable companies, calculate the implied value of your company by multiplying the company’s sales, operating income, operating cash flow, net income, book value and other key operating statistics by the respective comparable company multiples.

� In addition, comparable companies analysis provides useful information for DCF projections by providing operating statistics for a group of companies within your company’s industry (e.g., working investment, capital spending requirements, growth rates, margin trends).

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Definitions

� Equity Value (also referred to as Market Value)

- The market value of a company’s equity :

(Number of fully diluted shares x current stock price) – option/warrant proceeds)

- Number of fully diluted shares =“What the market th inks is outstanding”= Primary shares + “in the money” exercisable options/warrants + shares from

the conversion of “in the money” convertible debt/convertible preferred stock- What to do with option/warrant proceeds? Subtract from market value. (Options valued at intrinsic value).

� Enterprise Value (also referred to as Adjusted Market Value)- The market value of the total enterprise:Market value + net debt

- Net Debt = Long-term debt (including current portion) + short-term debt + “out of the money” convertible debt + minority interest + preferred stock + capitalized leases – (Cash + cash equivalents)

Note: As with equity values, net debt should be valued at its market value, not book value. Where market values are not easily discernible, we use book values as a proxy.

22

Valuation: Enterprise Value versus Equity Value

Enterprise Value = Value of all business’ assets

Equity Value = Value of the shareholders’ equity

Equity Value = Enterprise Value – Net Debt 1

Enterprise Value

Assets

Net Debt

Equity Value

Enterprise Value

Liabilities and Shareholders’ Equity

1 Net Debt equals total debt + minority interest + preferred stock + capitalized leases + “out of the money” convertible debt – cash and cash equivalents.

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Definitions of Key Operating Statistics

� Sales: Receipts from the sale of goods and services (excludes other income).

� Operating Income: Earnings before interest expense/income, taxes and unusual/extraordinary charges.

� Operating Cash Flow: Operating Income plus depreciation and amortization.

� Net Income: After-tax income from continuing operations after preferred dividends but before “below the line” income/charges for extraordinary items, restructuring, changes in accounting, etc. When Equity Value calculations assume conversion of “in the money” convertible debt, adjust Net Income by adding back the after-tax interest expense on any debt assumed to be converted.

� Tangible Book Value: Shareholders’ equity less goodwill and other intangible assets.

Definitions are a guide. You must try to understand the business to best determine whether to include or exclude various items of income or expense.

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Finding Comparable Companies

� Look for companies with characteristics similar to those of the business being valued.

Operational FinancialIndustry SizeProducts LeverageDistribution Channels Shareholder baseMarkets GrowthCustomers MarginsSeasonalityCyclicality

� Sources to check to initially select comparables:- Value Line- On-line data sources- Equity research reports and analysis- SIC code searches- Your colleagues

� Once you have organized your list of comparables, order the company documents (10-K, Annual Report, 10-Q) and review them to select those which you will analyze in detail.

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Calculating Comparable Companies Multiples

Enterprise Value Multiples� Enterprise Value or Adjusted Market Value = Market Value + Net Debt� Sales� Operating Cash Flow� Operating Income

Equity Value Multiples� Equity Value = Market Value� Net Income� Tangible Book Value

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Applying Multiples to DeriveComparable Companies Values

General Approach� Calculate the relevant multiples for each comparable company� Decide which companies are most comparable� Throw out the outlying multiples� Use common sense

Doing the Math� Multiply the operating results (revenues, operating income, etc.) of the company being

valued by the relevant comparable company multiples to derive implied values. Ideally, two sets of operating results should be used in comparable company valuations: latest twelve-month (“LTM”) results and projected full-year results.

� Remember to convert the equity values derived from applying comparable multiples of net income and book value to enterprise values by adding the company’s net debt.

� Adjust the resulting implied values for unusual assets or liabilities not reflected in the results on which the comparable company analysis is based. Examples include unfunded pension liabilities, unconsolidated minority investments, unallocated corporate overhead expense (if valuing a division), etc.

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Comparable Acquisition Analysis

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Comparable Acquisition Analysis:Overview

� Comparable acquisitions analysis values a company by reference to other private market sales of similar businesses.

� The trick is to find the right comparable transactions and to ferret out the information required to do the math. As in comparable companies analysis, look for acquisitions of companies with comparable operational and financial characteristics. Recent transactions are a more accurate reflection of the values buyers are currently willing to pay than acquisitions completed in the distant past. This is because market fundamentals are subject to dramatic change over periods of time.

� Comparable acquisitions analysis is based on the same multiples as those used in comparable companies analysis. Multiples should be based on the latest public financial information available to the acquirer at the time of the acquisition.

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Definitions

Purchase Price� The total price paid for the acquired company’s equity:

(Number of shares x acquisition price per share) – option proceeds

� Number of shares = fully-diluted shares outstanding= Primary shares + all “in the money” options/warrants + all “in the money” convertible preferred stock – option/warrant proceeds

Adjusted Purchase Price� The total price paid by the acquirer:

Equity purchase price + net debt assumed� Net debt = same definition as in comparable companies analysis

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Calculating Comparable Acquisitions Multiples

Doing the Math� Just like comparable companies analysis except:

� Convert all options, convertible debt, etc.� Gross up to 100% acquisitions of less than 100% of the target company to ensure that all

transactions are shown on an “apples to apples” basis (i.e., divide purchase price by percentage of total shares acquired).

Adjusted Purchase Price Multiples� Adjusted Purchase Price = Purchase Price + Net Debt

� Sales� Operating Cash Flow� Operating Income

Purchase Price Multiples� Purchase Price = Equity Value

� Net Income� Tangible Book Value

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Applying Multiples to DeriveComparable Acquisitions Values

General Approach� Calculate the relevant multiples for each comparable transaction� Decide which acquisitions are most comparable� Base your reference values on the most relevant multiples from the most

comparable transactions

Doing the Math� Use the date the acquisition is announced (not closed) to determine the LTM

period. Multiply the LTM results of the target company at the acquisition date by the relevant comparable acquisitions multiples to derive implied values.

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Summary

The Final Steps� Having derived comparable companies, comparable acquisitions and DCF

values, select a single range of reference values for the company in quesiton� Calculate the multiples of the company’s results implied by the highest and

lowest values in the reference range� Take a final reality check of the resulting multiples. Does your reference

value imply the company is worth 10 times operating cash flow when no similar company has ever traded or been sold for more than 7 times? If so, revisit your assumptions

Parting Observations� Try to develop and use judgment in your valuation analysis – about the

company, the public and private markets for comparable businesses, etc.