Equity Valuation Toolkit Additional Valuation Resources PDF

Official Use Only
Equity Valuation Toolkit

A toolkit to guide consistent application of valuation techniques commonly used at IFC.
TABLE OF CONTENTS OVERVIEW
Chapter 1: Valuation Overview and Standard Enterprise Value Adjustments ...... 8
Chapter 2: Market Capitalization, Liquidity Measures and the Impact of
Dilutive Securities on Enterprise Value ............................................................. 24
Chapter 3: Comparable Analysis ....................................................................... 37
Chapter 4: Discounted Cash Flow Analysis ........................................................ 64
Chapter 5: IRR and Discount Rates including WACC .......................................... 89
Chapter 6: Other Valuation Techniques Commonly Used at IFC ...................... 108
Chapter 7: Discounts Related to Level of Liquidity & Control .......................... 118
Chapter 8: Pre and Post Money Valuations ..................................................... 123
Chapter 9: Complex Adjustments in Deriving Equity ....................................... 128
|Page 2
TABLE OF CONTENTS OVERVIEW
Chapter 1: Valuation Overview and Standard Enterprise Value Adjustments ...... 8
1.1. Valuation Overview ................................................................................................. 9
1.1.1. Art versus Science ....................................................................................................................... 9
1.1.2. Guiding Principles for a Valuation at IFC ............................................................................ 9
1.1.3. Common Valuation Techniques .......................................................................................... 10
1.1.4. Valuation Process: 5 Steps .................................................................................................... 12
1.2. The Basics of Calculating Enterprise, Total Enterprise and Equity Values ................. 13
1.2.1. Terminology ............................................................................................................................... 14
1.2.2. Valuation Map............................................................................................................................ 14
1.2.3. When to Use EV, TEV and Equity ......................................................................................... 15
1.2.4. The Basic Enterprise Value Equation: Application to a Simple Firm.................... 15
1.3. Standard EV Adjustments....................................................................................... 16
1.3.1. Excess Cash ................................................................................................................................. 16
1.3.2. Non-Core Assets ........................................................................................................................ 16
1.3.3. Minority Interest – Non-controlling Interest (NCI) ...................................................... 17
1.3.4. Equity Investments .................................................................................................................. 19
1.4. Calculating Market Value of Associate Investments and Minority Interest .............. 21
1.5. Chapter Takeaways ................................................................................................ 22
Chapter 2: Market Capitalization, Liquidity Measures and the Impact of
Dilutive Securities on Enterprise Value ............................................................. 24
2.1. Market Capitalization: The Basics ........................................................................... 25
2.1.1. The First Step in Comparable Analysis ............................................................................. 25
2.1.2. How Much Liquidity is Sufficient? ...................................................................................... 25
2.1.3. Liquidity Measures .................................................................................................................. 26
2.1.4. Market Capitalization: Basic Formula .............................................................................. 27
2.2. Multiple Share Classes, Options, Restricted Stock Units (RSUs) and Convertibles .... 29
2.2.1. Determining Share Count and Market Capitalization ................................................. 29
2.2.2. Diluted Shares Outstanding with Options, Restricted Stock Units and
Convertibles ................................................................................................................................................. 30
2.2.3. Analyzing the Impact on Dilution from Convertible Debt ......................................... 32
Chapter 3: Comparable Analysis ....................................................................... 37
|Page 3
3.1. Comparables: Overview and Link to Value Driver Analysis ...................................... 38
3.1.1. Comparables Analysis Depends on Understanding of Value Drivers.................... 39
3.1.2. Use Comparables Analysis to tell a story: Sample Industry Multiples .................. 39
3.2. Review of Basic Calculations of P/E and EV/EBITDA ................................................ 40
3.3. Best Practices in Comparables ................................................................................ 43
3.3.1. Step 1: Choose the Comparable Companies Set ............................................................. 43
3.3.2. Step 2: Select the Multiple(s)................................................................................................ 46
3.3.3. Step 3: Calculate Multiple(s) Using Cleaned Earnings ................................................ 49
3.3.4. Step 4: Check and Interpret the Results & Select the Final Valuation Range ..... 55
3.3.5. Impact of Economic Cycles .................................................................................................... 56
3.4. Best Practice Output .............................................................................................. 58
3.5. Common Errors to Avoid ........................................................................................ 60
3.6. Pros and Cons of Comparables Analysis.................................................................. 61
3.7. Transaction Multiples ............................................................................................ 61
3.8. Quarterly Valuation Updates during Portfolio Supervision...................................... 62
3.9. IFC Comparables Data ............................................................................................ 63
Chapter 4: Discounted Cash Flow Analysis ........................................................ 64
4.1. DCF Basics.............................................................................................................. 65
4.1.1. A Fundamental Approach to Valuation ............................................................................ 65
4.1.2. DCF Concept and Formula ..................................................................................................... 65
4.2. Five Steps in Discounted Cash Flow Analysis........................................................... 67
4.2.1. Step1: Determine Forecast Type & Length, Project FCF ............................................. 68
4.2.2. Step 2: Calculate Terminal Value ........................................................................................ 76
4.2.3. Step 3: Select an Appropriate Discount Rate .................................................................. 79
4.2.4. Step 4: Discounted the FCF and TV to the Present Value ........................................... 81
4.2.5. Step 5: Check & Sensitize Results and Determine Equity Valuation Range......... 84
4.3. Common Pitfalls in DCF Valuation .......................................................................... 86
4.4. Presenting the Results ........................................................................................... 87
4.5. PROS and CONS of DCF Valuation Analysis ............................................................. 87
Chapter 5: IRR and Discount Rates including WACC .......................................... 89
5.1. Rates of Return versus Discount Rates ................................................................... 90
|Page 4
5.2. Internal Rate of Return .......................................................................................... 91
5.2.1 IRR Concept and Formula ...................................................................................................... 91
5.2.2 Cash Multiple Measure ........................................................................................................... 91
5.3. Weighted Average Cost of Capital .......................................................................... 96
5.3.1 WACC Concept and Formula ................................................................................................. 96
5.3.2 Four key questions when calculating WACC................................................................... 97
5.4. CAPM: Application, Inputs and Issues..................................................................... 98
5.4.1 CAPM Formula for the Cost of Equity ................................................................................ 98
5.4.2 Risk free rate............................................................................................................................ 100
5.4.3 Equity Risk Premium: Equity Market Risk .................................................................... 101
5.4.4. Beta: Company Specific Risk............................................................................................... 101
5.5. Incorporating Country Risk into the WACC ........................................................... 104
5.5.1 Country Risk Considerations ............................................................................................. 104
5.5.2 Summary Formula for WACC with Country Risk......................................................... 106
5.6. Chapter Takeaways .............................................................................................. 107
Chapter 6: Other Valuation Techniques Commonly Used at IFC ...................... 108
6.1. Sum of the Parts Analysis ..................................................................................... 109
Overview ....................................................................................................................... 109
Considerations in Applying the Sum of the Parts Technique................................................... 110
6.2. Other DCF Models (FCFE) (DDM) .......................................................................... 112
Free Cash Flow to Equity (FCFE) ......................................................................................................... 112
Dividend discount model ...................................................................................................................... 113
6.3. Back of the Envelope Checks ................................................................................ 114
6.4. Valuation of Early Stage Firms .............................................................................. 116
Portfolio Valuation for VC Investments .......................................................................... 117
6.5. Valuation of Conglomerates ................................................................................. 117
Chapter 7: Discounts Related to Level of Liquidity & Control .......................... 118
7.1. Discounts Related to Liquidity & Control .............................................................. 119
Overview ....................................................................................................................... 119
Graphic – Valuation Steps ..................................................................................................................... 119
7.2. Discounts for Lack of Liquidity .............................................................................. 119
Illiquidity Discounts: Key drivers & Evidence ............................................................................... 120
|Page 5
7.3. Discounts for Lack of Control................................................................................ 121
Minority Discounts: Key drivers & Evidence ................................................................................. 121
7.4. IFC Guidelines ...................................................................................................... 121
7.5. Common errors.................................................................................................... 122
Chapter 8: Pre and Post Money Valuations ..................................................... 123
8.1 Final Step: Calculating Pre and Post Money Valuation & IFC Stake ........................ 124
Pre vs Post Project Valuation: ............................................................................................................. 125
8.2 Chapter Takeaways .............................................................................................. 127
Chapter 9: Complex Adjustments in Deriving Equity ....................................... 128
9.1. Review of EV to Equity Adjustments..................................................................... 129
9.2. Complex Adjustments .......................................................................................... 130
Non-Operating Assets ............................................................................................................................. 130
Non-Operating Liabilities ..................................................................................................................... 130
Operating Leases...................................................................................................................................... 131
Unfunded Pension & Post-Employment Benefit Liabilities ...................................................... 133
Employee Stock Option Plans .............................................................................................................. 134
Off Balance Sheet Liabilities ................................................................................................................ 135
Appendices..................................................................................................... 136
Appendix 1 - Comprehensive Example for Minority Interest & Equity Investments at
various holding levels ..................................................................................................... 137
Appendix 2 - Complex Adjustments in Calculating Multiples ..................................... 137
Appendix 3 - Decomposing Steady State Multiples .................................................... 141
Appendix 4 - Proof of the constant Growth Formula ................................................. 143
Appendix 5 - Terminal Value Issues & Sensitivities .................................................... 143
Appendix 6 - Alternative Approaches to Terminal Value............................................ 145
Appendix 7 - Historic Estimates of the Equity Risk Premium ...................................... 147
Appendix 8 - Alternative Approaches to Estimating CRP ............................................ 148
Appendix 9 - Exercises on calculating Pre and Post Money Valuation and IFC Stake ... 149
|Page 6
INTRODUCTION
In the last 10 years, IFC’s equity portfolio has seen record growth. With 920 companies currently in
the portfolio, it is now valued at $15.7 billion with US$4.6 billion in unrealized capital gains. The
rapid expansion of the equity portfolio has driven an acute need to strengthen valuation capabilities
across the Corporation. Errors in valuation and misuse of techniques can result in mispricing at any
stage and impact the management of IFC’s portfolio. Errors in valuation can negatively impact IFC’s
returns, audit opinions, credit rating, funding costs and ultimately our reputation. Strengthening our
equity valuation capabilities thus enhances our ability to achieve returns, grow IFC’s balance sheet
and further our development impact.
The IFC Equity Valuation Toolkit (EVT) is designed to codify IFC best practice in using common
valuation techniques. This toolkit should serve as a reference for Investment Officers performing
any valuation analysis. The intent of the EVT is to support the consistent application of standard
valuation techniques and reduce the incidence of errors. The toolkit and the methodologies
outlined herein can only be leveraged effectively in the context of investment staff applying
expertise regarding key business value drivers and country and sector dynamics.
While valuation is often said to be “more art than science”, sound investment decisions and good
judgment must be rooted in accurate analysis. The EVT covers the basics of various valuation
techniques such as DCF, Comparables, IRR, DDM, sum-of-the-parts and back-of-the-envelope. IFC’s
equity business encompasses many industries and sectors and it is not the intention of this toolkit to
cover the nuances and complexities of each. Industry-specific supplements are planned which will
cover valuation in each sector, leveraging the expertise of Industry Specialists. There will also be a
supplement on the impact of structuring on value realization, as well as a new business
considerations supplement.
The focus here is on explaining each technique in detail, specifically, the EVT provides:
• an overview of standard market methodologies (DCF, Comps, IRR, DDM)
• issues and common errors in each methodology
• step by step examples to illustrate techniques
• exercises to practice on each topic are included in each chapter and can also be found in the
accompanying excel file
• detailed guidelines for deriving equity and enterprise valuation nuances specific to IFC and
emerging markets
• advice on interpreting results and triangulating value
This toolkit is for internal use only and strictly confidential. It was produced through collaboration
between Chief Credit Officers, the Portfolio Valuation Team, Chief Equity Specialists, Investment
Officers and the AMC. This document will be updated periodically to reflect changes in accounting
policies and market practices. This document will be maintained online and any changes or edits will
be posted to the CRKIC website. July 30, 2015
Contacts
Anandhi Rajakumaran, Chief Credit Officer Arajakumaran@ifc.org or askCredit@ifc.org
Junfeng (Jennifer) Shi, Head Portfolio Valuation Team, jshi@ifc.org
|Page 7
Chapter 1: Valuation Overview and
Standard Enterprise Value Adjustments
Chapter1: This chapter presents an introduction to valuation, a summary of the techniques commonly employed, and an
overview of some of the challenges in conducting a basic corporate valuation. The concepts of Enterprise Value, Total
Enterprise Value and Equity are defined and the methodology for making standard adjustments of excess cash,
investments in associates and Non-controlling Interest (NCI) are explained in detail.
Chapter Contents
1.1. Valuation Overview

1.1.1. Art vs Science
1.1.2. Guiding Principles for a Valuation at IFC
1.1.3. Common Valuation Techniques
1.1.4. IFC Valuation Process: 5 Steps
1.2. The Basics of Calculating Enterprise, Total Enterprise & Equity Values
1.2.1. The Basic Enterprise Value Equation: Application to a Simple Firm
1.2.2. IFC Terminology
1.3. Standard EV Adjustments

1.3.1. Excess Cash
1.3.2. Non-core assets
1.3.3. Non-controlling Interests (NCI)
1.3.4. Equity Investments
1.3.5. Valuation Map
1.3.6. When to use EV, TEV and Equity
1.4. Calculating the Market Value of Associate Investments and Minority Interest
1.5. Chapter Takeaways
1.1. See Appendix 1 for Comprehensive Example for Minority Interest & Equity Investments
1.2. at various holding levels
|Page 8
1.1. Valuation Overview
1.1.1. Art versus Science
Valuation is often said to be “more art than science”. Perhaps it is more accurate to consider
valuation as dependent on both the science - the technical aspects of employing various valuation
methodologies - and the art of utilizing sound judgment to develop the assumptions which will
determine the result of each method. The scientific aspect of valuation requires the rigorous
analysis of firm, sector and macroeconomic data along with the accurate implementation of the
techniques of discounted cash flow and comparable analysis or other techniques. The art aspect
relies on applying industry knowledge, as well as lessons of experience in the more volatile and less
liquid emerging market countries where IFC operates. The art is in interpreting the results of the
valuation analysis and triangulating a value based on that knowledge and experience.
Before beginning a valuation, one must consider the purpose of the valuation. At IFC, we are often
using valuation techniques in pricing an investment at entry, estimating the value of an investment
we own, or using that estimate to evaluate offers at exit. Some of IFC’s investments are listed and
there is an observable market price which should be considered or a private exchange of shares
which establishes a precedent price for the company’s shares. However, more often for unlisted
companies that are raising outside capital for the first time, a key challenge is to estimate intrinsic
value in the absence of a transaction. Without a market clearing price (i.e., the price at which a
willing buyer and a willing seller are prepared to conduct a purchase/sale transaction), there is
substantial uncertainty in estimating value. Further even when there is an offer price, either at exit
or an expectation from a client, independent analysis is necessary. In any situation, it is usually
recommended to utilize more than one valuation methodology to appropriately determine a
valuation range.
The valuations resulting from various techniques will differ, at times significantly. However, such
variations in results are not necessarily a function of the methodologies employed, but more likely a
direct result of the differences in the underlying assumptions. For example, valuations derived from
Discounted Cash Flow (DCF) and market comps could be materially different because the comps
used do not reflect the unique aspects of the business being valued. Further an Investment Officer’s
( IO’s)DCF result may differ from that of a client, as the client may be using more optimistic
assumptions. It is important to be mindful of the assumptions underlying each technique used.
By using alternative valuation methodologies, staff will be able to 1) highlight possible errors in the
resultant calculations; and 2) check the consistency of the assumptions employed. The more similar
the underlying assumptions in each methodology, the closer the resulting valuation ranges should
be. Understanding the drivers of the differences in valuation results supports the final triangulation
of a reasonable valuation range and the determination of a single entry price and/or a reasonable
estimation of fair value of an existing asset in our portfolio.
1.1.2. Guiding Principles for a Valuation at IFC
Valuation is only one of a number of inputs into an investment decision. Price and value can, and
often do, differ. Pricing reflects the market of interested buyers, supply of similar investments,
investor sentiment, seller/buyer timelines and negotiating strength.
|Page 9
At IFC, our negotiating position (e.g. additionality, availability of other funding or buyers for the
asset), our relationship with the owners and the evolution of market conditions may significantly
impact our pricing and returns. Deal structure and terms can enhance or detract from the ability to
realize a base valuation assessment. How we price a deal should reflect the ability to realize value
which depends heavily on non-quantifiable factors, such as the quality of the management team and
how the investment is structured, especially vis-à-vis exit rights.
When conducting a valuation exercise, it is inevitable that our valuations will be impacted by mental
processes that lead to bias which can have a direct impact on value. Often potential investees are
overconfident in the upside of their businesses. Even in the public market, behavioral finance
research demonstrates that herd behavior, over reliance on recent performance and other irrational
pricing behavior can also lead to pricing distortions.
Applying the key principles below will support staff in conducting a robust analysis:
1. Identify the purpose of the valuation and be mindful of your own biases and of those
providing inputs for the valuation; for example, the client and its financial advisors versus
independent industry reports.
2. Be clear about what you are valuing: Often clients and staff confuse the terms enterprise
value and equity value and the parameters and expectations are not clear. Distinguish
between the intrinsic valuation and the realizable pricing and exit value possibilities.
3. Be rigorous in the analysis, focusing on key value drivers of the industry. High equity returns
are most often driven by business performance; focus on the factors that will enable the
company to deliver superior returns on capital. Start with back of the envelope calculations
to gain baseline comfort with the business model. Include the application of IFC’s lessons of
experience, industry expertise and market parameters of value.
4. Ensure the science part of the analysis is accurate as small mistakes can lead to significant
errors or wrong conclusions. Always run sensitivities in each technique, as each method is
based on a series of assumptions (i.e., the “art”) which must be estimated.
5. Use your professional judgment and remember the combination of science and art that will
yield a reasonable value range and returns appropriate to the inherent risk of the
investment. Be clear about the negotiating context of the pricing discussion if any.
1.1.3. Common Valuation Techniques

The following table provides an indication of commonly used valuation techniques at IFC and where
you can find them in this guide:
| P a g e 10
Table 1: Commonly used Valuation Techniques
Technique Description
Market value Market valuation: Current market prices should fully incorporate all available
and adjustments information on firm and sector.
i. Useful for public companies and as basis for comparables
Chapter 1 and 2 ii. Understand how to make basic adjustments from equity to enterprise value
in order to interpret market value of the core operating business
Comparable Relative valuation: Similar assets should trade at similar prices

Companies i. Value based off a multiple of a measure of earnings
Analysis ii. Trading comparables – for liquid minority stakes
iii. Transaction comparables - sales of controlling or non-controlling Interest
Chapter 3 (NCI) stakes in private companies
Discounted Cash Intrinsic valuation: Present value of future cash flows

Flow (DCF) i. Free Cash flow to the firm is used to value the enterprise
Chapter 4
Internal Rate of Return based valuation

Return (IRR) i. Used in Leveraged Buyout (LBO), Venture Capital and private equity,
analysis; key IFC metric
Chapter 5 ii. Determine maximum price for firm based on required return on investment
Others:
FCFE/DDM FCF to equity:
i. Free cash flow to equity is used to value equity
ii. DDM for Financial Institutions Group (FIG)
Asset Value: Sum
Value individual segments of firm
of the Parts`
i. Can be applied to individual assets or business units (then sum the parts)
Chapter 6 ii. Allows for the combination of different methodologies and/or assumptions
for each segment of the business. Appropriate for conglomerates or
companies with a combination of cash flow and asset based businesses
| P a g e 11
1.1.4. Valuation Process: 5 Steps
Set out above are the major steps in conducting a solid valuation exercise. This 5 step process is
comprehensive and all steps are appropriate for the entry stage. At portfolio and exit, certain
parts of this process may be abbreviated.
1. Analyze business and key drivers, forecast scenarios:

a. consult industry and country specialists and staff with experience in the sector
globally and regionally,
b. spend time with the client on appraisal to understand the key drivers of their
business performance,
c. research key players in the sector and understand the basis of their competitiveness
in the relevant market,
d. read equity research reports to understand how the business is valued by investors,
e. investigate the details of any recent private transactions,
f. forecast scenarios and likely future outcomes based on key business risks and
drivers.
2. Select and apply valuation techniques and sanity check the results.
3. Triangulate a reasonable valuation range for a liquid minority investment.
4. Apply illiquidity discount to reach final valuation recommendation.
5. Determine price range if for internal review and proposed post-money stake for negotiation.
This toolkit mainly focuses on the technical aspects of steps 2-5 of IFC’s typical entry valuation
process. IOs should consult with Industry Specialists to understand the nuances and complexities of
valuation in specific sectors. The planned industry supplements will support valuation exercises with
| P a g e 12
sector specific guidance. IOs should also consult with Credit Officers and Equity Specialists early in
the project cycle to discuss the selection of entry valuation techniques and issues to consider when
conducting the valuation analysis. Tradeoffs are inevitable in each transaction and the structure of
the investment can have material impacts on valuation. The structuring supplement to the EVT will
address the impact of structuring on valuation realization.
At the portfolio valuation and exit stages, IOs should consult with the Portfolio Valuation Team for
guidance on quarterly valuations and appropriateness of techniques.
Throughout the guide we highlight frequently asked questions (FAQs) and cautions about common
errors in analysis. Key to accuracy in valuation is awareness of bias and the utilization of techniques
and sanity checks to minimize its occasion and impact. By keeping these issues in mind, staff can
ensure their analysis and investment recommendations are robust and capture an appropriate risk-
reward balance.
1.2. The Basics of Calculating Enterprise, Total Enterprise and Equity Values
The first step in valuation is to be clear in what you are valuing: the entire company or only the
common equity. If you are valuing the entire company (Enterprise Value or Firm Value), remember
that value belongs to all claimants or providers of capital. Whereas the equity value is only
attributable to common shareholders and is the residual value after deducting from Enterprise Value
the claims of other providers of capital (e.g. Lenders and Minorities). Valuation of financial
institutions, however, is somewhat different and equity value is calculated directly without any
calculation of Enterprise Value or Firm Value.
This is an area of some confusion as terminology or nomenclature is very different across markets.
Adding to the confusion and error is the fact that although IFC invests in the equity of its clients, we
often use Enterprise Value techniques to derive equity value. Clients sometimes confuse market
capitalization and Enterprise Value. In some situations investment officers and clients use a generic
term of “valuation”. The failure to specify exactly what is being valued can impede negotiation.
It is also critical to identify the scenario under which the valuation is performed: is it of the firm on
an “as is, pre-project” or “post-new project” basis? Whether or not we are willing to factor in the
valuation of the new project and how much we are willing to pay for it is a negotiating decision.
Clients may expect IFC to pay for the upside from new projects; however, Investment Officers should
be sure to analyze the value of the company on a standalone basis prior to factoring in the new
project. However, Investment Officers should always be analyzing a pre-money valuation range and
then factoring in our equity investment and ownership stake as a second step (post-money
valuation). Final determination of the entry valuation will be a result of negotiating leverage. The
topics of pre and post project and pre and post money are considered in detail in Chapter 9.
| P a g e 13
1.2.1. Terminology
It is important to distinguish between Enterprise Value (EV), which is sometimes called Firm Value
(FV) or Core Enterprise Value and Total Enterprise Value (TEV) which is also known as Consolidated
Enterprise Value. The former terms refer to operating assets only and exclude non-core and non-
consolidated assets. When considering core EBITDA or other operating metric based valuation, IOs
should isolate the core Enterprise Value. The latter set of terms includes the value of all assets
except for excess cash. In both cases however, the final equity value will be the same.
At IFC and in this Equity Valuation Toolkit (EVT), we follow common practice and use:
• Enterprise value (EV) = Value of core operations

• Total Enterprise Value (TEV) = Total firm value including investments and non-core assets
Below is an illustration of the differences between EV and TEV for the same firm:
1.2.2. Valuation Map
One can either calculate equity value and derive an implied Enterprise Value or calculate an
Enterprise Value and derive an implied equity value. In either approach, the value of all
intermediate components is critical to correctly computing the derivation.
Below is a basic illustration of deriving equity value from an Enterprise Value methodology:
| P a g e 14
1.2.3. When to Use EV, TEV and Equity
When valuing companies in the real sector, we normally focus on Enterprise Valuation techniques,
using DCF and EV/EBITDA multiples for example. This enables us to examine the value of the entire
operating business. In a DCF, we forecast free cash flow (FCF) from operations and thus need to
value all non-operating assets separately as their cash flows are not included in FCF. The same holds
for valuations based on EBITDA multiples as the earnings from these investments are usually
excluded from EBITDA. Benchmarking in both methodologies is more comparable at the EV level
versus TEV or Equity since EV excludes non-core assets and financing differences across firms. Equity
multiples work well in sectors with low leverage or where companies have similar level leverage.
They also work well in the FIG sector, specifically in the valuation of financial intermediaries like
banks, because of very high levels of leverage and the very different concept of debt for a bank.
These reasons are discussed in greater detail in Chapter 6 in the Dividend Discount Model section.
TEV which includes the EV and the value of the non-core assets is usually examined in an acquisition
context where we need to determine total funding required. This is sector dependent. In some
sectors, like telecom and beverages, where nearly all companies have large investments in affiliates,
TEV is sometimes used.
In some industries, e.g. FIG, free cash flow to equity (FCFE) is employed because the impact of a cash
conversion cycle is not relevant. Dividend flows are typically used as a proxy for FCFE. Other
industries, such as power project financed single asset companies also focus on FCFE.
At IFC, we usually are purchasing common shares of equity and thus focus on deriving equity
valuation. Even when we invest in preferred shares, if the preferred provides only a liquidity
preference and is similar to common in all other rights, then the methods described here for valuing
common equity can be used for valuing such preferred stakes.
1.2.4. The Basic Enterprise Value Equation: Application to a Simple Firm
Consider a simple firm with no subsidiaries or minority investors. If we assume the firm is capitalized
with debt, preferred stock, and common equity, the value of this firm or enterprise is:
Scenario 1: Simple Firm
EV = Debt + Preferred Stock + Equity
To derive the equity, Equity = EV – Debt – Preferred Stock | P a g e 15

1.3. Standard EV Adjustments
1.3.1. Excess Cash
The above formula on EV for a simple firm ignores the impact of cash and other adjustments. The
first adjustment to consider is excess cash. For firms with excess cash, a more accurate equation
follows where Net Debt = Debt less excess cash.
Scenario 2: With Excess Cash
EV = Net Debt + Preferred Stock + Equity, or
EV + Excess Cash = Debt + Preferred Stock + Equity, or
Equity = EV – Net Debt – Preferred Stock
Is Net Debt equal to debt minus all cash? What about operating cash? Restricted
cash?
Cash in an EV equation usually refers to excess cash and equivalent investments. Since
operating cash is required to generate income, it should not be deducted to derive
Enterprise Value. Similarly restricted cash has been put aside for a specific purpose
and cannot be considered as excess cash. Restricted cash is generally detailed in the
notes to the financial statements, often in the debt section. Operating cash will not be
identified explicitly and should be estimated based on firm and sector knowledge.
Regardless, it is key that you and the client are on the same page in discussing what
level of cash will be viewed as excess. Also be mindful of seasonal fluctuations and
cash levels which are only temporarily high due to working capital fluctuations (e.g.
commodity agriculture).
To find EV from Equity, adjust only for excess cash and cash equivalents
FAQ: Can Equity Value ever exceed Enterprise Value?
Yes, it is not unusual for a firm, especially a mature firm, to have cash levels exceeding debt, leading
to negative net debt. If net debt is negative, equity value exceeds Enterprise Value (ignoring other
adjustments).
1.3.2. Non-Core Assets
Next consider a company with non-core assets. As discussed earlier, firms can be analyzed in terms
of the operating businesses (EV) or operating assets and the non-operating assets (TEV). Operating
| P a g e 16
assets are typically the primary source of a firm’s income and are typically consolidated in EBITDA.
In addition, a firm may have non-operating assets such as unused real estate, assets held for sale,
minority investments in other firms, and assorted other assets, for example art collections. When
discussing a valuation, it is important to clearly convey whether the valuation is of the operating
business (EV) or the total enterprise including non-operating assets (TEV).
Scenario 3: With non-core assets
EV of core operations + Non-core assets = Net Debt + Preferred Stock + Equity
Or, Equity = EV of core + Non-core assets – Net Debt – Preferred Stock
1.3.3. Minority Interest – Non-controlling Interest (NCI)
When a firm owns and controls 100% of the equity in another firm, all income and balance sheet
items are fully consolidated and no EV adjustments are necessary. However, when a firm owns less
than 100% of the equity, it gives rise to one of two valuation complexities – either a claim on assets
by minority investors or a non-consolidated associate investment (asset).
When firms have subsidiaries jointly owned with minority investors, (for IFC clients these are often
original family owners), the minority investors own a portion of the equity in one or more of the
subsidiaries. The minority investors are stakeholders and have a claim on subsidiary income and
cash flow which must be considered when calculating equity returns and value.
In the case where a firm controls a subsidiary, usually by owning at least 50% of the equity or by
having voting control, most accounting standards require that 100% of the earnings (including all
EBITDA) are consolidated. On the income statement, the portion of subsidiary earnings that are not
available to common stockholders are classified as “Income attributable to noncontrolling interest”
and appears near the bottom of the income statement. On the balance sheet, the equity of the
minority shareholders is labeled “non-controlling interest” and is included in the equity section,
often at book value. Since the book value of such Minority Interest or NCI may not equal the value
of the minority shareholders’ equity, it is important to use market value when adjusting EV to find
equity value. If book value of the non-controlling Interest (NCI) is less than market value,
adjustments are made at book value and, equity will be mistakenly overvalued and IFC will
overpay for the common equity. Details on alternatives for calculating the market value of Minority
Interest is covered later in this chapter.
| P a g e 17
Exercise 1: Finding Enterprise Value (EV)
Use the information below to find the EV
Shares outstanding 1,000

Share price 15
Debt 6,000
Cash 200
Non-controlled interest 500
Financial investments 700
Solution 1
In this example equity value is calculated first and then the EV is derived
Enterprise Value = 20,600 = Equity + Debt + NCI – Cash – Financial Investments.
Illustration of Exercise 1: Start with Equity value to calculate Enterprise Value
In Exercise 1, use the market value of equity to find Enterprise Value. Core EV can then be used in
determining EV/EBIT and EV/EBITDA multiples (see Chapter 3).
| P a g e 18
1.3.4. Equity Investments
When a firm has a strategic but less than a controlling stake in another firm, the investment is
accounted for as an equity method investment and may be called an Investment in Affiliate or
Investment in Associate.
In the case where the firm owns less than 50% of a subsidiary, investments are accounted for under
equity method accounting (20-50% stakes or significant influence) or as financial investments (less
than 20% stakes). Under equity method accounting, the book value of the investment may or may
not be equal to its market value. In financial investments, they could be at market value under fair
value accounting standards. In both cases, the earnings, which are a share of net income, should not
be included in the EBIT and cash flows used for valuation purposes, but rather valued separately
from the core operating business. The below formula for scenario 5 summarize the basic EV formula
including all standard adjustments:
Scenario 5: With equity method investments
EV of core operations + Non-core assets + Investments = Net Debt + Preferred Stock + Equity + NCI
or, Equity = EV of core + Non-core assets + Investments – Net Debt – Preferred Stock – NCI
| P a g e 19
Exercise 2: Calculate Equity value and the Implied Share Price
Use the information below to find EV and implied share price.
Firm EBITDA 350.0

Peer EV/EBITDA multiple * 8.5
Bonds - market value 715.3
Cash 82.1
Assets held for sale 23.5
Minority interest 82.0
Equity investments 224.6
Preferred stock 125.0
Bank Debt 114.9
Basic shares outstanding 88.7
Diluted shares outstanding 91.8
Marginal tax rate 33.0%
Enterprise value
Equity value
Share price
* Similar firms trade at an average EV/EBITDA
Solution 2
In this example Enterprise Value is calculated using the EV/EBITDA multiple. The Enterprise Value
calculation then drives the implied equity value.
EV 2,975.0 = 350 x 8.5

Equity Value 2268.0 = 2,975+82.1+23.5+224.6-715.3-82-125-114.9
Share Price 24.72 =2268/91.8
Equity Value = Enterprise Value + Cash + Investments + Assets Held for Sale – Minority Interest –
Preference Stock – Bank Debt
Illustration of Exercise 2: Enterprise Value drives implied equity value
In Exercise 2, EV is estimated using the DCF or Comparables method. Implied equity value can then
be estimated by making appropriate adjustments from EV to equity.
| P a g e 20
FAQ: Why do we subtract cash, non-core assets and investments when computing EV? Don’t
these add value?
Cash, investments and non-operating assets do add value to the owners of the equity. Note that
equity value goes up when cash and investment values rise. However, excess cash and investments
do not add to EV--the value of the core operating assets and cash flows of the business-- so they
must be subtracted to value the Core Enterprise Value. Another way to look at this is that as an
equity holder, you will only receive your return after other claim holders are paid, but the cash and
other non-core assets can be used to pay off or provide returns to other claim holders and yourself.
1.4. Calculating Market Value of Associate Investments and Minority Interest

In a valuation exercise, one must make a series of assumptions in order to estimate the equity value
of a firm. The market value of a firm usually differs and is significantly higher than its book value.
Similarly the market value of each adjustment may differ from its book value. IOs must estimate the
market value of each adjustment in calculating equity value. The easiest to estimate are assets like
cash and marketable securities where the book value approximates current market
value. Although some practitioners use market value of debt (e.g. with distressed
firms), at IFC we generally assume that all the debt would need to be paid off at par and use book
value of debt. Estimating the market value of investments and minority interest requires deeper
analysis and the recommended methods are outlined below.
Proper valuation of adjustments is critical to correctly estimating equity value:

Just as book value of equity can be far less than market capitalization, the market
value of investments and NCI can differ dramatically from book values.
| P a g e 21
FAQ: Why use Market Value of Investments and Non-controlling Interest (NCI)?
IFC is negotiating to buy an equity stake in a firm. Is it in IFC’s interest to negotiate to use book
value in the valuation of the firm’s investments and of its Minority Interest?
Assume market values exceed book values for both investments and NCI. If you are able to acquire
the associate investments at book value this would be conservative; you would “under pay” for the
asset. If, however, you value the NCI at book value then you have underestimated what it would
cost to buy out the minority owners and you have now overpaid for the equity stake. Investments
are an asset and thus book value is conservative; however, minority interest is a claim and using
book value understates that claim and can lead to overvaluing equity.
There are three alternatives to using book value. As with valuation generally, it is best to apply
several techniques if possible. This is essential for entry valuation to avoid overvaluing equity. It is
equally important to be consistent in portfolio valuation in terms of methodology, balanced by time
constraints:
1. Preferred Method: Apply a P/E (Price to Earnings) multiple appropriate for the investment/NCI.
Information on the net income earned on investments is available in the notes to the Financial
Statements. Apply a P/E multiple appropriate for the investment to estimate market value. This
may be quite different from the P/E of the parent. For a non-controlling interest it may be
appropriate to apply the P/E multiple of the parent or it may be suitable to adjust based on the
nature of the business of the subsidiary in which there is an NCI. (See further detail on multiples
in Chapter 3). EV/EBITDA multiples could also be used; however, this requires making
adjustments to derive the equity value of each subsidiary from the EV of each.
2. Use a P/B (Price to Book Value of equity) multiple using either the parent as a proxy or a sector
multiple and apply this to estimate the market value of the investment or NCI. This approach is
not as reliable as an earnings multiple, unless it is reasonable to assume the investment/NCI will
trade at the same multiple. One also has to be mindful of differences in book value of the
parent versus the subsidiary (e.g. goodwill, age of assets). Book values at each entity may be
markedly different. In certain industries which trade on P/B multiples, this could be a useful
benchmark (e.g. FIG): however, they are often used with other metrics in FIG as well (e.g. P/E
multiples).
3. Use current market prices if the subsidiaries are publically traded. Most of the subsidiaries of
IFC clients are not listed; however, many of the comparables we use have listed subsidiaries.

Before beginning a valuation at IFC, be sure to keep in mind the Guiding Principles laid out in this
chapter and depending on the stage of the investment, follow the relevant stages of the five steps to
conducting a robust valuation exercise. Recognize the existence of bias and focus on analyzing the
| P a g e 22
key business drivers which will enable the investment to deliver high returns. It is essential to be
rigorous in the analysis and use multiple methodologies to sanity check results.
It is also important to define what you are valuing and make all adjustments appropriately for each,
whether the Equity, the Enterprise Value or the Total Enterprise Value. This chapter introduced key
terminology and the basic formula to derive EV and Equity including standard adjustments. You
should also have a basic understanding of the appropriate methodologies for calculating the market
value of associate investments and NCI. More complex adjustments are covered in Chapter 9.
Exercise 3: NCI and Equity Investments
Using the information provided below, find the value of WestCorp’s Investment in Affiliates and Non-
controlling Interest (NCI) using two different methods: a) apply a P/E multiple and b) apply the
market/book ratio of the parent.
Investment in Affiliates
Book value 1,041.0
Income from Affiliate 179.0
PE Multiple of earnings 12.0x
Implied value from multiple
Parent ratio of MV/BV 2.2x
Implied value from MV/BV ratio
Non-controlled interest
Book value 465.0
Income attributable to NCI 95.0
PE Multiple of earnings 12.0
Implied value from multiple
Implied value from MV/BV ratio
Solution 3
Investment in Affiliate
Implied Value from Multiple = 2,148.0 = 12 x 179
Implied Value from MV/BV ratio = 2,290.2 = 2.2 x 1,041
Non-controlled interest
Implied Value from Multiple = 1,140 = 95 x 12
Implied Value from MV/BV ratio = 1,023.0 = 2.2 x 465
| P a g e 23
Chapter 2: Market Capitalization,
Liquidity Measures and the Impact of
Dilutive Securities on Enterprise Value
This chapter demonstrates how to calculate market capitalization of an enterprise including the impact of dilutive
securities such as options, restricted stock units and convertible securities. While IFC typically invests in private firms,
accurate calculation of a firm’s market value is necessary for the valuation technique known as comparables analysis. At
IFC, comparables (“comps”) analysis often focuses on Enterprise Value multiples rather equity multiples for sectors other
than financial institutions. Also, since DCF is an Enterprise Value technique, these same adjustments must be used to
derive equity value from a DCF. Standard adjustments, including excess cash, investments in associates and Non-
controlling Interest (NCI,) are explained in detail in Chapter 1. Comparables analysis is discussed in Chapter 3 and DCF
analysis is discussed in Chapter 4 .
Chapter Contents
2.1 Market Capitalization: The Basics

2.1.1 The First Step in Comparables Analysis
2.1.2 How Much Liquidity is Sufficient?
2.1.3 IFC Guidelines on Liquidity
2.1.4 Market Capitalization – Basic Formula
2.2 Multiple Share Classes, Options, Restricted Stock Units (RSUs) and Other Convertibles
2.2.1 Determining Share Count and Market Capitalization
2.2.2 Diluted Shares Outstanding with Options, RSUs and Convertible Debt
2.2.3 Analyzing the Impact on Dilution from Convertible Debt
2.3 Chapter Takeaways
| P a g e 24
2.1. Market Capitalization: The Basics
2.1.1. The First Step in Comparable Analysis
An equity investment is generally valued using at least two methods, often DCF and comparables. In
comparables analysis (See Chapter 3), a firm is valued relative to select peers. This technique can be
performed to value Equity directly (P/E multiples) or to first value the enterprise (EV/EBITDA
multiples) and then derive the equity value implied by the Enterprise Valuation (See Chapter 1).
This chapter lays the groundwork for comparables analysis by explaining how to accurately calculate
the market capitalization of a firm, ensuring share count is accurate and that any potential dilution
has been considered.
In a liquid market, stock prices quickly reflect all publicly available information, including company,
sector, economic outlook and investors’ perception of risk. Therefore, if a firm is listed and has a
liquid secondary market for its outstanding shares, the market value of its Equity is the starting point
to determine Enterprise Value for calculating comparable multiples. This chapter will examine how
the market is valuing the company and how to use standard market practice for calculating basic and
diluted shares outstanding and market capitalization. To the extent an IO makes share calculations
that are different from market practice, the valuation and implied benchmarking analysis of that
valuation will be flawed.
Use of market values implies a belief that the market is appropriately valuing the firm’s Equity at a
point in time. Thus, if a firm is listed and liquid (See the Corporate Valuation Guidelines for portfolio
valuation only), current market capitalization must be used for valuation in the portfolio.
In many emerging markets, prices can be distorted by low levels of liquidity and also by information
asymmetries. These are important considerations as IOs examine prices for market comparables.
Further, IOs should be aware of the current state of the market, especially in unusually high, relative
to historical levels. In examining history, IOs should be careful of pricing during a bubble. Markets
can be overheated at times and as IFC is a long term investor (usually targeting 5-7 years), you
should be careful to place market valuation techniques in the context of the current environment
and as just one input amongst many in determining valuation to IFC. For example, IFC may have a
different view of the companies, sectors and the country risk versus public investors. Further, the
specifics of IFC’s rights, the structure of our investments and IFC’s additionally can lead us to price
our investments differently than a public market investor.
2.1.2. How Much Liquidity is Sufficient?
The stocks of many companies in emerging markets may be listed on public stock exchanges but
have such low trading volumes that it’s hard to say that the last trading price – or even an average of
recent prices – represents the real value of a company’s Equity. The low volume may be due to the
small size of the country and its stock market (i.e., there are few listed stocks and few buyers and/or
sellers), because the company has a small ‘float” (i.e. , a few shareholders hold most stock and only a
small percentage of shares are available to trade), or to structural issues in the market that cause
most buyers to hold and not trade (e.g. in many South American countries local pension funds have
| P a g e 25
limitations on holding foreign stocks so the demand for local stocks may exceed supply and few
investors want to sell). Whatever the reason, when a company’s shares have a low trading volume,
it is less likely that the price incorporates all the information available on the company, sector,
economic outlook, and risk. In such cases, other valuation methods should be used to supplement
the listed market price.
FAQ: When is a listed stock sufficiently liquid that its price reflects market value?
Liquidity in the stock market refers to how easy it is to buy and sell shares without seeing a change in
price.
But what volume is sufficient? The answer is not simple and is a question of judgment based on the
company and market. IFC has liquidity tests for portfolio accounting and terms sheets. THESE are
minimum standards for accounting and for defining legally establishing minimum liquidity for
qualified IPOs. Neither would be sufficient as establishing tests for verifying appropriate liquidity for a
stock prices in a comparables analysis purposes.
IOs will want to ensure that the trades are based on arms-length transactions between non-related
parties with full information in the market. Be careful when examining spikes or dips that could be
caused by block sales or private transactions which may reflect options that are being exercised at
non-market prices. The following section details measures that are commonly used to inform
judgment on liquidity.
2.1.3. Liquidity Measures
In addition to looking at trading turnover (Average Daily Volume / Shares Available), IO’s can also
examine the Average Daily Dollar Traded Value or a better measure which adjusts for one-off
spikes would be the Monthly Median Traded Value. That is the median of the daily traded value
in a month times the number of trading days. If that number divided by the market cap is over
15% for a year, the stock is considered liquid for the purposes on inclusion in some emerging
markets indices. A third parameter is the percent difference between the bid and ask prices: a
low spread indicates higher liquidity (under 1% for the most liquid stocks).
In addition to these numerical indices, look at the pattern of trading and to the extent available,
who the buyers and sellers are. If there is a pattern of constant trades by retail and institutional
investors and the company is covered by a number of mainstream stock analysts, it’s more likely
that the price fully incorporates market information and that price is reflective of value. If there
is no analyst coverage and there are a few occasional large trades (which may result in the same
average volume as above), IOs should try to find out who the buyers and sellers were and why.
It could be an institution that was forced to dump its shares for regulatory reasons or a family
disposing of an estate – both of which could indicate that the shares were undervalued. It could
| P a g e 26
also mean a strategic buyer is accumulating shares for a takeover or an insider wants to fortify
its voting position – both indicating overvaluation.
Ultimately, IOs must look at the totality of the circumstances and use judgment in deciding
whether a market price reflects value. If you are in doubt, use the market price as a data point
along with other methods, but you should not rely on the market price alone.
Corporate Valuation Guidelines for IFC’s Equity and Quasi-Equity Investments: Although not a
standard of liquidity, it is important for IOs to understand the portfolio test. When IFC is valuing
listed stocks in its portfolio, it uses the listed price if the average daily trading volume for the
prior 60 days divided by the company’s total outstanding shares to ensure that it exceeds
.0075%. This is a turnover test. Annualized, this means that only 2.7% of the company’s total
shares trade each year, a very low volume to be able to say that the trades incorporates all
information in an active market. For portfolio valuation purposes, and in line with auditor
guidance, IFC has set the liquidity test on the low side to avoid swings in its liquid population
based purely on trading volumes of a stock over the course of three months. When analyzing a
new investment, this volume test is too low, but at least this test sets a minimum floor, IOs
should consult with Credit Officers and Equity Specialists to discuss specific cases. For sure,
however, if trading volume is lower than .0075%, IOs should not use trading price to determine a
market cap.
CLED’s Equity Term Sheet Specimen. The guideline to determine if trading volume is sufficient to
allow IFC to sell its shares into the public market (generally used to cancel a put to sponsors) is
that average daily trading volume for the prior 6 months is not less than five times the shares
held by IFC divided by the number of trading days in the prior two months. What this represents
in terms of percentage of total shares depends on the percentage stake IFC holds in the
company. In general, this test will require a larger trading volume than the turnover test, but
given that its purpose is to gauge how long it will take IFC to sell its stake into the public
markets, it should not be used as “proof” that the market price indicates value. It is a
negotiated minimum which investees will agree to often to release put obligations.
2.1.4. Market Capitalization: Basic Formula
The first step in calculating equity value is to get an accurate count of the current number of shares
outstanding and the current market price. See below for the basic formula for calculating a market
capitalization.
Market Value of Equity =
Market Capitalization = # of shares outstanding * current share price
In market based approaches, equity value based on market cap drives Enterprise Value.
Use the following Exercises to test your knowledge:
| P a g e 27
Exercise 1: Find Market Capitalization & Enterprise Value for a simple firm
Tridor has 1,000 shares outstanding which last traded at $3.60 per share. The firm has $1,800 in
bank debt and excess cash of $300. Find the firm’s Enterprise Value.
Cash and
equivalents
300
1,800
Debt &
Equivalents
5,100
Enterprise
Value
Equity
3,600
Solution 1: Enterprise Value = Equity Value + Debt – Excess Cash or 3600+1800 – 300 = 5100
Exercise 2: Find EV and TEV using standard adjustments
Now assume Tridor has 1,000 shares outstanding which last traded at $3.60 per share. The firm has
$1,800 in bank debt and excess cash of $300. Tridor has NCI of $600 and Investments in affiliates of
$200. Find Tridor’s Enterprise Value and Total Enterprise Value.
The following formula describes the EV derivation using standard adjustments. Details on standard
adjustments and TEV can be found in Chapter 1.
EV + Excess Cash + Investments + Noncore Assets

=
Debt + Preferred Stock + NCI + Equity
Solution
Here, EV = Debt + NCI + Equity - Excess Cash - Investments

EV = $1,800 + $600 + $3,600 - $300 - $200 = $5,500
TEV = Debt + NCI + Equity - Excess Cash = $5,700
| P a g e 28
In Exercise 2, equity value drives Enterprise Value. The following graphic from Chapter 1 reminds us
of the components of EV and TEV.
2.2. Multiple Share Classes, Options, Restricted Stock Units (RSUs) and
Convertibles
In order to calculate market capitalization for a more complex firm, Investment Officers should:
1. Use most current outstanding shares

2. Consider all classes of shares
3. Include in Diluted Shares Outstanding the impact of any options or converts.
2.2.1. Determining Share Count and Market Capitalization
Current vs Weighted Average Shares Outstanding
Since valuation is done at a point in time, the relevant number shares to use is the number of
current shares outstanding because the current share price reflects that number of shares.
Weighted average shares outstanding (WASO) represent a time weighted average of the shares
outstanding over some period (quarter or year). WASO are used for earnings per share (EPS)
calculations but not in a valuation context. For example, the stock split yesterday will greatly impact
the implied share price today.
Multiple Share Classes
Some firms have multiple classes of shares outstanding with different prices. Be sure to include all
share classes in valuing the equity. In some cases, one class of share is more liquid, e.g. Hong Kong
vs China indices. In such cases, IOs should take the most liquid price times the total shares
outstanding. In other companies, the difference in stock prices reflects variation in voting rights and
thus the total outstanding number of shares in each class should be multiplied by the corresponding
stock price and added to calculate total market cap e.g. Turkey.
| P a g e 29
Basic versus Diluted Shares Outstanding
Use diluted shares outstanding because the current price should reflect any potential dilution from
existing convertible securities or options. The market is aware of the issuance of these dilutive
securities and has factored the expected dilution into the current stock price.
Exercise 3: EV and TEV with Diluted Shares
Recalculate EV and TEV for Tridor, assuming it has 1,000 shares outstanding, but has 1,150 diluted
shares outstanding which last traded at $3.60 per share. The firm has $1,800 in bank debt and
excess cash of $300. Tridor has non-controlling Interest (NCI) of $600 and Investments in affiliates of
$200.
Solution 3:
Now equity value = Diluted Shares * Current Stock Price or 1,150 * 3.60 = $4,140
EV = Debt + NCI + Equity - Excess Cash - Investments
EV = $1,800 + $600 + $4,140 - $300 - $200 = $6,040
TEV includes the investments and is Debt + NCI + Equity - Excess Cash = $6,240
2.2.2. Diluted Shares Outstanding with Options, Restricted Stock Units and
Convertibles
Adjusting Share Calculations for Options
To find the total dilutive securities for a listed firm, first look at the notes to the financial statements
and find the note on outstanding stock options. When calculating diluted shares outstanding, for
the purpose of comparables analysis, market practice is to include only the securities that would be
dilutive based on the share price at the time of the analysis. Any options that are “in the money” are
currently dilutive and are generally included whether or not they have vested. Note: when analyzing
potential future dilution of IFC’s investment, IOs need to look at all potential dilution to IFC’s
investment, i.e. consider out of the money options as well.
In practice, if an option were exercised, the firm would collect the strike price on the option. This
complicates the analysis as the firm would have cash that has not been valued. How can IOs
consider the dilution of the exercise of the options without considering the cash that the exercise of
options would raise? Market practice is to assume that all cash is used to buy back stock and thus
minimize the dilutive impact of the option exercise. This approach is referred to as the Treasury
Method and is the approach used to determine total diluted shares under US GAAP and IFRS. The
dilutive effect of an “in the money” option is reduced, so instead of adding all the full number of
shares issued, the net impact to the shares outstanding is calculated with this assumption of share
repurchase at the current stock price. The advantage of this approach is that it reflects the potential
| P a g e 30
dilution of outstanding stock options as a function of the difference in current stock price versus the
strike price, i.e. the cheaper the option relative to today’s price, the more dilutive it is.
The Treasury Method calculation follows. If the current stock price exceeds the strike or exercise
price, the option is dilutive and the total diluted shares outstanding is calculated using the formula
below.
Diluted Shares Outstanding = Common shares Outstanding + Net New Shares
Net New Shares from options = ((Stock Price – Exercise Price)/Stock Price) x # Options
Exercise 4: Impact of Options on Diluted Shares Outstanding
Assume the following for Kaiser Enterprises and find diluted shares outstanding and equity value.
Total outstanding shares of 1,000

Number of option shares: 100
Strike price per share: $5
Current price per share: $12
Solution 4
Since the options are “in the money” they are dilutive and impact diluted shares outstanding. IOs can
calculate the cash raised and then the number of shares repurchased:
Cash from options exercised = $5 * 100 = $500

Shares repurchased = $500/$12 = 41.7
Net new shares = 100 – 41.7 = 58.3
Or, using the formula above (($12 - $5) / 12) * 100 = 58.3
Diluted shares = 1000 + 58.3 = 1,058.3

Equity value = 1,058.3 shares * $12 = $12,700
A key point to note here is that the current price of $12 reflects the expected dilution.
Some firms have outstanding options at varied exercise prices. In such cases, each tranche of
options should be evaluated separately. This is considered in Exercise 7.
Share Calculations with RSUs
RSUs are shares given to employees which they do not own for a period of time (the vesting period).
They are often used to compensate senior management and incentivize them to stay through the
restricted vesting period. RSUs are essentially the same as options with an exercise price of zero. All
| P a g e 31
RSUs should be included when calculating diluted shares outstanding. Since the strike price is zero,
there are no stock repurchase calculations to reduce their dilutive impact.
Exercise 5: Diluted Shares Outstanding with Options and RSUs
Following on from Exercise 4, a firm has 2.356 million options outstanding with a strike price of
$26.94. There are also 6.073 million RSUs outstanding. If the current stock price is $44.92, find
the net new shares from dilutive securities.
Solution 5
Stock price at year end $44.92
Net
# of options Strike Price Shares
Stock Options Outstanding 2.356 $26.94 0.943
Restricted Stock Units Outstanding 6.073 $0.00 6.073
Net New Shares from Stock Compensation 7.016
2.2.3. Analyzing the Impact on Dilution from Convertible Debt
The impact of convertible debt on dilution is more complicated than options or RSUs. When
calculating EV there are 2 options: Either (i) treat the debt ‘as converted’ and include in share
calculations or (ii) treat the debt like any other debt and include in net debt calculation. The decision
on how to treat the convertible debt should be based on whether or not there is value in the
conversion. Like any other option, IOs should first determine whether the option is “in the money.”
Essentially, market practice is for dilutive share calculations to include only transactions which are
dilutive to earnings per share, so you need to calculate the impact of the conversion on both the
reduction in interest expense and the number of shares outstanding. If the net impact of the two is
dilutive to EPS, then treat the convert “as converted”. Again this is the practice for comparables
analysis, however for IFC’s own investments, IO’s should analyze all potential future dilution when
considering the returns on IFC’s investment.
| P a g e 32
Both the earnings and the number of shares will change if the debt converts. The numerator –
earnings - rises if debt converts since interest expense is eliminated. The denominator – shares-
increases if debt converts. Assume the debt is converted and recalculate earnings by adding back
the after tax interest on the bonds to account for conversion (post-conversion, no interest will be
due). The denominator is increased by the number of shares into which the debt converts. If EPS
| P a g e 33
falls, the debt is dilutive and you should then increase the number of shares assuming the debt
converts. If not dilutive, leave convertible bonds as debt and do not adjust earnings or shares. Take
care NOT to include the convertible debt in net debt for the EV calculation if you assume it converts
or you will then double count the debt.
Exercise 6: Convertible Debt
MaxCo has 1,500 convertible bonds with a par value of $1,000. Use the information below to
calculate diluted WASO and diluted EPS assuming:
A) Each bond has a coupon rate of 7% and converts to 50 shares of stock.
B) Each bond has a coupon rate of 12% and converts to 20 shares of stock.
Case A Case B
Net income 10,000,000 10,000,000
WASO 5,000,000 5,000,000
Bonds - # 1,500 1,500
Bonds - par 1,000 1,000
Coupon rate 7.0% 12.0 %
# shares each bond converts to 50 20
Tax rate 40% 0
Stock price $40 40
Solution 6
Case A Case B
# Shares of debt from =1500 bonds * 50
conversion 75,000 conversion rate 30,000
Total WASO 5,075,000 5,030,000
Adjusted equity value 203,000,000 at price of $40 201,200,000
Compare to value of equity

and bonds without
conversion 201,500,000 =250 bonds at $1000 plus 201,500,000
5m shares at $40
EPS - assuming no conversion $2.0 $2.0
Interest expense $105,000 180,000
Interest expense after tax $63,000 108,000
Adj Net income $10,063,000 10,108,000
Adjusted EPS $1.98 $2.01
In Case A, diluted WASO is 5,075,000 since the convertible bonds are dilutive. In case B diluted
WASO is 5,030,000 since the convertible bonds are not dilutive.
In Case A, the adjusted EPS is below the EPS without conversion so the convertible bonds are
dilutive. Since impact is dilutive, calculate diluted WASO assuming conversion. The convertible
bonds are valued as Equity. Do not include the bonds in the value of debt. In Case B, Adjusted EPS
exceeds the EPS without conversion so the convertible bonds are not dilutive so do not assume
conversion. Diluted WASO does not include the convertible bonds. EV includes the bonds at
market value in debt. For diluted EPS all dilutive securities must be included.
| P a g e 34
Exercise 7: Comprehensive Example
Part A: Use the information below to find the Enterprise and Total Enterprise Value of Zyango
Assumptions Options
# of Avg strike
Stock info Options price
Current stock price $28.00 0.219 $17.78
Basic shares outstanding 72.754 0.167 $20.37
Balance sheet info 0.351 $21.12
Cash 300 0.480 $25.61
Marketable securities 20 0.187 $27.97
Investment in affiliates 80
Total assets 1,180 # RSUs
ST debt 50 1.500 $0.00
Bonds 200
Non-controlling Interest 75
Shareholders Equity 720
Note: All units are in millions except for stock and strike price
Solution Part A
Options
# of Avg strike Net New
Options price shares
0.219 $17.78 0.080
0.167 $20.37 0.046
0.351 $21.12 0.086
0.480 $25.61 0.041
0.187 $27.97 0.000
1.753
# RSUs
1.500 $0.00 1.500
Diluted shares O/S 74.507
Equity
value 2,086.192
Net debt (70.000)
NCI 75.000
Investments 80.000
EV 2,011.192
TEV 2,091.192
| P a g e 35
Exercise 7: Comprehensive Example
Part B: How do your results change if you find that the market value of investment in affiliates is
$105 and the market value of NCI is $90?
Solution Part B
Equity Value calculation would remain unchanged
Equity Value 2,086.192

Net debt (70.000)
NCI 90.000
Investments 105.000
EV 2,001.192
TEV 2,106.192
The accurate estimation of market capitalization is the first step in the calculation of core Enterprise
Value required for comparables analysis. This chapter demonstrates proper estimation of market
capitalization which requires inclusion of all share classes and conversion of options and other
convertibles into shares.
Key Reminders for Calculating Diluted Shares Outstanding:

1) Include all classes of shares based on current shares outstanding
2) Include all in the money options and calculate dilution based on the Treasury Method
3) Include RSUs in diluted share calculations
4) For convertible bonds check for dilutive impact, treat as equity if convertible option is
dilutive OR include convertible bonds in net debt if they are not dilutive. DO NOT double
count debt.
Use the fully diluted market capitalization as the Equity Value and add and subtract adjustments to
calculate EV and TEV. Adjustments for excess cash, NCI, non-core assets and equity method
investments are covered in Chapter 1. More advanced adjustments, including unfunded pensions
and operating leases are covered in Chapter 9.
| P a g e 36
Chapter 3: Comparable Analysis
This chapter details the relative valuation technique known as “comparables” analysis. The chapter covers
identifying a peer set, cleaning earnings, calculating valuation multiples and applying multiples to determine EV
and equity value. Chapter 1 which details standard Enterprise Value adjustments and Chapter 2 which reviews
how to calculate market capitalization should be read in conjunction with this chapter as both are crucial to
accurate use of comparables as a valuation technique.
Chapter Contents
3.1 Comparables: Overview and Link to Value Driver Analysis
3.1.1 Comparables Analysis Depends on Understanding of Value Drivers
3.1.2 Use Comparable Analysis to tell a story: Sample Industry Multiples
3.2 Basic Review of How to Calculate P/E and EV/EBITDA Multiples
3.3 Best Practices in Comparables Analysis
3.3.1 Step 1: Choose the Comparables Companies Set
3.3.2 Step 2: Select the Multiples(s)
3.3.3 Step 3: Calculate Multiple(s) using Cleaned Earnings
3.3.4 Step 4: Check & Interpret the Results & Select the Valuation Range
3.3.5 The Impact of Economic Cycles
3.4 Best Practice Output Pages
3.5 Common Errors to Avoid
3.6 Pros and Cons of Comparables Analysis
3.7 Transaction Multiples
3.8 Quarterly Valuation Updates During Portfolio Supervision
3.9 IFC Comparables Data
See Appendix for Complex Adjustments in Calculating Multiples
See Appendix 3 for Decomposing steady State Multiples
| P a g e 37
3.1. Comparables: Overview and Link to Value Driver Analysis
Valuing an asset relative to other similar assets is based on the principle that similar assets should
trade at similar prices. The advantage of this technique, often referred to as “comps”, versus others
is that it summarizes current investor perspective on risk and return and incorporates all available
information at a point in time (sector, market, company). This is predicated on an efficient, liquid
market, see Chapter 2 for guidance on assessing liquidity of comparable firms.
However, there are many challenges associated with the comps approach. The first is that no two
firms are exactly alike. The second is that the market may “get it wrong” as in pricing bubbles or
markets that are temporarily over or under heated. Therefore, concluding that a firm is priced
“fairly” relative to competitors does not then imply the current price approximates intrinsic value
and this methodology needs to be compared to the results of other techniques, DCF for example.
Despite the challenges, this methodology is critical to benchmarking IFC’s entry valuations,
estimating exit value and ultimately assessing the achievability of IFC’s projected IRR. In particular
when IO’s expect a market based exit like an IPO, a well-done comps analysis will provide insight to
drivers of exit multiple and valuation.
Taking a step back, what does a 10x P/E or 15x EV/EBITDA multiple really mean? What does the
multiple tell you? An earnings based valuation multiple tells you how much each dollar of expected
future earnings is worth to investors today. Investors are using earnings as an indicator of future
profitability. Differences in multiples across firms within a sector may capture expectations about
future growth prospects, business mix, margins, or other factors which impact expected return.
Difference in multiples across sectors are driven by the differences in factors including the
underlying business model, cost structure, effective tax rate and capital structure. A dollar of
technology firm income might be valued higher than a dollar of commodity food, due to different
growth, margin and risk factors. In the financial institutions sector, the P/B multiple is also a good
proxy for current profitability and future earnings growth and will tell you how investors value the
book Equity of one bank relative to other players.
Comparables analysis can be used for both Enterprise Valuation and equity valuation. Trading
multiples refer to multiples of listed companies based on the closing prices of their shares on stock
exchanges. These reflect the valuations that a large number of institutional and retail investors
trading minority stakes in a company ascribe to the company. Transaction multiples refer to usually
private market sale/purchase of Equity stakes of significant ownership stakes that are bilaterally
negotiated, and valuations associated with such transactions often carry elements of strategic or
control premiums as well. In emerging markets, both provide useful insight; however, liquidity and
transaction volume can be quite low in the private and public markets. Since IFC's investments are
significant minority investments, but lack a control or strategic element, it makes sense to consider
both trading multiples and minority stake transaction multiples for IFC's valuations.
Outside of financial institutions, most practitioners prefer to use Enterprise Valuation techniques
because this approach is more reliable in situations where capital structures, non-operating assets
and cash levels vary across the peer set. This is especially important when one or more firms in the
comps set have non-operating assets and high levels of excess cash.
| P a g e 38
3.1.1. Comparables Analysis Depends on Understanding of Value Drivers
With comparable companies analysis, a firm is valued RELATIVE to other comparable firms. The
technique relies on the view that similar companies share industry dynamics, key business drivers
and risks. Therefore, the value of a firm can be estimated by comparing the firm to similar firms and
determining where it should be positioned within its peer group.
The exercise of analyzing comparables, when applied to a broad set of firms, can provide insights
into the key drivers of successful performance in the sector and facilitates understanding why some
firms trade at a premium. The results allow analysis into the drivers of the differences. For example,
in retail one firm might trade at a relatively high multiple due to the market’s assessment of higher
growth prospects, superior products, better market opportunity or better management, etc. The
key to utilizing comparables effectively is to uncover the major factors that lead to differences in
valuation. Investors are paying a premium for factors which will enhance returns and thus will focus
on the key drivers of growth and profitability. Brand strength and market share are two operational
drivers which are valued by investors in the manufacturing sector for example.
Thus comparables analysis enhances identification of the factors that make one firm’s risk/return
profile relatively more attractive to investors than another firm. For example, in hotels, firms with
the lowest CAPEX/room may trade at a higher premium than other hotels despite similar growth and
margins. In FIG, a bank that has a higher proportion of savings/checking deposits typically commands
higher multiples (ceteris paribus) since this represents a high stable and low cost funding source, a
key long term competitive advantage for a bank.
The most useful conclusion of a good comparables analysis is not a straight average of multiples, but
rather an informed identification of the sector value drivers, determination of which specific
companies are most comparable due to similarities in their drivers of value, and an understanding of
how the factors drive dispersion around the median multiple.
3.1.2. Use Comparables Analysis to tell a story: Sample Industry Multiples
At its most basic level, the multiple captures current market sentiment about the relationship
between value and the value driver. The multiple tells a story of what investors today are willing to
pay for a unit of something: real estate, Equity or barrels of oil, for example. An experienced IO can
use comparables analysis to tell the story of why companies in a sector are valued differently based
on key drivers and make a conclusion as to how to value a target company. An IO should get an
understanding of which multiples are most used by investors in a sector, this can be done by
analyzing Equity research reports on traded peers, even the ones that are not included in the
comparables set, the industry value drivers are profiled in such reports.
| P a g e 39
Below are some sample multiples for different sectors:
Sample multiples:
1. Real estate: Price / Square feet
2. Equity: Price per share / Earnings per share
3. Firms: EV / EBITDA
4. Oil fields: EV / Barrels of proven reserves
5. Airline industry: EV/EBITDAR
6. Agribusiness: EV/Crushing Capacity
3.2. Review of Basic Calculations of P/E and EV/EBITDA

This section provides a brief review on the basics of how to calculate and apply P/E and EV/EBITDA
multiples. Please proceed to 3.3 to skip the basics review.
1. Select desired multiple including time frame (historic versus forecast), note that investors price
Equity based on multiples of forward earnings, usually the Next Twelve Months (NTM)
2. Determine the value metric (numerator) generally share price, Equity or Enterprise Value and
the value driver (denominator), often EPS, net income, EBIT, EBITDA or revenues
3. Divide to get the multiple
4. Apply the multiple to the target company
5. Ensure consistency in time period – i.e. don’t apply a historic based multiple to forward
estimates of revenue.
In the following two examples, no operating data is provided to distinguish which multiples are
appropriate to apply. These exercises are intended only to provide practice on calculations. A
discussion of how to select the appropriate multiples is detailed later in the chapter.
| P a g e 40
| P a g e 41
Exercise 2: EV/EBITDA Multiple
Assume in the following exercise that Blue has been identified as the most comparable company to Aqua
and calculate the share price for Aqua if it traded on par with Blue.
Blue Aqua
EBITDA 9,000 1,800
Market value of equity Step 1 Step 6
Financial debt 41,250 13,500
Financial assets 15,000 9,000
Cash 3,000 2,850
Enterprise Value Step 2 Step 5
Outstanding shares 18,000 14,250
Weighted avg shares outstanding 16,125 15,750
EV/EBITDA Step 3 Step 4
Share price 2.5 Step 7
Solution
Blue Aqua
EBITDA 9,000 1,800
Market value of equity 45,000 12,000
Financial Debt 41,250 13,500
Financial assets 15,000 9,000
Cash 3,000 2,850
Enterprise Value 68,250 13,650
Outstanding shares 18,000 14,250
Weighted avg shares outstanding 16,125 15,750
EV/EBITDA 7.58 7.58
Share price 2.50 0.84
Recall the Valuation Formula and graphic from Chapter 1.

Use the formula to calculate EV (for Blue) = Equity + (Debt – Cash – Financial Assets). Then apply the
EV/EBITDA multiple of 7.6 to Aqua’s EBITDA to get Aqua’s EV.
Use the formula below to solve for Aqua’s Equity and Share price:
Share price (for Aqua) = (EV + Cash + Financial assets – Debt) / Outstanding Shares
| P a g e 42
3.3. Best Practices in Comparables
Table 2: Commonly used Valuation Techniques at IFC
1. Choose the Use drivers of the business to narrow set. Relevant parameters may include
comparable expected growth, market segment, market position and profit potential. Also,
companies set consider the macro environment.
There is no standard number of companies and the size of set will vary across
sectors. A general rule of thumb is to examine in detail 3-10 firms in a comps
set. Even if all are not used to value the target firm, analysis of a set this size
can provide insight into drivers of value for the sector. Be sure to provide a
rationale of which firms are most similar and how the target firm should be
priced relative to those comps.
2. Select the Identify appropriate valuation multiples for the sector. If sector investors focus
multiple(s) to be on P/E vs EBITDA, analysis should be consistent with market practice. Include
used non-earnings-based, sector-specific multiples that might be applicable (e.g.
EV/MW, EV/Customer).
3. Calculate the Make sure that you follow the valuation graphic from Chapter 2 to appropriately
multiple(s) using calculate EV. Also, ensure that earnings are calculated consistently for all
cleaned earnings companies (e.g., expense classification and elimination of non-recurring) and
same calendar periods, trailing and forward. Market trades on the Next Twelve
Months (NTM) earnings.
4. Check & This is the most important step and where the IO can add the most value to the
Interpret the analysis. Determine the context for the data: e.g., Where is the market today?
results and select What is the story behind each comparator today? Outliers are important for
the final assessing whether any of those factors also apply to the company under
valuation range valuation analysis. Determine whether most companies are comparable (is the
company similar to average) or whether your client is most like one or two
particular comps. Analyze the client relative to key operating drivers to narrow
set.
Consult the Industry Specialist/CRK at entry and Industry Specialist/CRMEQ in
portfolio stage.
3.3.1. Step 1: Choose the Comparable Companies Set
A comparables valuation is only as good as the set of comparable companies chosen. Therefore,
selecting the comps set is the first critical step in the analysis.
No two companies are the same; thus, there is no perfect comparable for a company. The goal is to
provide a set of reasonably similar companies in order to identify a valuation range in which the
target firm would trade if it were to be listed or should trade if already listed. The range will also
provide a benchmark for what a private buyer would pay given that private buyers are usually
looking at the same set of comparables. IOs should start with a broad universe to ascertain the
sector range and to get a sense of the key drivers of value in the sector.
| P a g e 43
Guidelines will vary from one industry to another. In most industries, if there are not sufficient local
peers, then IOs should look for peers in countries with similar market dynamics. How a sector trades
in one country versus another can provide insight into why an investor values the sector in that
country more highly than another. Sector dynamics can vary significantly across markets, so be
mindful of these differences in choosing the most relevant companies.
One useful starting point is to determine whether the sector is a global or local one. Banking, for
example, generally is a local industry (although with many cross-border linkages), so IOs usually
consider only banks operating in the same country as peers Likewise, if a bank operates in a region,
IOs should consider other regional players as peers.
• The comparables do NOT necessarily need to be all in the same country. For example, if an
IO is valuing a company in Sri Lanka, the IO does not necessarily need to use only Sri Lankan
companies, but may find other companies in markets with similar dynamics and growth.
However, an IO should be mindful of the parameters around reasonable relative valuation in
the local market and make certain that the comparables chosen are sufficiently liquid to
truly reflect a market view of price. (see Chapter 2)
• Once an IO has a thorough understanding of sector value drivers, narrow the comparables
set to a small subset of “close” comps to be used to derive the multiples. Provide the
rationale for your selection and for the exclusion of firms. See below for sample criteria for
narrowing your set.
• Consider where the firm you are analyzing should fall in that range. For example, firms with
higher growth prospects will generally have a higher multiple. The subset selection is critical
since it will determine implied value. Inclusion of exceptional firms (whether unusually
strong or weak) may distort the valuation unless the target firm shares similar
characteristics.
• General guidance is NOT to apply average multiples for a peer group, or to apply the lowest
and highest multiple to get a range. Using an average would only make sense if the target
firm is average in terms of key value drivers. Outliers can make the average multiple
irrelevant. Thus, use of the median is preferable if justified by client characteristics.
• Where a multiple is for a particular company is driven by a large number of factors (both
quantitative and qualitative), compare the target to other peers and then use judgment as
to a range of multiples for the target.
o In FIG, IOs are asked to do a simple scatter plot of P/B vs. RoE for all the peer banks
since P/B is more closely related to RoE than any other financial indicator. Based on
this scatter plot, and what the target's RoE is, an IO can assess a P/B range for the
target.
| P a g e 44
Focus on profitability and growth drivers when selecting the “right comps”. Consider these factors
when selecting the comps set and determining relative positioning:
• Industry (sub-sector) dynamics (e.g. number of competitors)

• Business model (low cost versus high value added)
• Business life cycle analysis: is this an emerging player versus an established player?
• Projected growth rate
• Business positioning (market leader, niche player, price setter or lowest cost producer)
• Size (maturity and growth and scale/margins)
• Markets (mature versus emerging)
• Cost structure and margins (efficiency of operations and capex)
• Product mix
• Geographic markets (high growth versus low)
• Regulatory barriers or subsidies; stability/maturity of the regulatory environment
• Capital structure (impacts which multiple to choose)
• Management and shareholder structure issues which could impact relative value.
FAQ: I understand the benefit of comparables, but can I use this in emerging market valuations?
I can rarely identify many truly comparable firms.
Even a small set of comparable companies can provide valuable information on market parameters
of value for a sector. If there are few directly comparable firms, consider using firms in other sectors
that have similar size, business models and growth characteristics. The question is where would you
expect the company to trade if listed and why?
For example, if you are valuing a Brazilian cosmetics company, you might have comps of U.S.
cosmetics companies, but for Latin America, only general consumer products companies. Both sets
of comps provide valuable data to estimate where a Brazilian cosmetics company might trade. By
understanding where U.S. cosmetics companies trade relative to U.S. consumer products companies
(i.e., the premium based on differential in growth, margin), you can estimate where the Brazilian
company would trade versus the Latin consumer companies. In this case, investor pricing of
cosmetics as a sector and Latin America as a region are both factored in the analysis.
Hints: As you begin the process of selecting the comparable company set, speak to the Industry
Specialist. The Industry Specialist can identify similar companies globally and can advise how sector
dynamics vary across regions. Other Investment Officers in the sector teams are also valuable
resources as they may have seen similar companies. Finally, check to see if there are similar
companies in IFC’s portfolio and if so determine how the Portfolio Officers value the firms. The
Portfolio Valuation team is a central resource for identification
External resources, including Equity Research reports for other companies in the sector (in particular
coverage initiation reports as they are usually much more detailed and include detailed valuation
analysis), can be an appropriate resource as the reports usually include a comparable valuation
analysis listing all the peers used. These companies might be operating in different regions and it is
important that the region-specific factors, such as tax rate, macro-economic development, sector
| P a g e 45
growth potential, and risk levels are similar. Nonetheless, some differences can be addressed by
making adjustments or normalizations. Overall, judgment is required to strike a balance between
having a perfect match among the different regions and having a very limited set of comparables.
Once the comparable company set is identified, an IO should approach the Equity
Specialist to confirm that this is a suitable set to use for valuation before starting to
prepare the detailed analysis of companies (Step 3). Note that once a comparable
trading set is identified at the IRM and the comparable valuation analysis is prepared,
the same comparable company set should be used consistently over the life of the
project, unless there is a reason why one or more of the comparables become(s) invalid
(e.g., a company is taken private or in case of transaction-based multiple the market
situation has changed significantly) or a new comparable has been identified (e.g., a
close competitor undertakes an IPO). Investment Officers should thoroughly document
the rationale behind the selection of a comparable set of companies, adjustments or
calculations made to the multiples, and any other assumptions made during the course
of the comparable-based multiple analysis.
3.3.2. Step 2: Select the Multiple(s)
The second step is to decide what the most appropriate multiples are for the sector and company.
The multiple is a ratio of economic value relative to value driver.
The numerator is the value measure; the denominator is the value driver.
Value measures include share price, market capitalization and/or Enterprise Value. Value drivers are
commonly revenues, EBIT, earnings, or book value of Equity for FIG.
For most assets, the value driver selected for the denominator is unlikely to be the only driver of
value. For example, by analyzing the multiples of price per square foot of twenty five townhouses in
Georgetown, you could determine the factors, other than size, which contribute to variations in
price. You would likely discover that location, views and other factors impact the price per square
foot. Similarly, if you analyze price per carat of thirty emeralds ranging in size from 2-4 carats, you
would recognize that color, cut and clarity, as well as number of carats, are key factors in emerald
prices. You would also discover that a four carat emerald generally trades at far more than two
times the price of a two carat emerald, highlighting the sometimes nonlinear relationship between
value drivers and value. Thus, IOs should have a deep understanding of the value drivers, other
than earnings, of each asset in the comparables set.
There are standard earnings multiples of EV and Equity and also many sector-specific multiples to
consider. A common mistake is to use equity valuation as the numerator and Enterprise Value
drivers in the denominator. Going back to the valuation graphic from Chapter 1, remember that the
value of the entire firm (Enterprise Value) is the value that provides returns to all financiers, debt
and Equity. If you examine an income statement, keep in mind that all the metrics above interest
expense (Revenues, EBIT, EBITDA) are available to pay returns to debt and Equity holders and are
Enterprise Value drivers. Only net income and EPS can be drivers of Equity Value and Equity
investors can only receive returns after all other claim holders receive their return (e.g. interest
expense, preferred dividends and minority interest). Similarly, as you look at sector-specific
multiples (i.e.,subscribers, barrels of oil, etc). These are resources the firm has to produce in order
| P a g e 46
to pay returns to both debt and equity holders and thus are drivers of Enterprise Value. See below
table for further detail.
Match the value driver with the value metric
A multiple must be internally consistent in that both the numerator and denominator
must be consistent with either the Enterprise Value or the Shareholders’ Equity. The
data/time frame for comp firms and the firm under analysis should be the same.
Table 3: Enterprise or Equity Multiples?
The key is consistency: Don’t Mix EV Values with Equity Drivers!
Value Measure Value Driver Multiple
Enterprise Value Sales EV / Sales

EBITDA EV / EBITDA
EBIT EV / EBIT
Free cash flow EV / FCF
Market Net income Mkt cap / NI

Capitalization Free cash flow to equity Mkt cap / FCFE
Book value of equity Mkt cap / BV
Share Price Diluted EPS

Book value per share P/E
P/E to EPS growth rate P/B
PEG
In the FIG and real estate sectors where fair value accounting is prevalent, P/B (in conjunction with
P/E) is a common multiple. It is important to consult with Industry Specialists and sector teams for
any given industry when choosing the value metrics as many industries, and even subsectors of
industries, use very specific metrics. Using the correct metrics is important not only for valuation at
the time of IFC’s investment, but also in forecasting potential exit returns, given that the eventual
buyers of IFC’s stake, be it through an IPO or strategic or share sale, will likely use the industry-
specific metrics.
Common IFC sector specific multiples
• EV / EBITDAR in sectors with heavy use of operating leases (R = rent or lease expense)
• EV / Revenues in high growth sectors with low/no earnings
• EV / Reserves in oil & gas (upstream focus)
• EV / Production in oil & gas for producing fields
• EV / Per subscriber
| P a g e 47
• P/E / EPS growth – PEG
• EV/MegaWatts of Generation Capacity
• P/B and P/E for FIG
• EV/Customer or EV/Subscriber
FAQ: Why are Banks and other Financial Institutions valued using Equity Multiples?
There are 4 main reasons:
1. Debt is part of a bank's operating assets, not just part of its capital structure.
2. Banks have high levels of leverage (8-15 times their equity), thus impact of enterprise
valuation on the equity value is highly pronounced.
3. Banks are heavily regulated, especially in terms of their Equity and capital structure.
4. Accounting rules for banks are very different from real sector companies and accounting for
asset values is a key driver of profitability.
FAQ: Why do practitioners prefer EV multiples to equity multiples for real sector analysis?
There are 4 main reasons:
1. Firms in a sector tend to be more similar at the core operating level than at the Equity level,
since core EV excludes differentials in non-operating items, capital structure and tax rates.
However, keep in mind that differences in investments, capital structure and taxes DO
impact the value of Equity returns and differences in P/E multiples reflect these differences
in value.
2. Differences in capital structure do not distort EV multiples (as with Equity multiples) since
EBIT is pre interest expense (see Table 1).
3. Differences in cash and investments do not distort EV multiples (as with Equity multiples)
since EBIT does not include interest or investment income (see Table 2).
4. EV multiples are easier to adjust for unusual and nonrecurring items as well as accounting
differences (e.g. EBITDA for differences in depreciation methods).
Using EV multiples are more consistent when comparing firms with different levels of financial
leverage. There have been cases in IFC’s portfolio valuation stage where EV/EBITDA and P/E
multiples based upon the same comps set led to quite different equity valuations because the comps
set had a different leverage structure than the IFC investee company.
The tables below illustrate the impact of capital structure and cash/investments on multiples. As
evidenced below, all three companies which are similar in operations, trade at the same EV/EBITDA
multiples. However due to the different levels of leverage, the P/E multiples vary widely, as they
should since Equity returns are impacted by leverage. In Table 5, the same holds true for companies
with different levels of excess cash.
Table 4: Impact of Capital Structure on EV/EBITDA and P/E Multiples
| P a g e 48
50% Debt 20% Debt No Debt
EBITDA 50 50 50
Interest -15 -6 0
EBT 35 44 50
Taxes at 35% -12 -15 -18
Net income 23 29 33
EV* 500 500 500

Debt 250 100 0
Equity 250 400 500
EV/EBITDA 10.0 10.0 10.0
P/E 11.0 14.0 15.4
*Ignores impact of capital structure on WACC and EV
Table 5: Impact of Cash and Capital Structure on EV/EBITDA and P/E Multiples
50%
Debt 20% Debt No Debt
EBITDA 50 50 50
Interest income -
3% 0 0 6
Interest expense -
6% -15 0 0
EBT 35 50 56
Taxes at 35% -12 -18 -20
Net income 23 33 36
EV* 500 500 500

Cash/Mkt
securities 0 0 200
Debt 250 0 0
Equity 250 500 700
EV/EBITDA 10.0 10.0 10.0
P/E 11.0 15.4 19.2
*Ignores impact of capital structure on WACC and EV
3.3.3. Step 3: Calculate Multiple(s) Using Cleaned Earnings
| P a g e 49
When calculating the multiple, ensure that the appropriate adjustments are made to get to core
Enterprise Value for EV multiples and that EBIT, EBITDA and net income are cleaned of non-
operational and non-recurring earnings appropriately for use in the relevant EV or Equity multiples.
This applies to both the target company as well as the peers.
When Calculating EV Multiples: Ensure accuracy in the numerator and the denominator
• Ensure the numerator – EV – includes only the core operations (EV not TEV). Why? Because
the purpose of the multiples exercise is to understand how core operational earnings are
valued. Do not distort the ratio by including non-operating assets (e.g. investments).
Calculate EV as described in Chapter 1 and Chapter 2 ensuring you use diluted WASO for
market capitalization, include all classes of shares, any preferred stock and non-controlling
Interest (NCI). Adjust for non-core investments, cash and other noncore adjustments.
Complex adjustments which may be necessary, including operating leases, ESOPs, options
and warrants, are covered in Chapter 9.
• The denominator – EBIT or EBITDA – should reflect core, recurring earnings to the firm.
Exclude non-recurring charges and gains, investment and interest income. Exclude
impairments, restructuring charges, unusual gains and losses from asset sales and other
items that appear non-operating or non-recurring. Since EBIT is pretax, all adjustments
should be pretax. If investments in affiliates have been excluded from EV (as
recommended), then exclude associated investment income from EBIT (more on this below).
When calculating Equity multiples:
• Work with a comp set with similar capital structures and cash/investment profiles.
• Ensure the numerator is calculated using diluted shares outstanding and that all classes of
common Equity have been included. All dilutive securities should be incorporated (See
Chapter 2).
• Net income should be adjusted for non-recurring gains and losses and the impact of
accounting changes. Ensure adjustments are on an after tax basis. Noncore income is
included in net income so long as it is recurring. Subtract any preferred dividends to obtain
net income available to common shareholders (more on this below).
Note that the P/E multiple derived from “Price per share / EPS” will differ slightly from the multiple
derived from “Market capitalization / Net income” since the market cap is derived from current
diluted shares outstanding and EPS is based on diluted weighted average shares outstanding for the
period (WASO).
Using multiples downloaded from global databases (e.g. Bloomberg) is appropriate only when
tracking industry trends or making “back of the envelope” calculations. Use of multiples
downloaded from external sources is unacceptable in a valuation since appropriate adjustments
may not have been made to value measures and drivers and thus the accuracy of the final results is
questionable. The final multiple used in an analysis is often an important data point in the analysis
of IFC’s investment/divestment decision and should be allocated sufficient time to calculate
correctly.
| P a g e 50
Clean earnings to ensure comparability
There are two primary issues in calculating the base driver of earnings accurately. The
first is that firms have diverse reporting practices with respect to recognition of
revenues, costs, gain in value of biological assets, provisioning for doubtful accounts,
impairments, depreciation, etc. and Investment Officers need to understand what
differences exist in a set of firms and make relevant adjustments where necessary to
ensure that the earnings measures are truly comparable. Notes to the financial
statements, press releases and Equity research reports provide valuable information
as to how different firms report earnings.
The second issue is that many firms have non-recurring charges which need to be
adjusted in order to ensure that the base earnings driver is “clean”. Some gains and
expenses, such as impairments, provisions, extraordinary gains/losses or restructuring
charges are of short term or one-time in nature and cross firm comparison through the
use of multiples is only meaningful when these items have been removed or “cleaned”
out to obtain recurring earnings. Generally this information can be found in the notes
to the financial statements. This is an area where judgment on the part of the
Investment Officer and consultation with the Equity Specialist is recommended. The
income statement should be adjusted to reflect one-time events by stripping out
exceptional gains/expenses. This can be done by simply reversing the item when
calculating EBIT and reversing on an after tax basis when calculating net income. For
net income adjustments first look at the financial notes to determine if the tax impact
of the item is provided. If not, estimate the after tax impact by using the marginal tax
rate (Federal plus any state and local).
Note, that when comparing EBIT and EBITDA figures, be sure to exclude items which
are being valued separately in the valuation (e.g. earnings of non-core business and
income from associate investments should be excluded if these items are valued
distinct from core EV. See the valuation map graphic in Chapter 1).
In FIG, when using book value in the context of a bank or a credit institution, ensure
that the appropriate adjustments are made to the book value for the quality of the
bank's loan book, investment portfolio and other assets (e.g. deferred taxes and
goodwill). Please consult with your Banking Specialist or Equity Specialist for
guidance.
| P a g e 51
Below are example problems to test your skills in normalizing earnings drivers
Exercise 3 - Calculate EBITDA, EBIT & Normalized Net Income

Reported
Sales 9,000.0
Change in value of biological assets 600.0
Total revenues 9,600.0
COGS - excluding depreciation (3,400.0)
Depreciation expense (1,260.0)
SG&A expense (2,360.0)
Merger related costs (800.0)
Earnings before tax 1,780.0
Tax expense (538.0)
Net result of discontinued operations 40.0
Net income 1,282.0
Firm tax rate 35.0%
Find
EBITDA
EBIT
Net income
Exercise 3 - Solution
Cleaned
Values Pre After tax
tax adj to NI
Sales 9,000.0
Change in value of biological assets 390.0 tax adjust at
Total revenues 9,000.0 marginal tax rate
COGS - excluding depreciation (3,400.0)
Depreciation expense (1,260.0)
SG&A expense (2,360.0)
Merger related costs (520.0)
Earnings before tax 1,980.0
Tax expense
Net result of discontinued operations 40.0 Already after tax
Net income 1,372.0 (below the tax line)
Firm tax rate 35.0%
EBITDA 3,240.0
EBIT 1,980.0
Net income 1,372.0
| P a g e 52
Be careful of downloaded data
For a large comps set, one can use downloaded data to get a general sense of where
the market is trading. However for an analysis of pricing of an investment, IOs should
do their own analysis of the comparables financials. There is less distortion when
analyzing forward mutliples as non-recurring earnings are mostly historical.
The following was obtained from CNBC with data from Cap IQ (a reputable resource
for financial information) on fast food firm, Wendy’s, in Fall 2013. Note the trailing
P/E. At the time McDonalds traded at a trailing P/E of 17.5, Burger King at 35.5 and
Yum! at about 25. Extraordinary charges at Wendy led to an unusually low trailing net
income value. As this was expected to be non-recurring, the share price traded at 230
times trailing earnings and 30 times projected earnings. Be careful to spread your
own comps (cleaning earnings and adjusting value metrics) to avoid including such
outcomes in your comps analysis
| P a g e 53
FAQ: Should I use trailing or forward looking earnings values for the denominator?
Market practice is to value a company based on the forward looking earnings, so in analyzing
comparables, these are the most relevant benchmark. The issue comes in determining the forward
earnings to use for the target IFC investment. Often at IFC, historical earnings are preferred since those
have already been earned by the company and “our money” is not being used to produce the earnings. A
complete analysis should include both trailing and forward. Most important is consistency so that all
firm multiples are calculated with either trailing or forward or both.
During portfolio stage, trailing multiples are generally used due to consistency and data quality
consideration. Forward multiples are encouraged with strong reliable support and documentation.
Check: The numerator (EV or share price) is fixed at the current value so is the same for trailing and
forward multiples. The denominator, a measure of earnings, is generally expected to rise in a growing
sector. Since the numerator is fixed and the denominator can be trailing or forward, trailing multiples
will be higher than forward multiples unless earnings are expected to fall. Early stage firms or those
expected to undergo a significant transformation as a result of IFC’s investment, should be valued either
on projected figures without considering the earnings generated by the investment or if not possible a
trailing multiple as that better reflects the value of the company into which IFC is investing. This is
especially important where IFC is the only provider of capital. This topic is discussed in detail in Chapter
7.
Book value multiples should also be based on latest financial results rather than projections.
Time periods and events can lead to distortions
Focus on core, normalized earnings over a consistent time frame. If the comp firms
have different year ends, calendarize the results. Example: If 4 comp firms have a
December 31 year end, while the 4th has a March 31 year end, ensure you calendarize
the results. Add/drop a quarter if quarterly information is available. If not, estimate
by using the relevant percent of a year. IOs should avoid annualizing any financials for
valuation purposes as seasonal variations in profitability, tax estimates and dividend
payment obligations could make a significant difference.
Another important adjustment is the inclusion of full year financials for acquired
business financials in examining historical earnings, in case there is a mid-year
acquisition. Companies consolidate acquired business financials in their financial
statements from the time of completion of the deal; however, the market generally
reflects the full value of the consolidated company starting from the announcement of
the deal. If available, full-year forecast for the acquired business should be used
instead of simply adjusting the actual financials to a full year or only consider the
forward multiple and not the historical multiples.
Also search for transactions and events which have occurred since the financial
statements were published such as stock splits, divestitures, acquisitions and new
debt issues. Check filings, proxy statements, recent news and press releases.
| P a g e 54
3.3.4. Step 4: Check and Interpret the Results & Select the Final Valuation Range
Upon completion of the comps calculations, check your results. Do they make sense, given what
you know about the companies in the set and the sector? In checking the results, consult with
Industry Specialists and Equity Specialists and read Equity research reports and determine whether
your results are consistent with what you learn about the sector. At the end of your analysis, you
should be able to draw conclusions about how the target should trade and be valued relative to the
public comparables chosen.
It’s important to note that the discount for lack of liquidity applied to many IFC investments SHOULD
NOT be applied to the multiple but instead is applied directly to equity value. This topic is covered in
Chapter 8.
Checking results for accuracy:
• How do current sector multiples compare to historic averages? Analyze and graph the
multiples over time, is the market at peak or trough ranges.
• Ensure the values seem reasonable. For example, if EV/EBITDA multiples are higher than
EV/EBIT, that would indicate possible errors. Also multiples using trailing earnings should
exceed multiples using forward earnings (unless earnings are projected to fall).
Check the results against sector information. Are higher growth and higher margin companies
trading at a premium to lower growth companies? Are there wide variations, and if so, is there a
logical explanation for the variations? Although emerging market multiples may be higher than
developed market multiples in sectors with high growth rates, the results should seem sensible.
Resources on Sector Multiples

Other resources you can use to provide an idea of where sector multiples have been and are
currently:
Aswath Damodaran (NYU) maintains a website with valuation data including sector multiples:
http://people.stern.nyu.edu/adamodar/
Cognient publishes quarterly updates of sector multiples: www.cognient.com
For FIG, use Bloomberg or FIG Spark for sector multiples data
Interpreting the results:
Consider the resulting multiples and interpret the results in the context of firm and sector dynamics.
Ask the following questions: Is the firm being valued about average in performance and
characteristics compared to the set or do the drivers indicate that it should trade near the high or
low end of the comparables? Do most of the traded comparables apply or are there just one or two
companies that are most relevant to the analysis? If there are outliers what is the explanation?
Where are the multiples in this sector or country relative to historic levels? The Investment Officer
| P a g e 55
should be able to “tell the story” of why companies are trading the way they are, trailing and
forward; and the IO should substantiate the conclusion of where the target company should be
valued/traded.
Where a multiple is for a particular company is driven by a large number of factors (both
quantitative and qualitative), in FIG for example, IOs can compare the target bank to other peers on
several factors including market share, interest margin, revenue mix, cost structure, leverage and
business mix. IOs then use their judgment as to a range for P/B for the target. Another approach is
to do a simple scatter plot of P/B vs. ROE for all the peer banks since P/B is more closely related to
ROE than any other financial indicator. And based on this scatter plot, and what the target's ROE is,
IOs can estimate a P/B range for the target.
3.3.5. Impact of Economic Cycles
Both economic cycles and shifts in investor sentiment can impact multiples significantly. Peak and
trough multiples are terms used to describe multiples throughout the economic cycle. Consult the
Industry Specialist or Equity Specialist and study equity research reports on firms in the sector to
obtain a sense of where sector multiples have been over the past 5-10 years and through economic
cycles. If IFC enters at a time when sector multiples are especially high this will impact prices. Take
care not to assume these multiples will stay at peak levels.
When calculating exit multiples, apply a long run multiple appropriate for the firm at that stage of
growth and life cycle. Consider how a cyclical firm will perform in economic downturns through
scenario analysis. Will the firm weather the downturn better or worse than competitors as margins
are compressed (consider firm’s cost structure relative to peers)?
FAQ: Why do I have such a wide range of multiples in my comps set?
First check to see that there are not errors in the calculations. Failure to clean earnings and
accounting differences can play a role. If the numbers seem correct, focus on differences in
projected growth and consider examining the PEG (the P/E to earnings growth) ratios to see
whether differentials are as high once growth differentials are accounted. As shown earlier in
Tables 1 and 2, P/E multiples can vary widely due to differences in capital structure and the level of
cash and investments. Margins, the spread between cost of capital and return on capital, risk and
tax rates also have an impact. Beyond those usual issues, IOs should research the companies in the
set to understand the key business drivers and differences in the sector dynamics across markets in
order to explain the differences. Research can also reveal whether there has been unusual positive
or negative news that is only specific to that company and not the sector, e.g. merger rumors or
accounting restatements. Such analysis is hugely valuable in triangulating where the target
investment company would trade.
See Appendix 3 for a decomposition of multiples which further explains variances.
| P a g e 56
Selecting the Final multiple to apply: averages and outliers
Often, Investment Officers compile multiples and then select the simple average or
median of a broad comps set as the final multiple to value the target firm. This only
makes sense when the firm is about average compared to the comps set. For
example, if the margins and growth rates of the target approximate the average of
the comps or if the other key drivers are “about average”. However, if, for example,
the firm under analysis has an especially high growth rate and would be expected to
trade near the top of the comps set or perhaps it is especially weak and should trade
at the low end, using the average would over value or under value the target
company.
Similarly, do not discard outliers with very high or low multiples simply because the
multiple is high or low. Understand the factors driving the outcome and have a
rationale as to why the multiple should not be used in the set. Ask the following
question: Are there unusual characteristics of the comparable company that merits its
exclusion? Also determine whether the target company that is being valued has any
of the same characteristics as the “outliers”.
Before selecting a final multiple range, ensure that the story behind the multiples is
clear. If some of the results do not make sense based on the knowledge of the sector,
check calculations and/or investigate to see if there are mistakes or if the analysis is
missing key operating information that would explain the variations. Be sure to
provide the rationale in the choice of the multiple range, based on the conclusions
from each set of comparables analyzed. For example, if a global set was analyzed and
discarded or narrowed, provide the rationale of narrowing the range and the
conclusions from analyzing the global set.
Caution regarding the median: Depending on the number of firms and the variations
in the comparable set, the average and median multiples may--or may not--be close to
each other. The use of a median multiple can be appropriate when there are large
deviations in the comparable set as it eliminates the bias of an “outlier”. However, if
the comparable set is limited in size, the median multiple can be misleading.
Most importantly, the IOs should ensure that the multiple range selected for the
valuation is reasonable and provide the rationale as to why it is reasonable. In some
cases, one particular company from the set could be determined to be the best
comparable for the target company rather than the mean or the median and a
rationale can be made as to why the target company would trade at a premium or
discount to such single comparable company. Again, judgment is involved and the
choice of metric should be documented and agreed by the Equity or Industry Specialist
understanding that future valuations will be prepared similarly once the investment is
in the portfolio supervision stage.
| P a g e 57
3.4. Best Practice Output
Finally, display the outputs in a summary table.
Key information should be consolidated in a summary table to analyze the results. The table should
be accompanied by a written explanation of how comparable firms were chosen and the rationale
for exclusion of companies. If the comparable valuation conclusion is based on just one or two of
the most comparable companies, explain why they were chosen. Historical ranges for trading
multiples for the sector should also be graphed or documented. The rationale for the final valuation
range should be explicit.
The summary table should be well documented and include at a minimum the following:
• Stock price in USD of each firm

• Date of stock prices
• Graph of P/E, P/B or selected multiples for the sector over time
• Current price % of 52 week high or 52 week high and low
• Market Capitalization in USD and Total Capitalization with leverage ratio
• Country
• EBIT/EBITDA and net income margins or other operating performance parameters
• 3 year forward CAGR of net income and/or EBITDA depending on multiple emphasized
• Business description or key sector appropriate operating measures, e.g. #1 in sector or
market share data
• Show Firm names, Sector and Subsector names
◦ Organize comparables by any sub-categories – such as EM vs mature markets
• Multiples trailing and forward: EV/EBITDA , P/E, sector specific ones and PEG ratios where
applicable
• Appendix should include one-pager on each of the comps or the most comparable
companies
• Note sources used and whether comparables were downloaded or calculated by team.
To facilitate the analysis, the summary table should generally include maximum, minimum, average,
and median measurements for the set. When making final valuation conclusions, remember to
consider liquidity discount for private companies versus the public traded values (See chapter 7 for
detail).
Below are two good practice examples of comparables analysis, one for FIG and one for real sector:
| P a g e 58
Market Cap Stock Price PB (5 Year PE (5 Year Equity to Assets Tier 1 Capital Net Interest Total Assets Total Equity
Name 52Wk High 52Wk Low P/B P/E ROA ROE
(USD Million) (INR) Average) Average) (%) Ratio Spread (USD Million) (USD Million)
Median 2,177 0.9 1.2 8.5 7.3 6.6 9.4 2.1 0.8 10.8 37,076 2,344
Average 7,186 1.7 1.5 12.8 9.9 11.2 14.7 2.5 1.6 12.0 58,800 4,183
Market Cap Weighted Average 23,207 3.1 2.4 19.6 15.9 10.1 13.1 2.0 1.6 15.4 125,355 9,660
HDFC BANK LIMITED 40,667 16.0 17.8 11.7 5.5 4.1 27.7 24.0 8.8 11.7 3.1 1.9 21.6 84,089 7,400
STATE BANK OF INDIA 31,484 4.1 5.5 3.1 1.3 1.4 12.9 10.7 6.2 9.5 2.3 0.6 10.4 400,054 25,426
ICICI BANK LTD 29,168 4.9 6.4 4.0 2.4 1.9 16.4 16.5 10.2 13.1 1.3 1.6 15.2 124,813 13,097
AXIS BANK LTD 20,709 8.7 10.5 4.5 3.3 2.3 20.3 13.6 9.9 12.8 2.0 1.7 17.6 64,508 6,413
KOTAK MAHINDRA BANK LTD 16,049 20.8 23.4 11.8 5.2 3.2 40.4 21.9 15.6 18.0 NA 2.1 14.4 20,410 3,232
INDUSIND BANK LTD 7,459 13.7 15.5 7.8 4.5 3.2 27.4 20.2 10.4 11.5 2.4 1.9 17.8 15,818 1,643
BANK OF BARODA 5,528 2.6 3.7 2.3 0.9 1.2 6.8 6.7 5.6 NA 0.8 14.1 112,890 6,346
YES BANK LTD 5,453 12.8 14.6 6.6 4.1 18.2 6.5 9.8 1.7 1.5 24.9 18,200 1,188
PUNJAB NATIONAL BANK 4,250 2.4 3.7 2.3 0.7 1.2 7.2 7.0 6.6 9.3 2.1 0.7 10.0 95,977 6,431
ING VYSYA BANK LTD 2,846 14.6 16.9 8.9 2.5 1.6 25.3 13.4 11.7 1.8 1.1 11.2 10,087 1,182
CANARA BANK 2,680 5.8 8.4 4.2 0.6 0.9 6.2 5.8 6.0 7.8 1.7 0.6 9.5 83,666 5,091
CENTRAL BANK OF INDIA 2,521 1.7 1.9 0.8 0.9 0.6 NA 5.5 2.3 (0.4) (8.1) 48,437 2,678
BAJAJ HOLDINGS AND INVESTMEN 2,315 20.7 26.4 16.6 1.2 1.1 7.3 5.0 96.4 105.0 NA 17.1 17.8 2,078 2,003
BANK OF INDIA 2,040 3.1 6.1 3.1 0.4 1.0 4.1 7.6 5.3 7.4 2.0 0.6 10.8 96,534 5,152
FEDERAL BANK LTD 1,801 2.1 2.5 1.4 1.6 1.2 13.2 10.4 9.2 14.6 NA 1.2 12.9 12,463 1,146
IDBI BANK LTD 1,799 1.1 2.0 1.0 0.5 8.5 7.1 7.2 7.9 0.2 0.4 5.1 54,926 3,953
L&T FINANCE HOLDINGS LTD 1,688 1.0 1.4 1.0 1.8 20.2 13.0 6.5 1.5 9.2 7,490 1,140
MUTHOOT FINANCE LTD 1,257 3.1 4.1 2.5 1.7 9.4 16.7 18.0 8.3 2.8 19.5 4,273 712
INDIAN BANK 1,245 2.6 3.6 1.8 0.6 0.8 6.2 5.2 7.5 10.4 2.2 0.7 9.0 31,305 2,344
ORIENTAL BANK OF COMMERCE 1,000 3.3 6.4 3.2 0.5 0.7 5.4 6.3 6.1 8.9 1.9 0.5 8.7 36,784 2,243
SYNDICATE BANK 997 1.6 3.0 1.5 0.5 0.6 3.3 4.3 5.1 8.7 1.5 0.8 14.9 42,238 2,164
ALLAHABAD BANK 856 1.5 2.5 1.4 0.4 0.8 4.2 5.2 5.4 7.5 2.1 0.6 10.1 36,892 2,011
INDIAN OVERSEAS BANK 822 0.7 1.5 0.6 0.3 0.6 6.9 7.5 5.9 7.5 1.8 0.2 4.1 45,900 2,700
JAMMU & KASHMIR BANK LTD 758 1.6 3.4 1.5 0.8 1.2 4.0 6.1 7.3 3.0 1.6 22.3 13,126 955
ANDHRA BANK 745 1.2 1.9 1.0 0.5 0.9 10.2 8.3 5.2 8.2 NA 0.3 5.1 28,284 1,463
CORPORATION BANK 706 0.9 1.4 0.8 0.4 7.3 5.6 4.6 8.2 NA 0.3 5.8 37,076 1,691
| P a g e 59
3.5. Common Errors to Avoid
• Multiples have been adjusted to reflect illiquidity. Note that at IFC, the discount for
illiquidity should applied to the final equity value from all methods. Applying the multiple as
well would lead to double counting the discount.
• Poor selection of comps set and/or failure to explain rationale for firms in comps set
• Over reliance on one multiple, e.g. in FIG P/B is primary, however P/E also important
• Selection of comps with fundamentally different business models / drivers
• Using comps from different countries without understanding potential cross country
differences (e.g. regulatory structure, tariffs)
• Using the comp average or median without explanation
• Eliminating firms with especially high or low multiples without a reasonable explanation
• Lack of consistency – mixing trailing and forward earnings across firms
• Mixing EV drivers and Equity value measures or vice versa
• Failure to include all share classes in calculation of equity
• Failure to clean earnings
• Relying on P/E multiples and then using a comps set where firms have capital structures
dramatically different from the target firm
• Mixing trading and transaction multiples
• Using book rather than market value for investments and non-controlling interests
• Ignoring options and warrants (covered in chapter 7)
• Failure to check results for reasonableness
• Poor documentation including omission of date, company description, % of 52 week high
| P a g e 60
3.6. Pros and Cons of Comparables Analysis
PROS:
+ In liquid markets, evidence suggests the market quickly and accurately incorporates the
current views of many investors
+ Comps incorporate the most current market information and sentiment on sector
+ Comps reflect prices actually paid rather than the forecast assumptions embedded in DCF
+ Comps are less dependent on firm specific assumptions regarding growth, margins etc.
+ Can be used as check on DCF approach
CONS:
- Impacted by market bias (i.e. overheated market)

- May be difficult to find good comps
- The market view of the firm’s profitability, cash generation capabilities and/or risk may not
reflect IFC’s view
- Comps do not reflect additionally provided by IFC. This additionally may lead to a stronger
exit value, lower perceived riskiness etc.
- May not be especially relevant or reflective of IFC views during times of high volatility
- Many firms are not public or do not trade in a liquid market
- Inaccurate if adjustments and cleaning not correct
- Small errors in calculating multiples can lead to large valuation errors
3.7. Transaction Multiples
Although IFC does not normally take controlling positions, it is still valuable to see the prices paid in
recent change of control transactions since these transactions can be considered a ceiling price
compared to values from trading multiples. Further, transaction multiples from non-control
transactions can be even more valuable as they do not include control premium and are more
similar to our minority stake valuation (See Chapter 7 for more detail on control premia).
Notably, trading multiples do not include the premium paid for control and thus are not directly
comparable to control transaction multiples. The information from transaction multiples can be very
difficult to obtain and often there are inaccuracies in public information related to the deal. It is
however useful for the IO to be familiar with the volume and overall pricing dynamics of the sector
especially vis-à-vis evaluating potential exit alternatives, i.e. sale to strategic buyer. Clearly IFC as a
minority investors without strategic synergies should be paying a considerable discount to such
transactions.
However, at IFC we also have data from our own prior transactions and an IO should leverage this
information. All equity IRM’s should include analysis of IFC’s prior deals and transaction multiples in
the sector (entry and exit). This analysis should be based on the projections the investment teams
had at the time of the investment¸ not on the actual eventual performance. For example, what was
the forward multiple paid at the time of commitment?
For external transactions, look for any research reports covering the transaction, news reports and
press releases. The Industry Specialist will know if there have been any relevant transactions in the
sector and within IFC. The Equity Specialist can also be a good resource in identifying precedent
| P a g e 61
transactions within IFC. It is best practice to retain a repository of such transactions for each sector
and document each transaction as it is committed (e.g. practice in CNGWM). If the acquirer or the
acquired company is publicly traded, there may be detailed information available in the public
filings.
Note that the resulting multiples represent multiples at the time of the deal rather than at present
and should be interpreted in that context. Particular attention should be paid to the financing
structure of the deal. Other steps in the process of analyzing, checking and interpreting the results
are similar to those above for trading comparables.
When interpreting the results, note that the specifics of the deal often make it difficult to find truly
comparable transactions. How recent was the transaction? In what country was the transaction?
Did buyer synergies exist? Where were sector multiples relative to historic averages? Was the sale
due to distress at the parent or at the entity?
3.8. Quarterly Valuation Updates during Portfolio Supervision
This chapter has been focused primarily from the perspective of new investments, but the general
principles and valuation methods presented should be applied consistently in the quarterly valuation
update process. The following section summarizes the Valuation Procedures outlined in the
Corporate Valuation Guidelines for IFC’s Equity and Quasi-Equity Investments and is recommended
for all portfolio investments.
Selection of the set of comparable companies
The IO is expected to review on an annual basis the availability, quality, and quantity of comparable
companies to make sure that the comparable companies that were initially selected at the
investment stage continue to be relevant. For example, a competitor may engage in acquisitions far
from its core business, which may change the financial profile of its operations, rendering the firm
inappropriate as a comparable. Similarly, new potential comparable companies may become
available (e.g. new IPOs in the industry) or unavailable (e.g. the LBO of a competitor).
Choice of multiple(s)
The IO should, in consultation with the Industry Specialist, assess the quality and adequacy of the
multiple being used on an annual basis. Generally, the multiples will remain throughout unless the
investee’s condition and/or the data available allow a switch to a more appropriate multiple. For
example, a multiple, such as EV/Sales may have been initially selected over EV/EBITDA because at
the time of IFC’s investment, the investee had unprofitable operations. However, as the company
matures and its financial condition improves, the IOs should consider switching to a more
appropriate multiple, such as to EV/EBITDA.
Calculation of multiple(s)
Overall, the IO should continue to calculate, adjust, and normalize the multiples for the selected
comparable companies consistently and as in the original comparable set identified and presented at
the IRM.
| P a g e 62
Interpretation of results
Review the results and update context and positioning of IFC investee in light of current information
and conditions. Changes to valuation based on comparables should be adequately explained by
changes to the business performance or the market sentiment about the industry or other factors.
Exceptions to Guidelines Regarding Quarterly Valuation Updates
During the quarterly valuation update process, IOs may face extraordinary circumstances that may
prevent them from adhering to these guidelines. Such case should be signed off by the region’s
Portfolio Manager and Equity Specialist.
3.9. IFC Comparables Data
Embedded Excel-based template to pull company multiples from Bloomberg. Bloomberg data is
sufficient for broad brush indication of trading mulitples, however for the purposes on anchoring an
entry valuation, IOs should conduct their own analysis using primary sources of data on selected
companies.
Comps Template.xlsx
Comparables analysis is an important valuation tool reflecting current market sentiment and
requires significant attention to detail in order to be effectively utilized. Choosing and justifying the
comps set, cleaning earnings, and appropriately adjusting to find EV are essential to successful
application of this technique. A thorough comparables analysis should provide insight into key value
drivers for the industry. AT IFC, comps analysis is typically conducted based on trading multiples
since IFC does not purchase controlling stakes. However, prices paid in recent change of control
transactions can be considered a ceiling price compared to values from trading multiples as they
include premiums for control.
| P a g e 63
Chapter 4: Discounted Cash Flow Analysis
This chapter details the fundamental or intrinsic valuation methodology known as “discounted cash flow”
analysis (DCF). The chapter focuses on the key steps in running a DCF and different approaches to terminal
value. DCF valuations are very sensitive to discount rate assumptions. WACC is the most common rate used
and is addressed superficially in this chapter: however, WACC is covered in more detail in Chapter 5 along with
internal rate of return (IRR).
Chapter Contents
4.1 DCF Basics
4.1.1 A Fundamental Approach to Valuation
4.1.2 DCF Concept and Formula
4.1.3 Exercise 1: DCF Basics
4.2 Five Steps in Discounted Cash Flow (DCF) Analysis
4.2.1 Step 1: Determine Forecast Type & Length, Project FCF
4.2.2 Step 2: Calculate Terminal Value
4.2.3 Step 3: Select an Appropriate Discount Rate
4.2.4 Step 4: Discount the FCF and Terminal Value to the Present Value
4.2.5 Step 5: Check & Sensitize Results and Determine Equity Valuation Range
4.3 Common Pitfalls in DCF Analysis
4.4 Presenting the Results
4.5 Pros and Cons of DCF Analysis
| P a g e 64
4.1. DCF Basics
4.1.1. A Fundamental Approach to Valuation
Discounted cash flow (DCF) analysis is a fundamental approach to valuation, which complements
and can be sanity checked against the relative valuation technique of comparable firm analysis. At
IFC, especially with expansion project oriented investments, the DCF analysis is crucial to the
investment decision.
This chapter examines the DCF methodology focusing on accurate calculation of FCF and alternative
approaches to TV. Common sources of error and detailed best practices for producing a reasonable
analysis are considered. The DCF techniques of FCF to Equity and Dividend Discount Model are
covered in Chapter 6.
The basic premise is that the price or value of any asset is equal to the present value of the expected
cash flows that it will generate over time. DCF is an Enterprise Valuation technique that values all
the cash flows that a company will generate. It is important to recognize that such cash flows are
available to provide returns to all providers of capital. In order to derive equity value from this
methodology, key adjustments must be made to calculate the implied equity value, notably debt,
associate investments, non-core assets and minority interest (See Chapter 1 for detail on valuing
adjustments).
Alternatively, a DCF can focus on free cash flow (FCF) to equity to calculate equity valuation directly
but this is less typical outside of financial institutions and some infrastructure companies. For
example, in a single project company which is significantly deleveraging over time, FCFE should also
be used to compare results to a standard DCF. DCF analysis can be used to value both non-
controlling Interest (NCI) and controlling equity stakes.
DCF is widely used in corporate finance valuations and proponents of the methodology appreciate
that it provides a measure of intrinsic value, less dependent on current market conditions (avoiding
asset bubbles). In fact, only the discount rate reflects current market risk and sentiment. Another
advantage is that the technique allows for incorporating detailed assumptions regarding future firm
performance and can provide insight into the key variables that will impact valuation. A distinct
feature of DCF analysis is that it enables the user to run scenarios to determine a range of values
under different possible future outcomes.
Disadvantages include the time to create the sheer number of assumptions required to build a DCF
and its sensitivity to discount rates and long term growth rates. The method is dependent on the
estimation of the forecasted cash flows and there is considerable room for error in deriving the
assumptions that drive a forecast.
4.1.2. DCF Concept and Formula
The premise of DCF is that the value of any financial asset is equal to the present value of expected
future cash flows. A DCF valuation is derived from assumptions about the expected magnitude,
| P a g e 65
timing and riskiness of the cash flows. To calculate the present value of a cash flow, divide it by an
appropriate discount rate which reflects the riskiness of receiving the cash flow. To incorporate the
time value of money, the rate needs to be raised to the number of years out to receiving the cash
flow.
Value0 = CF1 / (1+r)1 + CF2 / (1+r)2 + CF3 / (1+r)3 …….. CFn / (1+r)n
In the above equation, CF is the expected cash flow to the asset in a given year “n” and the discount
rate, r, is the required return on the investment. Value0 is value today.
DCF valuation of a firm as a going concern differs from valuation of assets with a finite life, like
bonds, in that there is no maturity date so the series of cash flows is, in theory, infinite. Practitioners
typically divide the valuation into two components: the value of cash flows during a limited forecast
period and an estimate of the firm value at the end of that forecast period, called Terminal Value
(TV). TV is simply the Enterprise Value at a point in the future, preferably when the firm has reached
a steady state with growth where modes and margins have stabilized. The forecast length
(discussed in detail later) is generally between three and ten years.
DCF: EV vs Bond Valuation
Test your knowledge: Apply the DCF technique to value the firm in Exercise 1.
For the purpose of valuing a company, here is the formula which values each cash flow in the
forecast period, as well as the Terminal Value:
Value0 = CF1 / (1+r)1 + CF2 / (1+r)2 + CF3 / (1+r)3 …….. CFn / (1+r)n+ TVn/ (1+r)n
Where n is the forecast length in years and TVn is the terminal value at the end of Year n.
Five Steps in Discounted Cash Flow Analysis
| P a g e 66
Exercise 1: Given the following forecast of FCF and Terminal Value, find EV, Equity and implied
share price
Year 1 2 3 4 5
Free cash flow 170,682 180,921 189,063 204,189 220,524
Terminal Value 551,310
Discount rate 9%
Net debt 160,442
# shares outstanding 51,380
Solution
Year 1 2 3 4 5
1
Discount factor 0.92 0.85 0.78 0.72 0.67
PV 157,311 153,684 148,019 147,338 513,305
EV 1,119,656.1
Equity value 959,214.1
Share price $18.67
1
(1 / (1+ rate) ^ year
4.2. Five Steps in Discounted Cash Flow Analysis

To calculate Enterprise Value and derive implied equity value, follow these 5 steps.
Table 6: Best practice in Discounted Cash Flow Analysis: 5 Steps
1. Forecast FCF Choose currency & decide on real vs nominal projections

Focus on key drivers and likely scenarios
Set forecast length – until firm reaches a steady state

Calculate FCF= unlevered cash from operations after tax
and new investment
In the case of concessions, the project period equals the

concession life.
2. Calculate terminal value (TV) Calculate the TV using both the multiple and constant
growth approaches
In the case of concessions, TV is not calculated

3. Select an appropriate discount rate Industry standard is to use WACC
If forecast is real, be sure to use a real discount rate
4. Discount the FCF and TV Discount both FCFs and TV to present value. In
situations where FCF to equity (FCFE) is calculated (i.e.
to value equity directly), discount at the Cost of Equity
rather than at the WACC.
| P a g e 67
TV is the value at the end of the last forecast year so if
the forecast is 10 years, discount the TV for 10 years
Apply a midyear adjustment if warranted
5. Check & sensitize the results; Check the reasonableness of the results, run scenarios
Derive implied equity valuation range on key drivers; and sensitize the results
Solve for the growth rate implied by the TV if the

multiple approach is used and the multiple implied by
the TV if the constant growth approach is used
Benchmark operating ratios against industry averages
Make adjustments from EV to derive Equity range
4.2.1. Step1: Determine Forecast Type & Length, Project FCF
Determine the currency. Generally at IFC, projections are done in the functional currency of
the company which is usually the local currency. Ask if most revenues or costs are in local
currency or are dollar-linked or driven by international commodity prices.
Decide on a real or nominal forecast. Both have positives and negatives which are covered
later in this chapter. Most importantly, match a real discount rate to a real forecast and
nominal discount rate to nominal forecast. Check consistency periodically.
Determine key drivers for forecast. Ask what are the key variables which will make or break
the company’s future financial performance? Where is the upside in the valuation going to
come from (e.g. market share, economies of scale, market growth)? The drivers of valuation
should be consistent with the investment thesis and the model should demonstrate the
upside.
Decide on a few possible scenarios and be sure to link the effects on income statement
drivers and balance sheet, e.g. under higher growth scenario, what investment is needed to
achieve growth? Also consider macro scenarios, e.g. what inflation correlates with
devaluation scenario or commodity price increases or if the market continues to grow, will
competition increase? Also if government subsidizes any input or customer, consider
valuation excluding subsidy.
Set the forecast length:
• Most companies are in a high growth stage at the beginning of the forecast, thus
extend forecast until such time as the company has reached a steady state. In the
steady state, the firm has matured and reached stable growth rate and efficiency
ratios and a profitability level that can be sustained for an extended period of time.
• Most DCFs have a 5 to 10 year forecast length.
• For some IFC clients, forecasting to a steady state requires a longer horizon.
Projecting FCF over longer periods is difficult and reduces the accuracy of the
forecast, but at the same time, shorter forecasts lead to TV which are a larger
portion of total value, particularly if the company is investing heavily and FCF is
negative in the early years. Also, as estimates of TV are very sensitive to
assumptions and subject to a high degree of errors, this is an important tradeoff.
| P a g e 68
The TV calculation is generally inaccurate if calculated prematurely and the firm has
not reached a steady state.
• With concessions, the forecast period should equal the concession life.
Forecast FCF to the firm:

• FCF is an estimate of the operating cash flow that the business generates after
paying taxes and investing in the necessary capital expenditures and working capital
investments in order to run the business. The concept is to value the company
regardless of the capital structure and thus these unlevered cash flows are the basis
of the valuation and interest payments and the tax shield on debt are ignored.
• Conceptually, these cash flows are available for distribution to all providers of
capital: creditors, any preferred stockholders, minority investors, and common
stockholders.
• FCF IS NOT EQUAL TO operating cash flow from the cash flow statement; FCF
notably includes deductions for CAPEX and excludes interest expense on debt and
the related tax shield on interest payments.
• The discount rate will capture value from changes in capital structure, or funding
choices.
Calculating unlevered free cash flow accurately is KEY
Errors in FCF calculations are common. To avoid mistakes, understand the FCF
rationale. Since the goal is to value the entire firm, use the net cash flows generated
from operations. These are called unlevered or free cash flows.
FCF are the operating cash flows, after tax, available to all the providers of capital. As
such, start with operating profits and remove cash taxes on the operating profits.
Then add back non-cash charges like depreciation and amortization deducted to
derive cash operating profit. Next subtract any annual investments required to run
and grow the business such as capital expenditures and investments in operating
working capital.
Remember, the faster a business grows, the greater the investment required for CAPEX
and operating working capital. However, the new investment required varies
significantly across sectors. It’s critical to understand the structure and dynamics of
the business as opposed to simply assuming CAPEX and working capital are an
average percentage. Never include financing costs since the FCF is later discounted at
the WACC. Inclusion, for example, of interest expense, leads to double counting the
associated capital cost.
| P a g e 69
Free Cash Flow Formula
The formula for FCF to the firm follows
FCFF = EBIT *(1-tax rate) = NOPAT (net operating profit after tax)
+ Depreciation and Amortization
- New investment in Capital Expenditures
+/- Investment in new operating working capital
+/- Investment in other long term operating assets/liabilities
On each element of the formula, be mindful of the following details to avoid errors:
EBIT is the forecasted core operating earnings. Recall in comparable firm analysis the emphasis on
cleaning earnings to calculate relevant multiples. DCF differs in that one is forecasting firm specific
information. If the firm is in the midst of a non-recurring item like a restructuring, DO INCLUDE this
in your EBIT value for DCF since it impacts the valuation. DO NOT include income from non-operating
items such as investments in affiliates that relate to assets that will be valued separately and
adjusted for in the in EV to equity value derivation.
EBIT *(1-tax rate) = NOPAT, which is also called EBIAT or NOPLAT. Next remove the taxes
associated with the operating profit. Taxes must be recalculated -- do not take tax expense from
forecasted income statement since the tax in the forecast is impacted by non-operating items and
the capital structure. The after tax operating profit is referred to by different names including
NOPAT, net operating profit after tax; EBIAT, earnings before interest after tax and NOPLAT, net
operating profit less adjusted taxes.
Tax rate - Which tax rate should I use to find NOPAT? The effective tax rate (ETR) or the marginal
tax rate (MTR)?
• ETR is the effective tax rate which equals Tax expense / Earnings before tax
• MTR is the marginal tax rate = the federal statutory tax rate plus any state/local tax
The tax rate selection can have a significant impact on the final valuation, but no clear consensus
exists. Some use the ETR under the assumption that the ETR best reflects the tax rate that will be
paid. Others use the MTR to be “conservative” or because the ETR is expected to approach the MTR
over time. The key is to understand what is driving the difference between the ETR and the MTR
and to consider if it is likely to continue. If the firm has an ETR below the MTR due to global
operations and this is expected to continue, use the ETR. If the ETR arises from conditions unlikely
to continue or from tax subsidies, use the MTR or increase the ETR over the forecast life to approach
the MTR. As mentioned above, if there are tax subsidies, run scenarios to determine valuation
excluding subsidies. Information on the ETR and MTR can be found in the notes to the financial
statements. WATCH: for situations where the ETR is significantly less than the MTR because of net
| P a g e 70
operating losses in some divisions/subsidiaries. If these do not continue to lose money, the ETR will
rise over time.
Net new investment in operating working capital (OWC) is the change in OWC from year to year.
This definition of OWC does not include changes in cash, marketable securities, debt, dividends
payable or interest payable and should only be for operating items including Accounts Receivable,
Accounts Payable, Inventories and short term tax assets and liabilities. Investment in OWC will
relate to the growth rate forecast. Check the reasonableness of the forecast by benchmarking
OWC/Sales over time and against sector averages.
Net new investment in capital expenditures (CAPEX) is new purchases of plant and equipment for
both maintenance and expansion. Investment in CAPEX will relate to the growth rate forecast and
level of excess capacity. Check the reasonableness of the forecast by benchmarking
CAPEX/Depreciation and Net PP&E/Sales over time and against sector averages. Be careful to
forecast to a steady state.
Net new investment in intangible assets is applicable only for purchased intangibles and should
have the same treatment as CAPEX above. Note that internally developed R&D is usually stated as
expenses on the income statement.
If long term operating assets, other than PP&E (picked up through CAPEX), are forecast to change
include these in FCF. Examples include long term receivables, deferred tax assets and pension
assets. Similarly, any long term liabilities of an operational nature impact FCF so should be included.
These might include long term deferred tax liabilities and warranties.
If the firm has amortization that is not all tax deductible, do a more detailed calculation
of tax and NOPAT. Be sure not to create a tax shield based on expenses that are not tax
deductible (example impairment of goodwill).
| P a g e 71
FAQ: What is the relationship between NOPAT and FCF over time as the firm matures and growth
slows?
FCF is essentially the cash a firm generates after investing in the necessary short and long term
assets to continue growing. When a firm is in a high growth stage, the ratio of FCF/NOPAT should
be lower than when the firm is in a low growth stage. At this stage NOPAT can even be negative.
High growth requires higher investment and thus near term generates lower FCF.
As growth slows and approaches zero, CAPEX, which should be largely maintenance at this stable
stage, gets close to depreciation (e.g. replacement cost) and new investment in OWC approaches
zero. Thus in a zero growth scenario, FCF becomes close to being equal to NOPAT.
Thus as investment teams consider sensitizing growth in the terminal period, they should be wary of
leaving the FCF/NOPAT ratio constant as that implies the ability to achieve higher growth without
the requisite higher investment.
| P a g e 72
Exercise 2 FCFF
Given the information below from the firm's I/S, B/S and CFS, find FCF
Tax rate 38.0%

Income Statement Balance Sheet
Revenues 2,180,134 Cash & equivalents 1,056,022
Cost of sales - excluding depreciation 1,013,762 Trade accounts receivable 279,057
Depreciation 18,060 Distributor receivables 669
Gross profit 1,148,312 Inventories 206,365
Operating expense - excl amortization 557,062 Prepaids and other current assets 54,503
Amortization 50 Total current assets 1,596,617
EBIT 591,199
Investments 23,194
Interest income 1,927 Net P,P&E 66,091
Gain(Loss) on investments and put (772) Deferred income taxes 58,576
Interest expense 0 Other long-term assets 6,540
EBT 592,354 Intangible assets 48,346
Income taxes 225,094 Total non-current assets 202,747
Net income 367,259
Dividends paid 0 TOTAL ASSETS 1,799,364
Cash Flow Statement Accounts payable 146,996

Net income 367,259 Accrued liabilities 40,550
Depreciation 18,060 Deferred revenue 17,441
Amortization 50 Other current liabilities 130,808
Change in Trade accounts receivable (60,985) Total current liabilities 335,795
Change in Distributor receivables 0
Change in Inventories (50,752) Long term debt 0
Change in Prepaids & other current assets (16,793) LT Deferred revenue 117,151
Change in Accounts payable 33,550 Total non-current liabilities 117,151
Change in Accrued liabilities 8,584
Change in Other current liabilities 5,858 Total liabilities 452,946
Change in Deferred revenue 21,713
Change in Deferred income taxes 0 Total stockholder's equity 1,346,417
Change in Other long-term assets (2,135) TOTAL LIABILITIES & EQUITY 1,799,364
Change in LT Deferred revenue 0
Operating cash flows 324,409
CAPEX (39,000)
Additions to intangibles 0
Change in Investments 0
Investing cash flows (39,000)
Change in Long term debt 0
Dividends 0
Financing cash flows 0
Change in cash 285,409
Cash - beg 770,613
Change in cash 285,409
Cash - ending 1,056,022
| P a g e 73
Exercise 2: Solution
Free cash flow

EBIT 591,199 From the I/S
NOPAT 366,544 Using the 38% tax rate
D&A 18,110
CAPEX (39,000)
Inv in OWC (58,825) Includes changes in current operating A & L
Inv LT Assets (2,135) Includes Deferred taxes & Other LTA
Inv LT Liabilities - Includes LT deferred revenue
Free cash flow 284,694
Impact on Economic Cycles
Economic cycles can impact DCF valuations significantly through revisions in forecasted growth rates
and margins. Further, as investor appetite and pricing of risk shifts, this impacts capital availability
and cost of capital thereby impacting WACC and the resulting valuation.
When forecasting a firm in a cyclical sector, forecast through the cycle.
• Forecast enough years to reach a state which is average for the sector/economy
• If Terminal Value is calculated using the constant growth model it is critical that the terminal
year free cash flows reflect the steady state, not peak or trough FCF
• Similarly, if Terminal Value is derived using multiples, the multiples should reflect the firm’s
long run multiple not peak or trough multiples
• Consider how a cyclical firm will perform in economic downturns through scenario analysis.
Will the firm weather the downturn better or worse than competitors as margins are
compressed (consider firm’s cost structure relative to peers)?
| P a g e 74
FAQ: Should I forecast in real or nominal terms? Does it matter?
There are advantages and disadvantages to each type of forecast. There is no official policy at IFC
on whether to use real or nominal forecasts. IOs should strive to model the company in the simplest
way possible without compromising analytical rigor. What is most critical is to match the discount
rate with the type of forecast.
In a real forecast, it is easy to identify key assumptions, including real price increases and see how
efficiency rates change over time. In a real forecast, the user is assuming that inflation differentials,
e.g. producer vs consumer price indices do not differ over time. Proponents of real forecasts argue
that it is impossible to accurately forecast long term inflation and those differences in assumptions
in inflation rates can then be a non-operational driver of valuation in a nominal forecast. It is
usually a simpler model as there are fewer assumptions.
However, IFC clients often think in nominal terms, interest and principal is paid in nominal terms and
equipment is purchased with nominal currency. Some recommend beginning with a real forecast to
understand business drivers at the transaction stage and then converting to a nominal forecast. At
the portfolio stage, results are updated in nominal terms and thus may be easier to manage.
Note that if a real model is used in the portfolio monitoring stage, as the valuation base year
changes, the model needs to be rebased each year to capture the inflation from original base year to
current year.
What about US Dollar versus local currency? The key issue on that topic is what are the operating
drivers of the business—local currency or US Dollar? IOs should document sources of inflation
forecasts as well as exchange rate assumptions if any changes are projected.
DON’T forecast FCF in real terms and then discount using a nominal discount rate.
Advantages of Real Forecasts
• Less assumptions to make

• Easier to view impact of key assumptions about growth rates, pricing and margins
• Easier to see how efficiency changes over time
• Inflation differentials do not impact margins
• Highlights real vs nominal price/unit increases
• Only feasible forecast for markets with hyperinflation
• Long term inflation estimates may be difficult to predict and errors distort results
• As implied DSCR is more conservative, has been a common practice at IFC in loan models
• More difficult to mask changes in business model or key underlying assumptions
Advantages of Nominal Forecasts

• Clients typically think and forecast in nominal terms, CAPEX is estimated in nominal terms for a
project
• Interest rates are quoted, interest expense and principal paid in nominal terms
| P a g e 75
• Financial statements are in nominal terms and some ratios, if calculated, in real terms may be
distorted
• Not all revenues and expenses inflate at the same rate and the nominal forecast allows for
flexibility here
• Better predicts adequate funding of later capital expenditures
• Better predicts the value of a depreciation tax shield
• If prices are rising, a nominal forecast leads to the economic reality of maintenance capital
expenditures exceeding depreciation. In a real forecast the two will be equal so the tax shield is
overstated
4.2.2. Step 2: Calculate Terminal Value

When valuing financial assets with a finite life, like bonds, a valuation or pricing exercise is
straightforward: forecast a finite set of cash flows (interest payments plus principal) and then
discount these cash flows to present values.
When valuing a company assumed to have an infinite life (i.e. a going concern), valuation is less
straightforward for two reasons:
1) actual cash flows are uncertain and require a number of assumptions to estimate
reasonably; and
2) the asset does not mature, assumptions are made into “infinity”.
To apply DCF to Enterprise Valuation, an IO must either assume a finite life, as in project finance, or
select a forecast length over which FCF is estimated and then make a further estimate of firm value
at the end of the forecast. The latter is most common. Essentially, the valuation is split into two
pieces: the present value of the FCF generated during the forecast period and the present value of
the firm at the end of the forecast. The value of the firm at the end of the forecasted period is called
Terminal Value. Making reasonable assumptions for the terminal years is the key as the TV is a
large portion of the Total Enterprise Value and the TV is highly sensitive to small changes in
assumptions.
There are two approaches commonly used to determine terminal value:
1) Exit Multiple Approach: Apply a multiple to the forecasted last year’s EBIT or EBITDA as in
Chapter 3. This approach values the firm at the end of the forecast based upon historic
sector multiples of either EBIT or EBITDA and considers the firm’s relative position in the
sector. When choosing an appropriate multiple, keep in mind that in many IFC investments,
the company will be in a lower stage of growth at the end of the forecast period. In such
cases, while the firm may currently be considered to have a relatively high multiple
reflecting current high growth prospects, the exit multiple should reflect a steady (lower)
growth rate and might more closely approximate the industry benchmark. Usually
practitioners select multiples that are lower than comparable multiples today and in line
with lower forward growth expectations.
| P a g e 76
2) Constant Growth: Use the growing perpetuity formula to value the infinite stream of cash
flows which are assumed to grow at a constant growth rate. This methodology has several
names: the constant growth, perpetuity or Gordon growth formula. The formula is below
for reference.
steady state FCFN * (1 + LT growth rate )

Terminal Value N =
(WACC - LT growth rate)
Since the TV often comprises a large part of total value, it is advisable to use both approaches.
Investment Officers can sanity check results by using the goal seek function in Excel to determine the
implied multiple that delivers a TV equal to that from the Constant growth Terminal Valuation
and/or the implied growth rate that returns a TV equal to that from the Exit multiple Terminal
Valuation.
In Appendix 2, other approaches to TV that can be used to further sanity check the results.
The assumptions KEY to the Constant Growth
TV = Next Year FCF / (WACC – long run growth rate)
Note: The numerator is the FCF in the first year following the forecast period. A
common error is to use the last historic year FCF. This is incorrect. Either forecast one
more year to use for TV calculations or estimate the next year’s FCF as last projected
year * (1 + long run growth rate)
The firm MUST reach steady state to apply this model.
The FCF must be sufficient to sustain the long run rate of growth.
The long run rate of growth cannot exceed the nominal growth rate of GDP.
A proof of this formula is provided in Appendix 1.
When making assumptions about the final FCF which goes into the above formula, be mindful of the
following “rules of thumb”:
• CAPEX should exceed depreciation; if CAPEX < depreciation, the company will depreciate
away. Setting CAPEX = depreciation assumes no growth and no inflation (unlikely in nominal
forecast)
• The perpetual or long run rate of growth should not exceed the rate of growth of GDP in
terminal year and should be consistent with type of forecast (real versus nominal)
• Asset efficiency ratios should stabilize (e.g. OWC/Sales)
• ROIC should be benchmarked to the mature industry
• The spread between ROIC & WACC should be reasonable for the steady state and
benchmarked to the industry
| P a g e 77
Exercise 3: Find the TV using the multiples approach and the constant growth approach using the
following information.
Expected EBIT is forecast at $1,500,000, depreciation of $95,000, and a tax rate of 38%. The firm will
need to invest $50,000 in increases in working capital and $100,000 in capital expenditures. The firm’s
weighted average cost of capital is 10%. Assume the firm has reached steady state growth of
approximately 4% and that the firm should trade at an EV/EBITDA multiple of 9.0.
Solution
Next year's forecast:
EBIT 1,500,000
Depreciation 95,000
CAPEX 100,000
Required Investment in OWC 50,000
Tax rate 38.0%
WACC 10.0%
Long run growth rate 4.0%
EV/EBITDA multiple 9.0
FCF 875,000
TV using FCF 14,583,333
TV using EV/EBITDA multiple 14,355,000
| P a g e 78
FAQ: Help! Why valuation results from my Gordon growth analysis and my Exit multiple analyses
are so different?
This is not infrequent as an IO begins the analysis and is one of the reasons IFC recommends using
multiple approaches and sanity checking results.
Note that the two approaches to TV will yield similar results if the embedded assumptions regarding
growth, margins, perception of risk and return on capital are the same. Thus, focus on the
differences in the underlying assumptions, e.g. growth expectations, margins, perception of risk.
Widely varying TV estimates may reflect current Equity market conditions which are currently high
or low by historic standards and therefore a comparables based, relative valuation may produce a
value quite different from the intrinsic value. Or, there may be an error in the calculations or
assumptions. In these situations check:
Are there calculation errors?
In the DCF, did the TV from comps differ significantly from the TV from the perpetuity method? If so
check the growth rate or the discount rate implied by the multiples based TV and the multiple
implied by the perpetuity based TV. If the two do not reflect a consistent story about the business
determine why. Is there an error? Is the market currently applying especially high or low values?
The comps based TV is driven by EBITDA and the multiple; the DCF by FCF in the exit year, and the
WACC. Ensure that the differences between EBITDA and FCF make sense. Check the WACC. If you
used a firm beta try using the sector beta and leveraging it for the target firm (see Chapter 5).
Double check the reasonableness of the Cost of Equity calculation (see Chapter 5).
Is the multiple used in the TV calculation equal to the multiple currently? Does this make sense or
will firm dynamics change by the end of the forecast?
Calculate TV using the alternative approaches described in Appendix 2.
Check the exit year FCF calculations as these determine TV. Are they consistent with long run
growth assumptions? Do the final year ratios make sense? Look in particular at NET PP&E/ Sales
and OWC/Sales.
4.2.3. Step 3: Select an Appropriate Discount Rate
The discount rate selected to value a series of cash flows should take into account: 1) the time value
of money as well as 2) the riskiness of the cash flows. The latter can incorporate industry, company
as well as country risks.
NOTE: THE DISCOUNT RATE:
| P a g e 79
• IS NOT a hurdle rate for IFC
• DOES NOT reflect IFC’s financing costs
• IS NOT IFC’s expected IRR
See Chapter 5 for detailed discussion of IRR and discount rates, including the estimation of the Cost
of Equity and the WACC.
Market practice is to use as the discount rate to value an enterprise since the FCF are the cash flows
available to all providers of capital and the WACC is the firm’s overall cost of capital. The parameters
for calculating WACC are summarized below.
WACC formula:
𝑫 𝑷 𝑬
WACC = = ∗ 𝑲𝑲 ∗ (𝟏 − 𝑻) + ∗ 𝑲𝑲𝑲 + ∗ 𝑲𝑲
𝑻𝑻 𝑻𝑻 𝑻𝑻
Where:
E = Market value of Equity including Equity from NCI

D = Market value of Debt, often approximated by book value of debt
P = Market value of Preferred Stock
TC = Total Capital = E + D + P
Ke = Cost of Equity
Kd = Cost of Debt
Kps = Cost of Preferred Stock
T = Marginal tax rate
WACC issues
• The WACC as displayed above is a nominal rate. If the forecast is real, WACC must be calculated
on a real basis (See Chapter 5).
• The market value of Equity, debt and preferred reflect the current capital structure. If the
“targeted” capital structure is significantly different and the expectation is that the firm is
moving toward the target weights then those may be used. In such cases provide the basis for
the target structure and expected time to move toward target.
• Any non-controlling Interest (NCI) should be included in Equity.
• The WACC calculation is detailed in Chapter 5. It is important to note that there is difficulty in
estimating some of the inputs related to the Cost of Equity and these can lead to variations in
the estimate of the cost of equity. However, the DCF is quite sensitive to WACC, thus this can be
problematic.
Capital structure changes: If a firm is expected to pay down significant levels of

debt or materially change the capital structure, DCF analysis requires estimating
multiple WACCs (See Chapter 5) or valuing equity directly using free cash flow to
equity. This approach is detailed in Chapter 6.
| P a g e 80
4.2.4. Step 4: Discounted the FCF and TV to the Present Value
Take the forecasted FCF and the TV and discount to find the present values of these flows today,
then sum for Enterprise Value.
The Present value = CF / (1+ WACC) ^ year
Alternatively, some prefer to calculate an annual discount factor to apply to each year’s cash flows.
The discount factor = 1 / (1+ WACC) ^ year
Continuing with Exercise 1 from earlier in the chapter, the result is calculated using discount factors
associated with a rate of 8.5% and is shown below.
Each factor is calculated as =1/(1.085) ^ year.
In year 2, for example, the discount factor = 1 / (1.085) ^ 2 = 0.8495.
Multiply the factor by the associated FCF to find the present value of the FCF for that year.
Year 1 2 3 4 5
Free cash flow 170,682 180,921 189,063 204,189 220,524
Terminal Value 551,310
Discount rate 8.5%
Net debt 160,442
Discount factor 1 0.92 0.85 0.78 0.72 0.67
PV 157,311 153,684 148,019 147,338 513,305
Issues: Stub years and midyear adjustments

Stub Year
What if the valuation occurs midyear or at quarter end? In such cases the cash flows received in
“Year 1” will not be twelve months but rather a shorter period, so called stub year. If forecasting a
stub year, it is important to have estimates of the balance sheet items at the midyear or to the
corresponding period when the re-valuation is performed in order to accurately make the
adjustments from Enterprise Value to equity value as of the date of the valuation.
When forecasting other than at year end, disregard cash flows that have already occurred in the
forecasted year 1. Those cash flows should be accounted for in the midyear balance sheet cash and
debt balances.
• A common practice within IFC is to pro-rate the annual cash flow of Year 1, assuming a straight
line distribution of the cash flow throughout the year. Thus, at the beginning of the year, Year
1’s expected cash flow includes the full year projection; at March end, Year 1’s expected cash
| P a g e 81
flow will include ¾ of the annual projection to account for the remaining 9 months (stub year);
so on and so forth. At December end, Year 1’s cash flow will be completely removed from the
projection period.
• It is important to recognize that the above simplified pro-ration does not fit to all the industry
sectors. For instance, a department/retailor store will have peak season and non-peak season,
and thus EBITDAs are not realized evenly in a year. When adjusting the cash flow for the stub
year, the investment staff should have considered the seasonality factor. However, since the
different approaches of making the stub-year adjustment generally does not have a significant
impact on the final NPV result, the benefit of keeping a simplified assumption outweighs the cost
of making more tailored and sophisticated stub-year adjustment.
Midyear Adjustment
Distinct from the stub year issue, is how to discount cash flows occurring throughout the year.
Common practice is to discount Year 1 cash flows for 1 full year; Year 2 cash flows for two full years,
etc. Some argue that this leads to “over discounting” if the cash flows occur approximately evenly
throughout the year and is only appropriate when cash flows fall primarily at year end. As a result
sometimes see a “midyear adjustment” is applied. The idea of the midyear adjustment is that if cash
flows occur evenly throughout the year, then the appropriate time to discount Year 1 cash flows is 6
months, Year 2 cash flows 1.5 years and so on. Applying a midyear adjustment will increase the
valuation since the time discounted is shortened by half a year.
While not common practice at IFC, application of the midyear adjustment is not an unusual market
practice and clients may apply such adjustment. If used, be careful to only apply this adjustment to
forecasted FCF and TV from the constant growth model. The midyear adjustment MAY NOT BE
APPLIED to TV from a multiple since the multiple would reflect any cash flow timing issues
embedded in the sector. Applying the adjustment would effectively imply a higher multiple than
comparable firms.
| P a g e 82
Exercise 4: Use the information below to find Enterprise Value.
Year 1 2 3 4 5 6
EBIT 81 88 93 98 102 105
Taxes (24) (26) (28) (29) (31) (31)
Depreciation 22 24 26 27 28 29
CAPEX (28) (31) (33) (34) (36) (37)
Change in OWC (7) (7) (8) (8) (8) (8)
Change in LT Operating items (3) (3) (4) (4) (4) (4)
EBITDA multiple for TV 7
LT growth rate 3.5%
WACC 9.0%
a. EV if TV is estimated from EV/EBITDA multiple?

b. EV if TV is estimated from the constant growth model?
c. EV if a midyear adjustment is applied and TV is from EV/EBITDA
multiple?
d. EV if a midyear adjustment is applied and TV is from constant growth model?
| P a g e 83
Exercise 4:
Solution
Year 1 2 3 4 5 6
EBIT 81 88 93 98 102 105
Taxes (24) (26) (28) (29) (31) (31)
Depreciation 22 24 26 27 28 29
CAPEX (28) (31) (33) (34) (36) (37)
Change in OWC (7) (7) (8) (8) (8) (8)
Change in LT items (3) (3) (4) (4) (4) (4)
FCF 42 44 47 49 51 53
Discount rate 9.0%
Discount factor 0.92 0.84 0.77 0.71 0.65 0.60
PV of FCF 38 37 36 35 33 32
Part A
EBITDA multiple for TV 7.0
TV 931
PV of TV 555
EV 767
Part B
LT growth rate 3.5%
TV 997
PV of TV 595
EV 806
Year 0.5 1.5 2.5 3.5 4.5 5.5
FCF 42 44 47 49 51 53
EBITDA multiple for TV 7.0
TV 931
Discount rate 9.0% =1/(1+ rate)^ year
Discount factor 0.96 0.88 0.81 0.74 0.68 0.62
PV of FCF 40 39 38 36 35 33
Part C
PV of TV Do not apply midyear adjustment 555
EV Discount TV from multiple for 6 years 776
Part D
LT growth rate 3.5%
TV 997
PV of TV Apply midyear adjustment 621
EV 842
4.2.5. Step 5: Check & Sensitize Results and Determine Equity Valuation Range
After completing the analysis, it is important to check the reasonableness of the results, run
scenarios on key drivers and sensitize the results. This is where industry benchmarking can be
valuable to check operating and efficiency ratios over time. IOs can use publically listed companies
as benchmarks or other private IFC clients for whom IFC has data. Industry Specialists can also
provide insight into reasonable ratios for more stable growth companies. IOs should be sure to
include the sources of benchmarking when providing the data.
| P a g e 84
The TV obtained from the two approaches will differ, but should be reasonably close. If the values
are very far apart, investigate the cause. Check the calculations for sign errors in the FCF
calculations. Evaluate key ratios to see that ratios have stabilized during the forecast and seem
reasonable. Find the multiple that would lead to the TV obtained using the constant growth
approach (the goal seek function in Excel facilitates this). Does it seem reasonable? Similarly, find
the implied growth rate that would lead to the TV found in the multiples approach.
Once satisfied with the EV output, adjust to derive equity value as discussed in Chapter 2. Use data
tables to demonstrate the sensitivities and value range varying the WACC, multiple, and long run
growth rate. Create scenarios to analyze valuations under likely future outcomes.
Sensitivity Versus Scenario Analysis
Sensitivity and scenario analysis are tools widely used to analyze when faced with uncertainty.
Sensitivity analysis is performed to highlight the sensitivity of key output (e.g., EV or equity value) to
changes in input assumptions. So, for example, you might consider the results under a range of
margins, input costs and levels or growth. Often, one or two key variables are sensitized and the
results are displayed in a data table.
Scenario analysis differs in that multiple inputs are identified to create one of several probable
scenarios expected to materialize in the future.
KEY: Sanity Check Ratios
Evaluate key ratios to see that the ratios have stabilized during the forecast and seem
reasonable. Benchmark firm ratios at the end of the forecast against those of mature
companies in the same industry and against industry averages. Consult your Industry
Specialist/Engineer for benchmark ratios.
Be sure to consider the following.

• Sales growth and margins are reasonable by end of forecast
• ROIC has moved toward sector benchmarks
• OWC / Sales has stabilized
• ROE and ROA have moved toward sector benchmarks
• CAPEX/Depreciation should fall toward 1 as growth slows; will not typically
reach 1 in nominal forecast due to high cost of new PP&E
• Net PP&E/Sales have moved toward sector benchmarks
• FCF / NOPAT rises as growth slows
• The final year tax rate is reasonable for the long run
• For FIG, Net Interest Margin, Provisioning Cost, Cost-Income Ratio, Capital
Adequacy Ratios and Leverage are in line with that of peers.
The exit year values of FCF drivers are especially important since they drive the
TV calculations.
| P a g e 85
4.3. Common Pitfalls in DCF Valuation
Guard against these common pitfalls
Forecast issues
• Do not create overly complex forecast models. Analyze in detail, model in aggregate. Ask if
any additional assumptions or detail incorporated really add value or merely add complexity.
Focus on key drivers of FCF and value. While uncertainty surrounds much of the forecast,
the valuation will be driven by a small number of key factors. Focus on getting these right.
• Do not overstate growth. There is empirical evidence that equity research analysts
consistently overestimate growth.
• Question whether price and quantity can continue to increase when there is excess capacity
in the sector.
• Factor in increased competition. Big profits usually lead to new entrants.
• Don’t double count income from affiliate investments. If EBIT includes income from these
investments (and it is preferable that it does not) then do not adjust for the investment in
the EV to Equity calculations.
• Take care not to forecast revenues to expand beyond capacity without related CAPEX to
fund the expansion.
• Watch for incorrect signs in FCF calculations (especially for CAPEX, OWC and dividends).
Terminal value issues
• Ensure TV has consistent use of forward or trailing multiples (i.e. don’t apply a forward
multiple to trailing EBITDA).
• Don’t apply a peak or trough multiples for TV; forecast through the cycle.
• Applying the midyear adjustment to the TV from a multiple; remember only apply to the FCF
or TV form constant growth.
• If the forecast includes TV use the constant growth model and ensure the forecast follows
the steady state. The steady state is characterized by:
• Sector has matured
• Growth <= growth rate in GDP
• ROCI slightly above WACC.
• Don’t apply a multiple from a high growth period to calculate TV. Once the firm reaches the
steady state, the multiple should move toward sector average for mature firms.
• Ensure that as assumptions about the growth rate change, FCF responds sensibly.
• Ensure that when growth is higher reinvestment rate is higher and as growth slows
reinvestment rate slows; this implies the ratio of FCF/NOPAT rises as growth slows.
Adjustment issues
• Errors occur in EV to Equity adjustments, e.g. miscalculating market values of adjustments.

• Equity value exceeds EV; this is possible though typically occurs only if net debt is negative.
| P a g e 86
• Be careful when comparing firms that use operating (off balance sheet) leases with those
that don't. The full lease payment is deducted as an operating expense so EBIT is lower. In
these cases EV/EBITDAR may be a more useful and more directly comparable multiple.
Discount rate issues
• When valuing a subsidiary, use the WACC of the subsidiary/target not the parent or acquirer
to pick up the risk inherent in its operations.
• Discounting for the wrong time period due to confusion between the PV, NPV and XNPV
functions in Excel. It is preferable to use a formula to discount (rather than the NPV
functions).
4.4. Presenting the Results
DCF output pages should include:
• Summary of key assumptions/drivers of business and forecast

• DCF analysis and scenarios consistent with key risks profiled in IRM
• Ratios analysis of operating and asset efficiency over time
• Detailed WACC calculation including choice of beta, country risk premium and Cost of equity
• Conclusions of valuation ranges under each scenario
• Data tables of sensitivity analysis, varying both operating drivers as well as discount rate, fx
and growth or multiples.
4.5. PROS and CONS of DCF Valuation Analysis

PROS:
+ Independent of current sentiment (avoids overheated market)
+ Driven by cash flows rather than profits so less prone to accounting issues
+ Provides long term value perspective
+ Utilizes firm specific assumptions
+ Best captures a business in transition
+ Can be used to value all firms, including private firms and can also be applied to a division
+ Allows for development of scenarios
+ Can be used to incorporate synergies in acquisition scenarios
CONS:
- Reflects only the view of the preparer (one view) rather than the market view (comps), thus
important to do sensitivity analysis and benchmark
- Small changes in long run assumptions about growth have a significant impact on value
- Value is very sensitive to discount rate selected
- Terminal Value is difficult to estimate accurately and it is often a large part of the total value
- Requires the development of numerous forecast assumptions, important to thus focus on
few key drivers
- Quality of analysis dependent on quality of modeling/forecasting skills
| P a g e 87
- Forecasts are typically based on projections supplied by the company; evaluate
reasonableness as well as management’s ability to execute the business plan driving the
projection.

Discounted cash flow analysis is a tool for fundamental valuation that allows for the inclusion of firm
specific assumptions and changes in key forecast assumptions. Carefully constructing the forecast
assumptions and scenarios are essential to accurately analyzing the application of this technique.
Forecast length should take the firm to a steady state where margins have stabilized and growth has
reached a long run sustainable level. Use several approaches to estimating Terminal Value since this
often constitutes a very large portion of total value. Exit multiples should reflect steady state
conditions for the firm/sector. If the forecast is real, be sure to apply a real discount rate. A key
factor in DCF is the discount rate assumption which is discussed in detail in the next chapter.
| P a g e 88
Chapter 5: IRR and Discount Rates including
WACC
This chapter reviews rates of return including internal rate of return and weighted average cost of
capital. At IFC, a primary measure of expected return on investment is internal rate of return. The
firm’s overall cost of raising funds is estimated as WACC and is used in DCF valuation at entry and
during portfolio supervision.
Chapter Contents
5.1 Rates of Return Versus Discount Rates
5.2 Internal Rate of Return

5.2.1 IRR Concept and Formula
5.2.2 Cash Multiple Measure
Exercise 1 – Calculate IRR and Cash Multiple
Exercise 2 – IRR and Cash Multiple with Intermediate Cash Flows
Exercise 3 – IRR and Cash Multiple with a Minority Stake
Exercise 4 – IRR Sensitivities
5.3 Weighted Average Cost of Capital
5.3.1 WACC concept and formula
5.3.2 Four Key Questions
o How are the capital structure weights for each component determined?
o How does IFC find the cost of debt?
o How does IFC estimate the cost of equity?
o What other issues are problematic in calculating WACC?
Exercise 5 – Calculate WACC
5.4 CAPM: Applications, Inputs & Issues
5.4.1 CAPM Formula for the Cost of Equity
Exercise 6 – Calculate Cost of Equity and WACC
5.4.2 Risk Free Rate
5.4.3 Equity Risk Premium: Equity Market Risk
5.4.4 Beta: Company Specific Risk
Exercise 7 – Levering and Un-levering Betas
5.5 Incorporating Country Risk into WACC
5.5.1 Country Risk Considerations
5.5.2 Summary Formula for WACC with Country Risk
Exercise 8 – WACC with Country Risk
| P a g e 89
5.1. Rates of Return versus Discount Rates
In Chapter 1, a distinction was established between the pricing of an investment and the valuation of
a company. Pricing is related to valuation, but more complex and dependent on many factors which
can impact value realization. In the same way, it is important to distinguish between the rate of
return on a minority equity investment versus the discount rate to use in a valuation of a company.
These two are related, but distinct.
When analyzing an investment at entry, IOs estimate the expected IRR or internal rate of return of a
potential investment. A projected IRR is calculated from assumed entry and exit prices which are
determined by valuation assumptions (plus any intermediary cash flows, e.g. dividends). One of the
primary inputs for the entry and exit prices is the valuation of the company which is often based on
DCF or FCFE model which requires a discount rate assumption.
The weighted average cost of capital or WACC is the discount rate most commonly used by public
and private equity investors for valuing corporates and thus is critical to assessing the exit valuations
which are the basis of estimating expected IRRs. In the FIG space, since valuation involves
discounting dividends flows to estimate the equity value of a bank directly (the Dividend Discount
Model the discount rate used is the Cost of equity Ke.
IOs should keep in mind that as equity investors, IFC’s expected return should be higher than the
company’s WACC. WACC is a blended cost of capital including debt whereas the IRR is a return to
specific equity holders only.
IRR is most practical for an investment with one entry and one exit point. Comparability between
IRRs of different investments becomes more difficult when one assumes multiple cash exit points as
is quite common for IFC exits. Unlike discount rates, IRR analysis is not data dependent or based on
observable objective market benchmarks and thus most IOs find it easier to use. However, IOs
should be aware that the use of IRR as a sector hurdle rate is fairly subjective and should take into
consideration the detailed terms and conditions of the transaction which impact the risks of value
realization.
Both IRR and WACC are primarily influenced by perceptions of risk. Hence in a riskier investment, IFC
should require a higher IRR or return criteria and on a stand-alone basis, the DCF should be based on
a higher WACC. Just as there can be differences in opinion about future cash flows, investors can
differ on estimation of the appropriate discount rate. And by the same token, different investors
may differ in their return criteria (IRR hurdle) and hence price assets differently. Therefore, IFC’s
assessment of the risk and views on risk/reward trade-offs may differ from those of the market
overall.
This chapter begins with an overview of calculating IRR and highlights common mistakes seen at IFC.
Next, current market practice in calculating cost of equity and WACC is detailed. While IOs focus at
entry may be on estimating the expected IRR of an investment, a thorough understanding of WACC
is important when negotiating valuations at entry and exit and as well for portfolio valuation. In the
last sections, issues particular to emerging markets are highlighted including IFC guidance on
| P a g e 90
appropriate incorporation of country risk. The related topics of illiquidity discounts and control
premia are addressed in Chapter 7.
5.2. Internal Rate of Return
5.2.1 IRR Concept and Formula

Internal rate of return is one method of measuring return on investment. At entry, IFC’s expected
IRR is estimated; however, the realized IRR can only be measured once IFC exits an investment.
During periods where IFC continues to hold an investment, IFC measures the unrealized IRR based
on estimates of current valuations, typically from DCF and comps.
IFC returns are driven by the 4 inputs in the IRR formula: entry price, exit price, holding period and
interim cash flows (if any). (See formula below)
Mathematically, the IRR is the discount rate that results in a NPV equal to zero for a series of cash
flows. The calculation is analogous to calculating the yield to maturity on a bond.
The formula for IRR follows, where CF refers to the cash flow each period, which may be positive or
negative. CF0 is typically the price of the investment at entry.
0 = CF0 + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 + . . . +CFn/(1+IRR)n
IRR cannot be calculated unless there are both negative and positive cash flow. CF0 is usually the
only negative value unless additional funding from investors is required over the life of the
investment.
In Excel the IRR can be calculated as:
=IRR(CF0, CF1, CF2,…)
When analyzing IRR, note these related issues:

1. Be clear about labeling whether the IRR is calculated in a real or nominal IRR and whether it’s
local currency or US dollar. As IFC is a US Dollar investor, when investment teams calculate
IRRs, they should be considering expected deprecation of the currency as sensitivity and be
calculating expected US dollar IRRs.
2. IRR fails to consider the rate at which proceeds received along the life of the investment are
reinvested, similar to yield to maturity on a bond.
3. IRR on its own is not sufficient to compare investments, IOs should also consider cash on cash
multiple, investment size, and likely holding period. The latter assumption should consider
likelihood of exit feasibility as well as role completion.
One example is that a lower IRR earned on a larger investment may be preferable to a high IRR on a
very small investment. For example assume Project A requires an investment of $1 million and
yields an IRR of 40% for 2 years. Project B requires an investment of $25 million and yields an IRR of
20% for 5 years. The larger project with a smaller IRR will yield more cash profit for IFC.
5.2.2 Cash Multiple Measure
| P a g e 91
The cash multiple is one metric commonly calculated in addition to IRR. The metric is often used in
private equity and compares the magnitude of cash returned to the original investment. It is
important to note that as commonly calculated the cash multiple DOES NOT DISCOUNT the cash
flows for time value of money or risk so is an imperfect measure but provides another piece of
information on outcome.
The formula follows:
Cash Multiple = Sum of cash distributions divided by the initial investments
Exercise 1:
Consider a firm with expected cash flows below.
Find the TV and IRR assuming you invest 15,000.
Projected Year
1 2 3 4 5
EBITDA 45 122 366 2,196 6,588
Exit year 5
Multiple 9.0
Solution
TV - - - - 59,292
Price paid 15,000
CF (15,000) - - - - 59,292
IRR 31.6%
Cash Multiple 3.95 = 59,292,/15,000
Be careful of cash flows and what IRR you are calculating (e.g. IRR to IFC only, to all
equity holders, for the project or for the sponsor).
Include all investments as negative cash flows and dividends and exit proceeds as
positive cash flows.
NOTE: Dividends assumptions should be conservative and take into consideration of
reinvestment requirements of the firm and regulatory restrictions on dividend
payments. DO NOT ASSUME that all excess cash flow will be paid out as dividends.
Many countries have restrictions related to net income. IOs should consider
sensitivities on capex, working capital, and debt repayment as well as required
accounting reserves in estimating dividend payments.
Remember, IFC uses IRR to measure the return on IFC’ equity investment which may
be different from the company ROE. Also, note that IFC’s IRR on its Equity investment
will also differ from the project IRR, depending on how the project is funded and how
cash is returned to all investors and the pricing to each at entry. Also, in order to
calculate Equity returns, if the exit is based off Enterprise Value, one needs to first
deduct from EV all adjustments, subtracting debt and NCI using exit year values.
| P a g e 92
Exercise 2: IRR and Cash Multiple with Intermediate Cash Flows
Consider the purchase of 100% of a firm with the expected cash flows below. Find the IRR
assuming a price of 45,000 and exit in year 5.
Projected Year
1 2 3 4 5
EBITDA 288 1,034 3,540 7,409 11,880
Expected dividends 1,000 1,200 1,800 3,500 4,000
Debt 15,000 14,000 13,000 12,000 11,000
Non-controlled interest 6,500 7,000 7,500 8,200 9,000
Multiple 9.0
Solution
TV 106,920
Price paid 45,000
Dividends 1,000 1,200 1,800 3,500 4,000
CF (45,000) 1,000 1,200 1,800 3,500 90,920
IRR 17.6%
Cash Multiple 2.9
Note: The Year 5 CF = TV + dividends less exit year debt and NCI.
Exercise 3:IRR and Cash Multiple with Minority Stake

Continuing with the above example, now assume IFC invests 9,000 for a 20% stake. Find IFC’s expected
IRR and cash multiple. Redo the above for a 15% stake
Projected Year
1 2 3 4 5
Price Paid 9,000
Stake 20%
Dividends 200 240 360 700 800
CF (9,000) 200 240 360 700 18,184
IRR 17.6%
Cash Multiple 2.2
What if IFC invests 9,000 for a 15% stake? Calculate IFC's expected IRR and cash multiple.
TV
Price paid 9,000
Dividends 150 180 270 525 600
CF (9,000) 150 180 270 525 13,638
IRR 10.8%
Cash Multiple 1.6
| P a g e 93
DON’T FORGET to Run Sensitivities on Key Drivers of IRR
An IRR based on a static set of assumptions is inadequate as there are many key
drivers which will impact returns. Just as valuations are sensitized from comps or DCF,
expected IRR based on the same key drivers are sensitized. IRR calculations can be
reverse engineered to determine the maximum price to pay to achieve a desired
return. Sensitivity analysis can help drive that pricing analysis. Be sure to calculate a
US Dollar IRR as IFC is a USD funded institution and expected volatility in FX rates can
have a big impact on returns.
From the formula, internal rate of return is a function of the investment and the timing
and magnitude of future cash flows. How important is each factor? Data tables
provide useful information sensitizing these critical and uncertain inputs.
Here are examples of key drivers for sensitivity data tables:
Entry Price
Exit Price (e.g., exit multiple and EXIT EBITDA)
Dividend payments
FX (return impact of currency appreciation/depreciation)
Revenue or cost drivers
Market or other cash flow drivers (should mirror key DCF sensitivities)
Exercise 4 - IRR Sensitivities

Consider the following cash flows. Find the IRR and create a data table to analyze the sensitivity of IRR
to the exit year and exit multiple. Be sure to tie TV calculation to the exit year with an IF statement
(not sure how? See the solution file in the accompanying Excel file). If you have never created a data
table, see the step by step instructions provided in the accompanying Excel file on the Ch 5 IRR
Exercise set up tab.
Projected Year
1 2 3 4 5 6 7 8 9 10
EBITDA 115 173 242 314 377 414 456 479 503 528
Exit year 5
Multiple 10
TV
Price paid 1,000
CF
IRR
| P a g e 94
Solution
Projected Year
1 2 3 4 5 6 7 8 9 10
EBITDA 115 173 242 314 377 414 456 479 503 528
Exit year 5
Multiple 10
TV 0.0 0.0 0.0 0.0 3,767 0.0 0.0 0.0 0.0 0.0
Price paid 1,000
CF (1,000) 0.0 0.0 0.0 0.0 3,767 0.0 0.0 0.0 0.0 0.0
IRR 30.4%
IRR Estimates
For select multiples & exit years
30.4% 5 6 7 8 9
11.5x 34.1% 29.7% 26.7% 23.8% 21.5%
11.0x 32.9% 28.8% 25.9% 23.1% 20.9%
10.5x 31.7% 27.8% 25.1% 22.4% 20.3%
10.0x 30.4% 26.7% 24.2% 21.6% 19.6%
9.5x 29.0% 25.7% 23.3% 20.8% 19.0%
9.0x 27.7% 24.5% 22.3% 20.0% 18.3%
Take-Away: IRR is often highly sensitive to both the exit year and exit multiple. The results are
also dependent upon exit year EBIT.
IRR calculations can also be reverse engineered to determine the maximum price to achieve a
given return. Make an assumption about exit valuation and then discount it back by your required
return range to estimate a range of prices to pay for the investment. See exercise above, the data
tables demonstrate range of prices to pay based on IRR and range of exit EBITDA’s (assumes
constant exit multiple). Note in the data table below, in order to achieve a 25% return, IFC cannot
pay more than $734 if EBITDA reaches 350 at exit.
Price Estimates Assuming Exit in Year 7

Based on Varying EBITDA & Return Criteria
### 200 250 300 350 400 450
15% 752 940 1,128 1,316 1,504 1,692
20% 558 698 837 977 1,116 1,256
25% 419 524 629 734 839 944
30% 319 398 478 558 637 717
35% 245 306 367 428 489 551
| P a g e 95
5.3. Weighted Average Cost of Capital
5.3.1 WACC Concept and Formula
As mentioned at the beginning of the chapter, IFC’s expected IRR is based on our entry price, our
interim cash flows and the timing and pricing of our exit. As such, the IFC IRR often differs from the
IRR of other equity investors. To emphasize, the IRR is an output – it is the return on investment
based on assumptions regarding entry and exit prices and intermediate cash flows. When valuing an
entire company, take the rate as an input to discount future cash flows. This discount rate is a key
driver of DCF valuation. Enterprise Valuation is used at IFC at entry, during portfolio supervision and,
most critically, when we are considering timing of IFC’s exit. A keen understanding of how the
market will value an asset including the market’s perception of risk and required return (i.e. discount
rate) is critical to IFC’s assessment of entry and potential exit value.
The discount rate selected to value a series of cash flows (as in a DCF) should take into account: 1)
time value of money; 2) riskiness of the cash flows; and 3) the capital structure. The riskiness of the
cash flows is dependent upon industry, company and country risk assessments as well as an overall
market price of risk. This blended rate is called the weighted average cost of capital or WACC. This
WACC should incorporate the return required by all providers of capital, both debt and equity. This
rate should reflect the company’s current cost of raising capital.
As noted in Chapter 4, this discount rate is NOT IFC’s hurdle rate, does not reflect IFC’s financing cost
and most importantly IS NOT IFC’s expected IRR.
WACC is the most common discount rate used by both private and public equity investors globally.
There are challenges and criticisms of using WACC as a discount rate; however, it is market practice
and the following section lays out the issues in estimating each component and provides guidance
for calculating a reasonable range for each input consistent with market practice.
The two main components of WACC are the firm’s Cost of Debt (after tax) and an estimate of the
firm’s Cost of Equity. Each is weighted by its relative proportion in the long term capital structure. If
a firm has significant preferred stock and/or NCI, these proportions should also be included in the
calculation of WACC.
The formula for WACC is:
𝐷 𝑃 𝐸
WACC = = ∗ 𝐾𝐾 ∗ (1 − 𝑇) + ∗ 𝐾𝐾𝐾 + ∗ 𝐾𝐾
𝑇𝑇 𝑇𝑇 𝑇𝑇
Where:
E = Market value of Equity including Equity which is Minority Interest or NCI
D = Market value of Debt, often approximated by book value of debt
P = Market value of Preferred Stock
TC = Total Capital = D + P + E
Ke = Cost of Equity
Kd = Cost of Debt
Kp = Cost of Preferred Stock
T = Marginal tax rate
| P a g e 96
5.3.2 Four key questions when calculating WACC
1. How are the capital structure weights for each component determined?
• The WACC formula weights the capital components based on proportions in the capital
structure; for example 30% debt /70% equity—the percentages must sum to 100%.
• The weighting is meant to be the average for the forecast period. Generally, one should use
the market value of equity and debt to determine the weights, unless the firm capital
structure is projected to change.
• The book value of debt is often a good proxy for market value even when debt does not
publicly trade, unless there has been a significant change in the credit rating since issue.
Use all financial debt, including capital leases, when calculating the debt component.
• Even in unlisted companies, however, one should estimate a market value of Equity to
calculate the weighting or use benchmarks of capital structure from the average of peers or
for the industry, or based on talking to the client and their target. It is not recommended to
use the book value of equity to calculate weights, it is better to have an estimate of
market weighted TARGET capital structure.
• NCI should be included as Equity in the WACC calculation, ideally at market value (see
Chapter 2 on estimating MV of NCI).
• Preferred stock should be included at is market value, if outstanding.
• In situations where the capital structure is expected to change significantly over the forecast,
either use target weights or in situations where the capital structure will be constantly
shifting as, for example, when debt continues to be paid down, calculate distinct WACCs or
use the FCFE approach discussed in Chapter 6.
2. How does IFC find the cost of debt?

• The key question is “At what rate, can the company raise debt today?” The company’s cost
of debt is the current cost of financing which may not be equal to the average cost of debt
issued in the past.
• Estimate this cost using current cost of bank debt, current yield to maturity on bonds or with
an appropriate credit spread. Use long term debt or if the company only has short debt, use
the yield curve to calculate the implied long term funding cost (at least 5 years).
• Commercial debt pricing is the most relevant. If the company has significant subsidized debt,
exclude those rates as they do not reflect market perception of the credit risk.
• The cost of debt should then be stated on an after tax basis.
• Adjust at the marginal tax rate, to capture the tax shield created by debt. This is found as
pre-tax cost of debt * (1 – marginal tax rate). The effective tax rate is not appropriate.
3. How does IFC estimate the cost of equity?

• As Equity risk is not easily priced in the market, it needs to be estimated based on a “building
block approach”.
• At a minimum, the cost of equity should be higher than the cost of debt.
• Cost of equity is most commonly measured using the Capital Asset Pricing Model (CAPM).
• Given the variety of assumptions, it is best practice to sensitive valuations around the cost of
equity and the resulting WACC.
| P a g e 97
• The basic building block approach is to estimate: 1) the risk free rate, 2) the premium above
this for equity risk overall, 3) the relative risk premium or discount for the volatility of the
sector/company, and 4) an estimate of country risk if needed.
4. What other issues are problematic in estimating WACC?

• If the firm uses preferred stock, include this in the WACC and estimate the cost as the
dividend on the preferred stock divided by the price. Since preferred stock is riskier than
debt, but less risky than common equity, the cost of preferred should be between the two.
• WACC can be calculated on a nominal or real (no inflation) basis. The WACC should be
consistent with the cash flows so if the forecasted cash flows are nominal, use a nominal
WACC, if the cash flows are stated on a real basis then the WACC should be real as well.
Exercise 5 - Calculate WACC

Use the information below to calculate the firm's WACC.
Cost of equity 15.0%
Pre-tax cost of debt 10.5%
Marginal tax rate 26.0%
BV debt 200.0
MV debt 180.0
BV equity 300.0
MV equity 450.0
Exercise 5 Solution
MV firm 630.0
% debt 28.6%
% equity 71.4%
WACC 12.9%
5.4. CAPM: Application, Inputs and Issues
5.4.1 CAPM Formula for the Cost of Equity
There are a number of models that are used to estimate the cost of equity. One model is the Capital
Asset Pricing Model or CAPM. Research by academics and practitioners has raised limitations of the
CAPM. The basic premise in CAPM is that in a diversified portfolio, the premium embedded in the
cost of equity (Ke) need to only capture non-diversifiable risk. In cases where an investor does not
have a fully diversified portfolio, this may be a problematic assumption in terms of estimating the
required return for the investor. However, if IFC assumes the market prices risk assuming
diversification is cheap and easy then CAPM may provide a reasonable result. (Sellers of equity are
not going to price their shares lower to compensate for potential buyers’ lack of diversity.) Despite
CAPM issues, it remains the most widely used model in practice and is the most common market
approach used to estimate the cost of equity.
| P a g e 98
At IFC, although IFC prices investments on its return criteria (IRR), IFC uses CAPM and WACC to
estimate valuation. Since IFC is required to exit all its investments, it is important to understand
how the market will price the cost of equity using CAPM.
The CAPM distinguishes two components of risk: the part that can be diversified away, called non-
systematic risk and systematic risk which is unavoidable. When using the CAPM to build a cost of
equity, IFC starts with the risk free rate which is usually the US 10 year treasury. Then, IFC adds the
equity risk premium (ERP) which is the price of risk of an average Equity investment. The ERP
estimates the difference between the expected return on the stock market overall versus the risk
free rate. The ERP is sometimes referred to as the market risk premium or MRP. Estimating this
premium on a forward basis is challenging. Thus, most banks analyze historical data on the return of
the Equity markets over the risk free rate over some historic period. The period chosen can
significantly impact the rate.
In order to adjust the price of risk for an average Equity investment to a specific firm, the CAPM
incorporates a measure of the non-diversifiable risk of the company known as the Beta. This beta
should also be forward looking; however, as forward looking betas are often not available, historical
betas are used to estimate forward.
The resulting formula for the cost of equity follows:
Ke = Krf + BL * (Km – Krf)
Or, Ke = Krf + BL * ERP

Where:
Ke = Cost of equity; Krf = Risk free rate; Km = Expected return to market; BL = Levered beta; ERP
= Equity risk premium = Km - Krf
| P a g e 99
Exercise 6 - Calculate Cost of Equity and WACC
Use the information below to calculate the firm's WACC.
Cost of debt 11.5%
MV debt 2,600
Stock price 11.5
# shares outstanding 495
Beta 1.6
Risk free rate 6.0%
Mkt risk premium 6.5%
Tax rate 29.0%
MV debt 2,600
MV equity 5,693
Total 8,293
% debt 31.4%
% equity 68.6%
Cost of equity 16.4%
After tax cost of debt 8.2%
WACC 13.8%
FAQ: Where can I find the inputs for the risk free rate, ERP and beta for the average private,
emerging markets corporate?
Estimating the inputs for the cost of equity is challenging in all markets, but data is particularly
difficult to find for IFC clients. The following section walks through the standard building block
approach to estimating the Ke and then describes recommended adjustments to account for country
risk.
5.4.2 Risk free rate
• The most common proxy for the price of risk free investing is 10 year government bonds
from high rated countries. Ideally, the currency of the bond should match the cash flows. In
practice, most use the 10 year US Treasury bond.
• The rate should be the current or smoothed average (e.g. 6months); however, it should
reflect current market conditions.
• For new investments, IOs should use the current US Treasury 10 year yield.
• For portfolio investments, please refer to the most updated Portfolio Valuation Guideline
which is a weighted current average of the US Treasury 10 year yield.
• Given the long term nature of the cash flows, shorter durations should not be used. Longer
term bonds can be used if they have sufficient liquidity.
| P a g e 100
• Some banks use shorter government rates; however, they compensate with higher risk
premiums, and market Ke are broadly similar amongst practitioners.
• Some practitioners embed the country risk premium directly, by adding the local
government bond spread over US Treasuries to the Rf (See country risk section below).
5.4.3 Equity Risk Premium: Equity Market Risk
An ERP, also known as the market risk premium (MRP) is the price or return investors require over
the risk free rate, Rf, for taking on Equity risk. In principle as Equity is more risky than debt, one can
assume that the ERP should be higher than any credit risk spread.
By extension, the discount rate for average risk equity investments is then the risk free rate (Rf) plus
the ERP. This premium does not remain constant over time or across markets because perception
of risk changes daily based on the information on the market. As ERP rise, perhaps due to rising
investor risk aversion, investors charge a higher price for risk and therefore apply a higher discount
rate, leading to lower asset valuations. As valuations change with changing risk perceptions and
appetites, the resulting valuation multiples shift as well, thus providing a link between DCF and
comparable company’s analysis. Thus, sector multiples are sometimes described as at average, peak
or trough levels. Thus, if IFC uses current ERP and current multiples, results should be consistent
and differences should result more from the assumptions about future cash flows and not risk
perceptions.
Most banks and PE firms use historic spreads between Equity and risk free investments, where the
risk free is typically a medium term government bond. At IFC, the portfolio valuation team publishes
an ERP which IOs can use at entry and portfolio.
ERP Conclusions
The ERP varies over time, across markets and depending upon how it is measured. ERP estimates
may be based on historical averages or implied from current prices and expectations. In a DCF, even
if cash flow assumptions are correct, subsequent valuations can change if investors’ views on risk
change. However, changes in valuation should stem from changes in business performance or in
market conditions and not from changes in the technique used to source ERP.
5.4.4. Beta: Company Specific Risk
While various sources exist for the risk free rate and the ERP, once selected, these inputs are
common to all firms in a given market. The only item that should vary across firms in a given country
is beta. Accordingly, the beta estimate drives the relative cost of equity. Despite its significance,
measurement of beta is neither easy nor uniform.
Although the CPM valuation guidelines on discount rates are set assuming a beta of 1.0, IOs should
adjust the beta to be appropriate to the company being valued.
As the third important building block of CAPM, beta measures the risk of the company compared to
the market. It does not measure the “riskiness” of a stock, but rather the relative volatility of that
stock versus the market. In more technical terms, Beta is a measure of the systematic risk of the
| P a g e 101
firm, which is defined as the covariance of that stock’s return with the market return, divided by the
variance of the market return.
In the original CAPM model, beta was intended as a forward looking estimate. Beta should be
forward looking, though in practice, historic betas are often used to predict future betas. The
following are two sources for data on forward betas:
• Bloomberg publishes a raw beta based on a single factor model using 60 months of historic
data and an adjusted beta in which it attempts to eliminate “noise” from the regression and
assumes the beta will move toward the market average over time. The formula used to
adjust the beta is
o Adjusted beta = Raw beta * .67 + 0.33
• Barra (subscription required) provides many different types of betas: historic, predicted,
global, local
Levered vs Un-levered Betas
As most firms have some leverage, the observed beta of a stock is usually referred to as its levered
beta. Levered betas capture the relative risk of the firm including financing structure, business
model and operating leverage.
If a firm is private or does not trade in a liquid market, comparable firms can be used to estimate
industry or peer betas. This is also true if the firm is a new issue or has had major changes in its
business model.
However, prior to using peer betas to estimate a firm’s beta, remove the impact of the financing
structure in order to isolate the industry risk component. This process of adjusting the beta is called
un-levering the beta. The resulting beta is often called the asset beta or industry beta and is usually
an average of the unlevered the betas for the sector.
Once the unlevered beta is calculated, then re-lever that beta based on the capital structure of the
target firm being analyzed. The examples below follow the formulas for un-levering and re-levering
betas:
First un-lever the comp firms:

Bu = BL / (1 + D / E * (1 – T))
The re-lever the target firm:
BL = BU * [(1 + D / E * (1 – T)]
Where D/E is the debt to equity ratio and T is the marginal tax rate.
Summary: Key Steps in un-levering and levering betas:

1. Identify a set of comparable firms that trade in a liquid market
2. Un-lever the betas using the equation above, Hamada’s equation (developed by Robert
Hamada)
3. Find the average or median
4. Re-lever the beta to fit the target firm’s capital structure.
| P a g e 102
This approach should not be applied to firms with dramatically different capital structures because
over wide changes in financial leverage, there does not appear to be a linear relationship between
leverage and beta (similarly there is not a linear relationship between leverage and credit spreads
over large changes in leverage). For FIG, betas are not unlevered and re-levered as the capital
structure impact is not as linear as it is for the real sector.
Exercise 7 - Levering and Un-Levering Betas

You are analyzing a private firm and need to estimate beta.
You have analyzed three comparable firms and found the firm betas (levered) as shown below.
Use this information to estimate the firm's levered beta.
Firm Levered beta MTR % debt % equity Unlevered beta
CompA 1.20 30.0% 30.0%
CompB 1.35 28.0% 35.0%
CompC 1.00 33.0% 20.0%
Avg unlevered beta
%
Apply to Firm MTR debt % equity
27.0% 32.0%
The levered beta
Solution
Firm Levered beta MTR % debt % equity Unlevered beta

CompA 1.20 30.0% 30.0% 70.0% 0.92
CompB 1.35 28.0% 35.0% 65.0% 0.97
CompC 1.00 33.0% 20.0% 80.0% 0.86
Avg unlevered beta 0.92
%
Apply to Firm MTR debt % equity
27.0% 32.0% 68.0%
The levered beta 1.23
FAQ: I am evaluating a private firm in Guatemala. Does my WACC need to be in the same
currency as my forecast? There aren’t good local comps to use to estimate beta. Can I use firms
in the same sector from other countries?
In short, yes. CAPM is fundamentally about estimating the price of varying types of risk. The market
benchmarks used as proxies for measuring risk thus need to be liquid benchmarks. For some
emerging markets, it is thus more reasonable to use mature market benchmarks for the Rf and ERP,
and separately measure the country risk premium. Similarly, betas for the sector will be more easily
measured in more liquid markets than most local markets. Finally, it is best to match the WACC to
the currency and nature of cash flows i.e., real vs nominal and local vs USD. In general at IFC,
investment teams forecast in local currency and use local currency WACCs unless significant inputs
or outputs are USD linked.
| P a g e 103
5.5. Incorporating Country Risk into the WACC
5.5.1 Country Risk Considerations
Even in a mature market, there are challenges to estimating the WACC, including which is the
appropriate risk free rate, how to best estimate beta and what to use for the equity risk premium. In
emerging markets, it is even more complex as country risk must be taken into account.
The key questions are:
• How much more expected return do investors require today to compensate for the
increased risk of investing in firm in an emerging market?
• What is the appropriate benchmark for measuring country risk?
• How are reasonable assumptions made when faced with poor data quality or illiquid market
conditions and lack of reliable historical data?
Country risk refers to a number of factors including:
• Currency devaluation
• Political or economic instability
• Changes in legal framework on investor or corporate rights
• Changes in regulatory or tax regimes
• Transparency and liquidity of financial markets.
How should these risks be incorporated into the analysis? There are two important components
that need to be addressed. Similar to other drivers, one can analyze specific country macro factors
which will affect the equity value through sensitivity and scenarios analysis.
For example, if currency depreciation or a reduction of government tax subsidies are possible, these
should be modeled in the DCF and IRR sensitivity analyses. The sensitivity analysis will enable a
careful drill down on the impact on IFC’s IRR of the one factor in question. Scenario analysis which
link correlated factors in likely scenarios is also extremely helpful in analyzing country economic risk.
Below are three examples of such scenarios:
• Scenario 1: continuation of reforms, healthy economy

• Scenario 2: high interest rates, low growth, low inflation, stable exchange rates
• Scenario 3: higher interest rates, lower growth, high inflation
In regards to the WACC, a Country Risk Premium should be added to capture the additional risk for
investing in an emerging market.
Key questions surround the selection of the risk free rate, ERP and beta. Should each be local, global
or some combination? Should the country risk premium be consistent across all firms in the
country? Theoretically, one could adjust all three: Krf, ERP and Beta to local factors. However, this
has two problems. One is the potential to double count country risk and therefore overestimate the
| P a g e 104
country risk premium and the cost of equity. The second is more practical and is the difficulty in
obtaining quality data. While it seems clear that not every company is impacted equally for the
same country risk, the data does not lend itself to easily making reasonable adjustments to the
WACC and thus at IFC, these factors are considered in the cash flow projections and other qualitative
assessments of the risk profile of the company.
IFC’s recommended approach is detailed below. A review of other approaches is provided in
Appendix 2.
FAQ: How should an IO incorporate Country Risk into WACC?
At IFC, a simple approach is recommended:
Add a CRP to a USD Krf
or use a local Krf for local currency projections.
In both cases, use a global ERP and global industry betas. Note that in all cases, judgment needs to
be used to ensure consistency and reasonableness. This is especially true for the beta estimates if
local industry dynamics are markedly different from global.
Note that if the CRP is added then cash flows should not be adjusted for country risk to avoid double
counting (Karl).
There are issues in adjusting each factor which are presented below.
How to measure Country Risk Premium: The easiest way to adjust the Ke for country risk is to use a
local Rf. Thus instead of the U.S. Treasury, use the rate on the 10 year local currency government
bond. This is most appropriate for a local currency nominal WACC. However, another common
approach is to use the 10 Year U.S. Treasury as a base rate for Rf and separately measure a country
risk premium (CRP) and add it to the WACC.
The CRP is estimated by many banks by examining long term USD Country Sovereign debt spreads
over US Treasuries and applying that average spread over US Treasuries as the CRP. Alternatively,
some use credit default swap rates on the sovereign debt. As some countries do not have liquid
public debt instruments, some banks use the debt of similarly rated countries as proxies.
At IFC, the pricing team publishes macro spreads for each country IFC operates. The macro spread
incorporates some of the analysis discussed above and is an estimate of country risk. The macro
spread historically at IFC was capped at 375 for debt pricing purposes. However, the pricing team
will be publishing equity macro spread data for the purposes of calculating country risk premia. The
cap on the equity macro spread is higher at 725bp and is more appropriate for estimating the
market pricing of country risk. While IOs can start to use the new equity macro for valuation at
entry, the migration from the old macro spread to the new macro spread at portfolio stage will take
time since this change is subject to all internal reviews, KPMG’s reviews and senior management
approval. The implementation at the portfolio stage will also need to be careful to avoid sudden
unexplainable drop in value by simply using the new spread without proper assessment of other
aspects of a DCF model. IOs should be aware that the level of country risk faced by a firm can be
| P a g e 105
impacted by currency sensitivity and sources of revenues, location of divisions and corporate risk
management practices. Note that these issues could come up in negotiations with clients on the
overall WACC or perception of country risk. However, IOs must include a CRP based on the country
risk of the sourcing of cash flows of the company.
Damodaran publishes on his website (see Appendix 1) country specific ERP which combine country
risk and ERP. This may provide useful information for getting a sense of market estimates of country
risk and in client negotiations.
What about local ERP and betas?
The beta and ERP must be consistent to avoid double counting country risk. Most banks, including
IFC, recommend only adjusting the Krf and using a global ERP.
To ensure consistency, it is recommended to use global industry betas, being sure to un-lever the
comparables company betas and re-lever the average beta based on the target capital structure
(method described earlier in this chapter).
The one caveat to this is that sometimes local industry dynamics may be very different from global.
For example, in the airline industry, betas of US airlines are much higher than Asian peers due to
significant differences in demand and cost dynamics. A simple, less scientific approach is to adjust
global betas only in these circumstances. Why not just use a local beta? That could be done if the
ERP is local but then country risk could be overestimated. If the data on a local ERP is reliable (with
strong historic liquidity), calculate the cost of equity both ways and analyze the sources of any gap in
the results.
5.5.2 Summary Formula for WACC with Country Risk
Formula for Nominal WACC with CRP

WACC = K *(1-T)* (D/TC) + (Ke + CRP) * (E/TC)
Formula for Real WACC with CRP

WACC = Kd * (1-t)* (D/TC) + (Ke + CRP) * (E/TC) - inflation*
*CRP = Equity Macro Spread.
Subtract local inflation projection or US inflation depending on currency of WACC
Above formulas assume no preferred stock
| P a g e 106
Exercise 8- WACC with Country Risk
It is March 2010 and you have been asked to estimate WACC for a Mexican investment.
Use the information below to find:
a) Local nominal WACC
c) Real local WACC
Inputs
Risk Free Rate (10-year T-Note) 3.60%
REAL Risk Free Rate (10-year T-Note) 1.46%
Country Risk 1.00%
Country Inflation Differential 1.89%
Market Risk Premium (rm) 7.20%
Debt to Cap. Ratio 45.00%
Unlevered Beta 0.90
Tax rate 28.00%
Cost of debt 9.00%
WACC March 2010

Cost of debt - nominal, pretax 9.00%
Inflation built into US 10 year rates 2.14%
Cost of debt - Local REAL 4.97%
Real, local After tax cost of debt 3.58%
Nominal after tax cost of debt 6.48%
Risk free rate - local currency REAL 2.46% equals the US real risk free plus CRP
Risk free rate - local currency Nominal 6.49% equals the US risk free (nominal) plus inflation spread plus CRP
Target Beta 1.43 Lever the beta BL = BU * [(1 + D / E * (1 – T)]
Ke = Cost of equity REAL 12.76% From CAPM starting from the real risk free rate
Ke = Cost of equity Nominal 16.79% From CAPM starting from the nominal risk free rate
Debt to Capital ratio 45.00%

Equity to Capital ratio 55.00% Equals 1 minus the percent of debt in the capital structure
WACC - Local, nominal 12.15% Using the nominal cost of debt and equity
WACC - local, real 8.63% Using the realcost of debt and equity

It is important to distinguish between the rate of return on a minority equity investment versus the
discount rate to use in a valuation of a company. IFC’s IRR in an investment should be higher than
the weighted average cost of capital (WACC) used in a DCF valuation. Both are impacted by market
conditions and IOs should be careful about the assumptions used in estimating both.
| P a g e 107
Chapter 6: Other Valuation Techniques
Commonly Used at IFC
Chapters 2-4 examined valuation based upon market values, comparable firms and discounted cash
flows. In this chapter other techniques commonly used at IFC are introduced. These techniques
derive from the earlier valuation methods and have been created to address specific situations
including early stage firms, conglomerates and firms with different business units where a single
multiple or discount rate may not be appropriate.
Chapter Contents
6.1 Sum of Parts Analysis
• Overview
• Considerations in Applying Sum of the Parts
• Exercise 1 – Sum of the Parts
• Exercise 2 – Sum of the Parts
6.2 Other DCF Models

• Free Cash Flow to Equity
• Dividend Discount Model
6.3 Back of the Envelope Checks
6.4 Valuation of Early Stage Firms
• Portfolio stage Valuation
6.5 Valuation of Conglomerates
| P a g e 108
6.1. Sum of the Parts Analysis
Overview
The sum of the parts valuation technique is, as the name suggests, a technique where various parts
of a firm are valued separately and then summed to determine a total value. The methodology is
sometimes referred to as break-up value, since it examines value in a scenario where the firm is
broken into the various logical operating parts, and each piece is valued on a stand-alone basis. This
analysis enables a better understanding of the drivers of value on a segment basis.
Sum of the parts is useful when analyzing a company:
• that is a conglomerate and operates in different business segments.

• with operations in different countries.
• with various operations exhibiting different paths, e.g. steady versus high growth.
• consists of current operations, pipeline business and “blue sky”.
• with a new division that will not be profitable for several years.
• to consider the impact on value of spinning off a division.
Benefits:
When using comparables analysis, the Investment Officer can apply different multiples:
• Different segment multiples, e.g. a food multiple for the food business and a beverage
multiple for the beverage segment.
• If the company has business in Asia and Latin America, apply Latin comps analysis results to
the Latin and Asia to Asia.
• Even within a segment and country, there could be variations in the growth rate, margins
etc. e.g. high growth gets the higher multiple.
• Use different earnings multiples for each unit, e.g. P/E for some, EV/EBITDA for others and
EV/Sales for newer units. Each should be justified by the same principles outlined in Chapter
3. Or for example, earnings multiples for the real sector segment and P/B multiples for a
financial arm.
When using a DCF approach, the Investment Officer can use different discount rates and different
growth rates for the various business units and associated Terminal Values. For example, apply a
higher beta to one segment or a different exit multiple or a different WACC based on different
country risk premia.
Allows valuation of a firm, using a combination of the DCF and comparables approaches. A full DCF
may be built for the primary operating units and then valuation of smaller units could be done with
multiples
Use sum of the parts analysis when there are “hidden value” components, use traditional methods
on core businesses and other methodologies for the non-core such as:
• Mine with a large concession area; and

• Property that is under-utilized (see Chapter 2).
| P a g e 109
Considerations in Applying the Sum of the Parts Technique
• Carefully consider multiples, growth rates, margins, free cash flows and discount rates for
each segment separately. As the parts are aggregated, the total values should seem
reasonable.
• Allocate corporate overhead to divisions based on % of revenues, EBIT or industry
bench marks for segments.
• If depreciation and amortization are not provided by segment, allocate to divisions
using methodologies including % of assets, revenues, EBIT or industry norm for segments,
etc.
• Ensure that sum of the parts financial information equals the consolidated financial
information for the entire company.
• Be sure to exclude intercompany transactions and sales in valuation.
• Minority interest could be applicable to a single segment or may have components
from all segments. If from a single segment, be sure to make note of it in the valuation
analysis.
• Ask if one segment is driving or distorting value when the enterprise is valued as a whole.
• Be careful of cross-holding structures and do not double count when making valuation
adjustments of each
| P a g e 110
This image cannot currently be displayed.
| P a g e 111
6.2. Other DCF Models (FCFE) (DDM)
Free Cash Flow to Equity (FCFE)
A traditional DCF (Chapter 4) values the entire firm based on available cash flows to both debt and
equity holders. Then Enterprise Value is adjusted by the value of debt and other items (Chapter 2)
to derive equity value. In certain cases, IFC may want to value equity directly. The DCF concept can
be applied to Equity directly by analyzing free cash flow to equity (FCFE) or forecasted dividends to
equity investors (Dividend Discount Model/ DDM).
Free cash flow to equity
The forecasted cash flows are free cash flows available to equity providers. The main difference
from FCF is that the starting point is Net Income (NI) and not EBIT:
• Start with Net Income available to common shareholders

• Add non-cash charges
• Subtract net repayment of debt
• Subtract investments in working capital and capex
• If Terminal Value is estimated using constant growth: Substitute FCFE for FCF in numerator
and Ke for WACC in denominator
• Alternatively estimate Terminal Value using a P/E multiple (not EV/EBITDA)
Discount the cash flows and TV at the Cost of Equity
| P a g e 112
Dividend discount model
When valuing banks and other credit institutions, “Enterprise Valuation” is either very difficult or
does not make sense. The approach generally adopted is therefore to value the Equity directly.
Reasons include: a) it is difficult to define debt for a bank, as debt is more like working capital for a
bank; b) banks are highly leveraged, so a small inaccuracy in enterprise valuation will translate into a
large inaccuracy in equity valuation; c) it is difficult to define reinvestment in the case of a bank in
terms of fixed assets, so the correct approach is to assess additional capital required in each year to
support the growth of risk-weighted assets and treat this as “reinvestment” of capital/earnings; d)
estimating cash flows are challenging in the case of a bank.
In order to do an equity valuation using cash flow discounting approach, IFC typically prepares
financial projections, and then estimate the amount of capital or net income that needs to be
retained to support growth in future years. This level of capital needed to support growth is not
necessarily the regulatory minimums, in fact it is typically several percentage points higher. Any
capital, in a given year, that is over and above this level of capital needed for growth can be treated
as “excess capital” that can notionally be assumed to accrue to shareholders as dividends. This
concept is very similar to the notion of treating Free Cash Flows in real sector companies as accruing
to shareholders in the respective years, although the cash is not necessarily actually paid out to
shareholders.
Once the notional dividend streams are estimated for the period of projections, and the Terminal
Value is estimated (either by using a P/BV approach or by using the terminal growth formula), the
cash flows are discounted at the Cost of Equity (not the WACC, since only equity-related cash
streams are being discounted) to come up with the Dividend Discount Model value.
Special questions:
• How to calculate dividend flows for a company that does not pay dividend?
• Should financial projections and dividend flows be modelled in LCY or USD?
• How should other forms of capital including subordinated debt and hybrid capital, including
preference shares be treated?
Exercise 3: DDM
Given the following forecast of Dividend Flows and Terminal Value of Equity, find Equity Value and
Implied Share Price.
Year 1 2 3 4 5
Dividend flows 170,682 180,921 189,063 204,189 220,524
Terminal Value of
551,310
Equity
Cost of equity 9%
IFC Equity
$160,442
Investment
| P a g e 113
Year 1 2 3 4 5
1
Discount factor 0.92 0.85 0.78 0.72 0.67
PV 157,311 153,684 148,019 147,338 513,305
Equity Value (Post- $
Money) 1,119,656
Less IFC Equity $
Investment* 160,442
Share price (pre- $
money) 19
1 (1 / (1+
rate) ^ year
*Assuming IFC investment is in year zero
6.3. Back of the Envelope Checks
Before devoting hours to an analysis, it may make sense to do some simple calculations to
determine project viability. Such calculations are commonly referred to as “Back of the Envelope”.
These calculations also serve as a sanity check on results from IRR, DCF and comparables analysis.
While these checks are tailored to each sector, here are a few examples.
By analyzing the basic economics of the project, one can test the viability and return potential fairly
quickly. The back of the envelope checks are often based off the following factors.
• Contribution margin
• Payback period
• Break-even price or quantity
• Industry “Rules of Thumb”
Contribution margin:
Contribution margin checks allow for a quick look at project viability. If the unit contribution margin
is too low, fixed costs will not be covered and the project is not viable.
Unit contribution margin = Unit revenue – Unit variable cost
Payback metrics
Payback metrics look at the time required to recover invested capital, either on a nominal or present
value basis. There are different versions of the measure. A basic calculation is:
Payback period = Invested Capital / Cash Contribution
Where cash contribution is defined as revenues less direct costs.
| P a g e 114
EBITDA (on an after tax basis) is often used as a proxy for the cash margin. A very short payback in
some sense minimizes project risk, while a very long payback raises the risk of recovering the initial
investment and earning the expected return.
Return on Invested Capital
Calculate ROIC to analyze return adequacy. ROIC can be quickly estimated on a gross or operating
basis. Ask if the ROIC and payback makes sense in the industry context.
ROIC = Cash Contribution / Invested Capital = 1 / Payback
Break-Even Analysis
Break even can be calculated based off price or quantity. Again, there are different ways to calculate
it; however, it is simplest to look at break even on an operating profit basis where total revenues
equal total costs. Then ask how likely the firm is to achieve the break-even price and quantity.
Break-even price = Variable cost per unit + (Total fixed costs / Quantity)
Break even quantity = Total fixed costs / (Price per unit – Variable cost per unit)
Financial Markets Metrics

To assess the reasonableness of a P/BV multiple, consider the multiple decompositions and tables in
the appendices.
In the steady state, the following price to book multiple holds. Note that there is a strong
correlation between ROE and P/BV multiple, and it is not meaningful to attribute a P/BV multiple to
a bank (using whatever method) without anchoring it to its ROE. Are the implied ROE and growth
rates achievable for the firm in the long run?
Price / BV = (ROE – g) / (Ke – g)
Remember not to use P/BV exclusively for FIG valuations. P/E ratios are very important too and
provide a reality check on comparables-based valuations.
Industry “Rules of Thumb”

Most industries have a “Rule of Thumb” based on experience. Note, these vary by sector and
country.
Examples:
Hospitals: Compare capex per bed to revenue per bed and EBITA margin after tax to see the payback
period on capex. Higher complexity hospitals will charge higher price and have higher EBITDA and
this can justify higher capex costs. Analyze payback period and margins of comps.
Talk to the Industry and equity specialists about back of the envelope metrics in your sector.
| P a g e 115
6.4. Valuation of Early Stage Firms
The valuation of early stage companies is especially challenging since most early stage firms have no
earnings and negative cash flow and there is considerable uncertainty about the nature of the
growth in such new products/projects. Therefore, attempting a DCF analysis may be less
meaningful. While multiples based valuation is preferable for early stage firms due to difficulties in
creating realistic cash flow projections, determination of an appropriate multiple may be equally
challenging. Please consult IFC’s Venture Capital Team for guidance on valuation when working on
early stage investments.
While especially challenging to value, early stage firms offer tremendous potential return to IFC. It
is difficult to provide generic guidance, but several possible approaches follow:
1. Use DCF with scenarios
Estimate scenarios for potential market size and firm market share once the market develops,
perhaps 10 or so years out. Consider reasonable EBIT margins at this point. Be sure to estimate the
implied market share if a number of players are entering at the same time. Then extrapolate to get
from the 10 year forecast back to the present. While there is tremendous uncertainty in the DCF, it
will highlight what needs to happen in terms of market penetration, market share, total spending on
the product and margins for a reasonable return. Discount rates tend to be very high given the risk
associated with these investments. A probability weighted approach may be preferred where
probabilities are assigned to success and failure. Consider three or more possible scenarios such as
home run, modest success and failure. Complete the DCF for each and then probability weight the
scenarios to arrive at an expected value.
2. Apply a revenue multiple.
This is a dangerous metric as even revenue multiples imply an opinion on future profitability.
However in the absence of earnings, this is often the best option. The challenge here is to find
comparables and understand the drivers of the multiples for companies that are trading on revenues
(e.g. is it brand recognition, expected margins, market share, first mover advantage).
3. Base the value on required IRR
Start with a reasonable required rate of return based on the risk. Forecast out over the investment
horizon over several possible scenarios. Based on the future expected valuation, discount back using
the range of required IRRs to determine the maximum price to pay to achieve the required IRR. This
is common in private equity and venture capital. The reasoning here may go along these lines: “We
believe we can exit in 7 years at $50-55 million, our target return is 25-30%, so the pre-investment
valuation is $8-11 million.”
4. Use information from recent transactions
Look at recent equity investments by third parties to obtain information on current valuations in the
industry.
Make appropriate adjustments for control or liquidity premiums (more details in section 7.1). Also,
be sure to factor in the expected dilution and the amount of financing necessary to achieve the
growth. Also factor in which round of financing and how de-risked the project is. For example, first
| P a g e 116
round is riskier than the third round. More detail on dilution issues and structuring are covered in
chapters 8 and 9.
Portfolio Valuation for VC Investments
Considering the challenges faced in valuing early stage investment, Portfolio Valuation Team and the
Venture Capital Team have developed a guideline on valuing early stage investments at portfolio
stage.
6.5. Valuation of Conglomerates
Conglomerates are companies that either partially or fully own a number of other companies
operating in different sectors. Examples include General Electric, Cheung Kong Holdings and
Berkshire Hathaway. The valuation of conglomerate firms is challenging since there are not good
comparable firms to use for relative valuation and the firm segments have different risk, growth and
cash flow profiles. DCF of all the segments can also be complex and a single WACC may not apply
evenly to the whole business (see Sum of the Parts section).
This is often exacerbated by complex financial statements. In such situations, use the sum of the
parts technique outlined at the beginning of the chapter. The theory regarding the advantages and
disadvantages of conglomerate firms has changed dramatically over the past fifty years. At one
point conglomerates were viewed as more valuable because of the perceived benefits of the
resulting firm diversification. Based on this, conglomerates often traded at a premium during the
1960s and 1970s. Since it is now straightforward and inexpensive for investors to diversify directly,
the value of diversification at the firm level seems to have diminished. On the contrary, IFC now
hears of “conglomerate discounts”. A conglomerate discount might exist if, for example, the market
applies a discount due to the complexity of the financial statements or if the “wrong” discount rate,
growth rate or multiple is applied during the valuation due to an inability to correctly identify these
variables. Portfolio managers are biased to value “pure play” investments more highly since they
can more efficiently weight sector exposure and can more easily use their discretion to change
weightings over time in tactical tilts based on their sector views.
Others see that the conglomerate discount arises as firms diversify beyond areas of core
competencies, leading to the diversion of management time, energy and resources and ultimately
what investment guru Peter Lynch refers to as “diworsification”. Academic research on the topic has
yielded mixed results but studies have found conglomerate discounts in the 5-10% range globally
with some studies showing discounts of up to 15%. Other views are that poorly performing
companies expand into unrelated sectors; also, related to the resources point, some say that there is
an inefficient allocation of resources within a diversified organization
Alternative valuation methodologies including sum of the parts, free cash flow to equity and the
dividend discount model may be useful for some IFC investments. Further, the valuation of early
stage firms and conglomerates pose challenges and traditional DCF and comps analysis may prove
insufficient as techniques. Back of the envelope sanity checks are very useful as a sanity check for
valuation of both established and early stage companies.
| P a g e 117
Chapter 7: Discounts Related to Level of
Liquidity & Control
IFC often invests in minority stakes in firms with limited liquidity. The lack of control and illiquidity of
these investments should impact return criteria. In this chapter, illiquidity and minority discounts are
examined and the interaction between these two factors is considered. This chapter is written more
towards valuation at entry. Guidelines for discounts for lack of control and lack of marketability at
portfolio stage is explained with the link under section 7.4. The slight divergence of the approach
between valuation at entry and valuation at portfolio stage is based on more judgment needed at
entry and more consistency required for portfolio and accounting purposes.
Chapter Contents
7.1 Discounts related to Liquidity& Control

• Overview
• Graphic: Valuation Steps
7.2 Discounts for Lack of Liquidity

• Illiquidity Discounts: Key Drivers & Evidence
7.3 Discount for Lack of Control

• Minority Discounts: Key Drivers & Evidence
7.4 IFC Guidelines
7.5 Common Errors
| P a g e 118
7.1. Discounts Related to Liquidity & Control
Overview
The majority of IFC’s investments are minority stakes in private companies. Liquidity and control
add value compared to less liquid and/or minority stake investments.
In selecting valuation techniques for determining equity value, IO’s should use methodologies that
do not include any premiums for control. Specifically, be mindful of the control premium embedded
in most transaction comparables (see Chapter 3). Only after discounting for control, can transaction
comparables be used in conjunction with trading comparables, DCF or DDM and IRR analysis to
triangulate a reasonable equity valuation range for a liquid minority stake. Once that is done, IO’s
should apply an illiquidity discount to the resulting equity value to determine the valuation to IFC
depending on the level of illiquidity estimated. This chapter will review the issues in assessing and
apply such discounts. As discussed in Chapter 1, this is one of the final steps prior to determining an
offer price in a transaction.
Graphic – Valuation Steps
7.2. Discounts for Lack of Liquidity

A core assumption in comparables analysis and DCF or DDM is that the investment team is valuing a
liquid investment. For example, in an IPO, equity research analysts will use both methods to
triangulate a value and then apply an IPO discount. Similarly, at IFC, investment teams should first
triangulate the valuation between the chosen methods and apply an illiquidity discount tailored to
the investment situation.
Determining how to measure the illiquidity discount is challenging. However, the following “rules of
thumb” provide some guidance. A company which is pre-IPO should have the smallest discount
| P a g e 119
(~10-15%). Firms which are listed, but are not actively traded should have a higher discount. Any
company with shareholders who do not plan to sell to strategic or financial investors or list their
company should have the highest discount (~25-35%). In between these two benchmarks are
companies with very marketable equity (e.g. firms with many potential strategic suitors or those that
have high IPO potential) (15-20%) and others where exit options are more limited (20-25%). What is
clear is that all private companies and illiquid listed companies should be valued with an illiquidity
discount.
Key Questions to help determine a reasonable discount range:
• Is the company a likely IPO candidate? Is there an IPO plan in the foreseeable future?
• Are there strategic companies that are already identified as probable buyers? And are
the other shareholders open to selling majority control?
• Are there co-investors or financial buyers interested in the space? Does the firm have
private equity funds within the shareholder base that are aligned with IFC on the exit?
• If listed, compare level of proposed IFC holding vis-à-vis stock liquidity, and how long it
will take for IFC to be able to sell our holding in the market without affecting stock price
significantly.
The illiquidity discount is a separate adjustment to be done at the end of an

equity valuation and should not be applied to Enterprise Value nor incorporated
in the discount rate.
If IFC plans to exit through an IPO, an IPO discount should be applied to the
assumed exit valuation. If we are exiting through a put, IOs can specify the put exit
multiple and/or a fair market value approach. In the latter, IOs can also request
that no liquidity or minority discount should be applied to a fair market value.
Without this provision, IO’s should assume that 3rd party appraisers will apply an
illiquidity discount to IFC’s exit valuation. This discount is used regardless of whether
valuation is driven by comparables or DCF. The discount is for the lack of liquidity of
the investment. It is not a discount to market multiples.
Illiquidity Discounts: Key drivers & Evidence
• Valuations across asset classes generally reflect a discount associated with illiquidity.
• Most valuations are developed assuming reasonable marketability since market information
drives both multiples and discount rates.
• Evidence from restricted stock units, pre IPO prices and private equity funds suggest
discounts for illiquidity range from 5-45% and average 20-25% across time and markets.
• Key factors driving the discount level include: ownership level, firm size, financial condition,
probability of going public in the future, and the liquidity of the underlying firm assets.
• Notably, transactions in listed shares demonstrate that controlling stakes of illiquid firms are
sold at much higher prices than minority stakes at such firms, in part due to the control
premium but also due to the generally greater marketability of a larger stake versus a single
share.
| P a g e 120
FAQ: I am evaluating an investment in a textile company. Should I build in a
marketability/illiquidity discount? If so, how much?
It depends! A sizeable company with a strong brand and IPO potential, where co-investors are also
financially focused would justify a low illiquidity discount compared to an investment where the other
investors are family members who plan to keep all shares for inheritance and are averse to selling
their stakes. Similarly, if the holding period is longer, for example a timber company with immature
timber, then the discount should be higher.
Consult Credit Officers, Equity Specialists and Portfolio Valuation Unit for guidance.
7.3. Discounts for Lack of Control
IFC does not take controlling stakes in its investments. If a valuation has already included a discount
for illiquidity, there may not be a need for any further discount related to lack of control. However,
in analyzing any control transactions benchmarks, including prior rounds of financing for the
company, IOs should discount for the existence of a 20-30% control premium on average.
Minority Discounts: Key drivers & Evidence

• Evidence from M&A transactions and academic research consistently demonstrates that a
51% stake has far more value than a 49% stake due to control issues.
• Minority discounts are a function of shareholder structure, regulatory structure protecting
investors and corporate governance practices.
• Minority discounts are also a function of shareholder structure, regulatory structure
protecting investors and corporate governance practices.
• Why? The lack of control implies the minority owner’s inability to make operating decisions
or control payments of cash distributions.
• Even in M&A transactions that involve a minority investment, there is a “strategic premium”
associated with investments by strategic investors (as opposed to financial investors), for
example by a technical partner who may be earning other income streams by providing
services to the investee company, or by a larger player looking for entry into the investee or
market or country.
• Evidence suggests minority discounts cover a very wide range from as low as 5% to a high as
65% and often fall in the 15-25% range.
7.4. IFC Guidelines
• Consult Credit Officers, the Equity Specialists and the Portfolio Valuation Unit to get a
sense of what discount is most appropriate for a private and illiquid, listed investments.
• Show explicitly, any discounts and provide the rationale.
• Please refer to the Guidance Note on Liquidity Discount for determining appropriate
level of discount at portfolio stage.
| P a g e 121
7.5. Common errors
Avoid these common errors.
• Don’t build the illiquidity discount into the multiples and/or discount rate and then add
another illiquidity discount.
• Don’t assume all private firms are equally illiquid, consider specific circumstances of
each investment, including controlling shareholder openness to sale/IPO.
• Avoid inconsistency at the portfolio level: only change discount if company
circumstances have changed materially in terms of liquidity.

Liquidity and control are valued by equity investors. Most IFC equity investments are for non-
control stakes and are in private companies. After completing DCF and Comparables analysis, the
resulting valuation range is that of a liquid minority stake and thus IOs should discount these
valuation ranges for illiquidity. Such discounts should also be considered when calculating projected
exit values and projected IRRs. Control premium and strategic premiums are embedded in
transaction comparables, thus IOs should be careful and discount for the control premium imbedded
in those transactions. Even listed companies can be illiquid in emerging markets and illiquidity
discounts should be applied to valuations.
| P a g e 122
Chapter 8: Pre and Post Money Valuations
IFC often contributes Equity to fund new projects and expansion. The terms pre and post money refer
to equity valuation before and after new equity funds are injected in the company. This topic is
critical in client negotiations and yet has proven confusing to many. In this Chapter the pre/post
money and pre/post project concepts are analyzed and a framework for analyzing the boundaries
between which IFC should negotiate an equity stake is introduced.
Chapter Contents
8.1 Final Step: Calculating Pre and Post money Valuation & IFC Stake
• The impact of capital injection on enterprise and equity value
• Pre vs Post Project analysis
• FIG methodology for calculating Pre and Post Money Stakes
| P a g e 123
8.1 Final Step: Calculating Pre and Post Money Valuation & IFC Stake
The terms pre and post money refer to equity valuation before and after new equity funds are
injected in the company. This final step in a valuation exercise at entry is to determine the IFC
percentage ownership stake as well as the value per share. The basic math of the calculation is to
start with the agreed valuation negotiated with the client, which is usually referred to as the pre-
money equity valuation. This is the valuation price negotiated with the client for the equity of the
company prior to the injection of our capital. Most of the negotiation is around what the value of
the company is prior to the equity raise. To calculate the post money valuation, simply add all the
capital being raised in the round of equity financing. Only include primary issuance because
secondary issuance goes to shareholders and not into the company.
Pre-Money Equity Valuation + Cash equity to be contributed = Post-Money Equity Valuation
IFC % ownership = IFC Stake / Post-Money Valuation
Price per share = Post Money Valuation / (total number of shares outstanding after issuance)
While the concept is straightforward, the pre/post money calculations are riddled with confusion
and have potential for error. The basic concept is that the agreed equity valuation is based on the
future cash flows and the current capital structure and adding the cash from equity raise increases
the value of the equity (see Chapter 1 on Enterprise to Equity value adjustments). This assumes that
the company has a valuation which takes into account all the spending (e.g. capex) required to
achieve the NPV. A cash injection would thus increase equity value.
Although the purpose of this chapter is to focus on issues related to pre and post money valuations,
there is also some confusion about pre and post project. Does the initial pre-money valuation range
include the valuation of new projects that are funded with the equity raise? This question should be
addressed earlier in the valuation process by determining which projects and business lines to
include in the projections. This is also a part of the negotiation process and the art of a valuation
exercise, determining how much upside IFC is willing to pay for or how much of a discount to take to
new, higher risk projects versus the established business the client already has.
IFC clients are often raising funds to finance specific projects (i.e., expansion, new markets, new
products). When making assumptions for both DCF and comparables, the Investment Officer can
model the company as it is today (pre-project) and then separately value the firm including the cash
flows and earnings of the contemplated project (post-project). This can be difficult in practice if
projects are already underway and if the client only has guidance and projections including all
projects. However, to the extent possible, investment teams should try to model both pre and post
project since new projects often have higher risk profiles and IFC may be willing to pay more for
existing business versus the new potential higher-risk business that IFC is financing. These are
negotiating points and are very situation-specific in terms of achievability. In a greenfield project,
IFC often comes in at cost with the sponsor and returns are equal for IFC and other shareholders. To
the extent a project is more de-risked or the client has built a larger business and has multiple
funding sources, IFC may participate at a lower return versus original sponsors. IFC will have more
| P a g e 124
negotiating power where additionally is high or where IFC is bring a larger financing package to the
table (mobilization of debt or equity.
The KEY to Pre/Post Valuations: Which is your client talking about?

When negotiating with clients, ensure that the client and IFC are discussing the same
parameters. For example, is the price they are asking for pre or post money? Often,
numbers are thrown out without this context explained. A second clarification would
be if both parties expect the same valuation parameters for existing business versus
pipeline.
While understanding pre/post valuation is crucial for valuation at entry, this concept is equally
important at portfolio stage. Because IFC typically participates in our clients right issues, it is not
uncommon for IOs to value our existing investment taking consideration of our future equity
injection. This is incorrect. Please consult the Portfolio Valuation Team if unsure about what to do
in this type of situation.
Below are some simple examples to illustrate scenarios of pre and post money and pre and post
project valuations and the range of IRR’s IFC and the client would receive under various scenarios.
Keep in mind, that the initial triangulation of a reasonable equity range should consider how much
IFC would like to discount existing business versus new projects under consideration and blue-sky
upside.
Pre vs Post Project Valuation:

In a DCF analysis, the cost of the project is usually included in the cash flow projections, as well as in
all the returns. For example, negative capex and working capital expenditures have to be modeled
to generate future revenues and EBITDA from the project. This is if the valuation is of the company
post-project. However, if IFC wants to negotiate to pay for the company pre-project, only cash
investment and flows from existing business would be valued. It is important to perform both
valuations as IFC’s negotiating position and the client’s may be at the opposite ends of these two
valuations. This holds true if 100% of proceeds go into the company for projects. When Equity will
be used to repay debt or shareholder loans results will differ.
In a DCF that includes the new project, the negative cash flows related to investment in the project
are in the forecast. The value of the company derived from the DCF is a pre-money valuation (albeit
post project). In order to properly calculate IFC’s percentage stake, one needs to divide IFC’s
investment by the implied equity valuation + new money raised.
For example: If it is agreed that a company’s equity is worth $100 million and IFC is investing $15
million and others are investing $35 million, then the formula may be as follows:
$15 (IFC stake) / [$100 (post project valuation) + $50 (new money)]
Thus IFC would get a 10% stake post-money.
A second DCF excluding the project may yield an equity value of $50 million. In that case, IFC’s equity
stake would rise to 15% on a post-money basis. Hence the impact of including the new project is
| P a g e 125
clearly a higher price for IFC and a lower percentage of the company. This example illustrates clearly
the impact of what projects are included in valuing the company’s pre-money equity
$15MM/ [($50MM (pre project) + $50MM (new money)]
The range of value considered in the negotiation is influenced by a number of factors. Each project
should increase the value of the company and the primary negotiation between IFC and the sponsor
is on how returns on the value creation could be shared between the sponsor, IFC and other
investors. In a greenfield or early stage project, IFC can negotiate more easily for higher returns in
line with the sponsor. The more established the business and the higher the number of investors
interested, the more of a premium could be requested.
FIG methodology for pre and post money:
Equity investments in most FIG deals do not have specific projects linked to them; instead, they
support the bank/company’s overall capital base and thereby support growth of assets and income.
Consequently, for most equity investments in financial institutions, separating out dividend streams
into post-project and pre-project is very difficult, if not impossible. FIG investment analysis like FCFE
or DDM almost always assumes flows including IFC’s capital, however the NPV of the capital
injections are subtracted so that the final equity valuation becomes pre-money, albeit post-project.
Always use dividend streams post-project (i.e., assuming the proposed equity raise including IFC’s
equity investment has been completed) when carrying out a DDM valuation. Any valuation metric
used to compare valuation should be on this pre-money valuation. This is very different from a real
sector valuation.
Key questions to keep in mind:
• If the company offers IFC a 10% stake, understand 10% of “what”.
• Is IFC negotiating pre or post project valuation?
• Is IFC willing to pay for the upside IFC helps fund? How much value does the sponsor bring
and how important is IFC’s funding?
For more detailed examples which illustrate the issues to consider in determining post-money
valuation, please refer to appendix 12. They highlight how to think about analyzing the negotiation
of IFC’s ownership stake. The first few examples are simple to establish a framework and
parameters for analysis and then build up to cases typical for IFC.
The KEY is to understand how to calculate the boundaries for the negotiation of IFC’s
Equity stake. This is highly dependent on IFC’s additionality and the company’s
alternatives for funding and the shared view of the prospects of the project/company.
Coming in at cost provides better returns; thus terms regarding valuing future rounds
should be carefully considered to minimize future dilution.
| P a g e 126
IFC typically negotiates an Equity stake based on post money and post project valuations. Be very
clear in discussions with the client regarding what the valuation includes. Understand the
boundaries over which to negotiate and leverage IFC’s additionality when negotiating.
| P a g e 127
Chapter 9: Complex Adjustments in
Deriving Equity
In chapters 1 and 2, the major adjustments commonly used to derive equity value from Enterprise
Value were covered in detail. This chapter will cover less common, more complex adjustments. These
adjustments are similar in scope to those covered previously. They are either added or subtracted
from Enterprise Value depending on their impact on the value of Equity
Chapter Contents
9.1 Review of EV to Equity Adjustments
9.2 Complex Adjustments

• Non-operating Assets
• Non-operating Liabilities
• Operating Leases
• Exercise 1: Operating Leases
• Unfunded Pension & Post Employment Benefit Liabilities
• Exercise 2: Pension Liabilities
• Employee Stock Option Plans
• Off Balance Sheet Liabilities
| P a g e 128
9.1. Review of EV to Equity Adjustments
Recall from chapters 1 and 2 the major adjustments commonly used to derive equity value from
Enterprise Value were covered in detail. The basic formulas are repeated below.
EV to Equity Formula
EV = Core Operations
EV + Excess Cash + Investments + Noncore Assets
=
Debt + Preferred Stock + NCI + Underfunded Pension Liabilities + Common Equity
EV versus TEC Formula and Graphic
TEV = Total Firm Value
TEV + Excess Cash

=
Debt + Preferred Stock + NCI + Underfunded Pension Liabilities + Common Equity
| P a g e 129
9.2. Complex Adjustments
Non-Operating Assets
Issue: The firm has non-operating assets. Non-operating assets are assets not used for the core
business. This may include assets held for sale related to a discontinued operation, a corporate art
collection, unused real estate, and investments in affiliates. Since the assets are not related to day
to day operations, any value from the asset is not included in EBIT. To facilitate comparables
analysis, create multiples of core Enterprise Value divided by core EBIT or EBITDA. These multiples
should be calculated using EV cleaned of non-operating assets and EBIT excluding any earnings
related to non-operating assets. A special case of non-operating asset is a net operating loss. The
financial notes can be useful in identifying non-operating assets. Common balance sheet labels for
non-operating assets include: assets held for sale, investments, and other assets.
Treatment: Comparables analysis
• For EV multiples, ensure that income from non-operating assets is not included in EBIT, then
value the non-operating asset separately and include at market value in the EV to Equity
adjustments (should increase equity value). Net operating losses should be valued
separately as timing and jurisdictional issues impact the value. If material, seek tax
professional advice.
• With P/E multiples (not recommended)
o Difficult to identify comps with similar non-operating assets.

o Determine if earnings from the non-operating asset have been included in EPS.
Typically this will be the case for investment in affiliates, but not for items like assets
held for sale, art collections etc. which do not generate earnings.
Treatment: DCF analysis
• Ensure that income from non-operating assets is not included in EBIT (and therefore FCF)
and then value the non-operating asset separately and include at market value in the EV to
Equity adjustments. Net operating losses should be valued separately as timing and
jurisdictional issues impact the value. If material, seek expert assistance here.
Non-Operating Liabilities
Issue: The firm has non-operating liabilities, generally liabilities not associated with the ongoing
business. Examples include liabilities associated with discontinued operations, restructuring
reserves, litigation, and environmental remediation. Non-operating liabilities are conceptually
similar to non-operating assets in the sense that EV multiples should exclude the impact in both the
numerator and denominator.
Treatment: Comparables Analysis
| P a g e 130
• Similar to non-operating assets, ensure expense not included in EBIT and then value
separately and include as EV to Equity adjustment (should decrease equity value). Again,
P/E multiples not recommended as true comparables may not exist.
Treatment: DCF Analysis
• Similar to non-operating assets, ensure expense is not included in EBIT and then value
separately and include in EV to Equity adjustments (should decrease equity value).
Operating Leases
Issue: Some firms buy assets and finance with debt; others use operating leases. EBIT is lower for
firms that have rent expense from operating leases. A firm that buys and finances an asset or uses a
capital lease will have a higher EBIT than a renting firm since only depreciation expense is recognized
as an expense in calculating EBIT. Financing costs appear below EBIT. Operating lease expense
essentially combines depreciation and the financing cost of an asset.
• The goal is to determine the debt equivalent of the operating lease and strip out the impact
of the rent expense so that multiples will be comparable regardless or lease or buy decisions
among firms.
• The investment team must adjust both the numerator and denominator of EV multiples to
take out the impact of an operating lease.
• Adjust the denominator by adding back rent expense to EBITDA. The result is called EBITDAR
where R equals rent/lease expense. Earnings of firms that buy or lease are now more
comparable.
• Adjust the numerator by capitalizing the lease to convert it to a debt equivalent.
To capitalize the lease:
o Use the “Rule of 8” or ask the Industry Specialist for the relevant lease multiple. To
use this approach multiply lease expense by 8 or the appropriate sector multiple.
o Find the note on operating leases and find the present value of future lease
payments using the cost of debt as the discount rate. Often this approach leads to a
lower value since firms only report lease commitments and not the expected
renewals.
• P/E multiples will not be comparable.
• It is not typical to make adjustments.

• Note in benchmarking, firms with operating leases will have relatively lower debt and asset
levels versus those who buy or have capital leases.
| P a g e 131
Exercise 1- Operating Leases
Apple reported the following in its 2012 10K
Lease Payments 2012 488.0
2013 516.0
2014 556.0
2015 542.0
2016 513.0
2017 486.0
Thereafter 1,801.0
Total minimum lease payments 4,414.0
Assume that payments after year 5 remain at Year 5 levels.
Assume the cost of debt is 4%.
Part A: Convert to a lease equivalent using the "Rule of 8"

Part B: Convert to a debt equivalent by finding the present value of the lease payments
Part A: Convert to a lease equivalent using the "Rule of 8"

Debt equivalent from Rule of 8 3,904.0
Part B: Convert to a debt equivalent by finding the present value of the lease payments
Assume that payments after year 5 remain at Year 5 levels.
Assume the cost of debt is 4%.
Cost of debt Lease payments 4.0%
1 516.0
2 556.0
3 542.0
4 513.0
5 486.0
6 486.0
7 486.0
8 486.0
9 343.0
Debt equivalent from PV of lease payments

3,679.5 NPV of Payments
| P a g e 132
Unfunded Pension & Post-Employment Benefit Liabilities
Issue: Defined benefit plans and other post-employment benefits (OPEBs) may be under or over
funded and may or may not appear on the balance sheet. On the income statement the charge to
earnings may include non-operating items such as financial items related to the accounting for
pensions.
Pension plans are either defined benefit plans or defined contribution plans. Only defined benefit
plans create adjustment issues since the firm has an obligation to pay out future funds and may or
may not have fully funded the liabilities. In many countries, pensions and other post-employment
benefits are unfunded or underfunded. The under or over funded balances appear on the balance
sheet under IFRS and US GAAP, but may not be presented under all local accounting standards.
Typically, detailed information is provided in the notes to the financial statements. Although these
liabilities are not common for IFC clients, they are common for the global comparables and thus
adjustments need to be made to ensure that EV comparable multiples are calculated correctly. It is
market practice in the U.S. and Europe to adjust equity value for pension related liabilities.
• First look at the balance sheet and notes and search for under or over funded pension assets
and /or liabilities. Next search the notes for information on the related expense. Adjust
EBIT so that only the service cost is expensed to arrive at EBIT.
• Adjust EV to include the unfunded pension and OPEB liabilities as debt equivalents. This will
reduce equity value. This account is on balance sheet under many but not all accounting
standards, thus Investment Officers should verify treatment. In some countries, funding the
liability is tax deductible and in those cases the debt equivalent should be stated on an after
tax basis where the value is multiplied by (1-marginal tax rate). If there is an overfunded
pension plan this is sometimes treated as a noncore asset, but if so typically evaluated on an
after tax basis. More common is adjustment of future expenses related to pensions.
Treatment: DCF Analysis
• Equivalent to the comparables treatment.
| P a g e 133
Exercise 2: Unfunded Pension Liabilities
IndigoCo has reported operating profit of $1,000. Its marginal tax rate is 20%. On the balance sheet
the firm reports an unfunded pension liability of $120. You search the notes and find the following
information related to pension expense:
Service Cost 50
Interest Cost (5)
Expected Return on Plan Assets 20
Amortization of Prior Service Cost 10
Amortization of Net Gains 5
Pension Expense (20.0)
Part A: Find IndigoCo’s adjusted EBIT.

Part B: Find the debt equivalent first assuming no tax impact and second assuming funding the
liability creates a tax deductible item.
Part A: In pension accounting only the service cost relates to the current cost of pension expense.
The other items relate to prior years, financial items and accounting rules.
EBIT = operating profit of $1000 + pension expense of $20 (undo the total) – service cost of $50 =
$970.
Part B: The debt equivalent of the liability is $120 pretax and $120*(1-.20) = $96 post tax. The debt
equivalent should be included in EV.
For more information on pension accounting please refer to following pages:

1. Deloitte
2. Alliaz Pendion Solutions
Employee Stock Option Plans
Issue: Potentially dilutive. As firms shift toward Equity-based compensation, stock options are
granted at many firms to both top management and other employees. These options may be
converted to stock in the future and thus create the potential for dilution of ownership.
• Most accounting standards require that ESOP expense is deducted as an operating expense,
thus if it is an expense in EBIT then no adjustment is necessary. If not deducted, then adjust
EBIT downward by the expense.
• Equity value must be calculated using diluted shares outstanding. These calculations are
covered in detail in Chapter 2. All stock options, RSUs and convertible securities that are
dilutive must be included in share count.
| P a g e 134
• As above, verify that ESOP expense is expensed to find EBIT.

• When converting from EV to Equity and implied share price, use diluted shares outstanding
as explained above.
Treatment: IRR analysis
• Be sure that total expected dilution is included in valuing IFC’s exit share value. If further
dilution is expected, that will impact the IRR.
Off Balance Sheet Liabilities
Issue: May be considered debt equivalents
Off balance sheet liabilities include operating expenses (covered above) and litigation, take-or-pay
contracts, throughput arrangements; accounts receivable sold with recourse; guarantees.
• Consider converting to debt equivalent if probable and material or adjust EBIT to reflect the
expense associated with the liability. DO NOT adjust both EBIT and debt or you will double
count. If a debt equivalent, will lower equity value.
• Same as comparables adjustment
Some firms have non-operating assets or liabilities, unfunded pensions and operating leases. These
items require special attention when using comparables and DCF analysis to ensure accurate
calculation of multiples and appropriate valuations. Failure to adjust the analysis may lead to
significant errors in the results.
| P a g e 135
Appendices
Appendix 1 - Comprehensive Example for Minority Interest & Equity Investments
at various holding levels
Appendix 2 - Complex Adjustments in Calculating Multiples
Appendix 3 - Decomposing Steady State Multiples
Appendix 4 - Proof of the constant Growth Formula
Appendix 5 - Terminal Value Issues & Sensitivities
Appendix 6 - Alternative Approaches to Terminal Value
Appendix 7 - Historic Estimates of the Equity Risk Premium
Appendix 8 - Alternative Approaches to Estimating CRP
Appendix 9 - Exercises on calculating Pre and Post Money Valuation and IFC Stake
| P a g e 136
Appendix 1 - Comprehensive Example for Minority Interest & Equity
Investments at various holding levels
Illustrative example how NCI and investments are included in Market Valuation:
The Conglomerate Agrico (Agrico) is a listed company and has 4 subsidiaries/investments. They own
the following stakes:
Investment 1. 100% of AgricoB:

Investment 2. 85% of Farmco and have voting control:
Investment 3. 25% of Cattleco and have significant influence:
Investment 4. 7% of Investco and have no significant influence:
Investment 1 is fully consolidated and requires no adjustments from market capitalization to

Enterprise Value.
Investment 2 has a minority investor (NCI) which owns 15% of Farmco and its claim on assets and
cash flows has been considered by investors in pricing Agrico’s equity, i.e. investors are only
including 85% of the value of FarmCo in the stock price of Agrico. Similar to debt, the NCI is a claim
on the assets and must be added to market capitalization in order to calculate the value of the entire
firm or Enterprise Value (e.g. for comps). If EV had been estimated from a DCF, implied equity is
found by deducting the NCI at market value.
Investment 3 is an Associate Investment and will be included in equity value at the value the market
estimates, likely based on P/E multiples since the income reported is as net income (EBITDA
information is usually not available).
Investment 4 is a financial investment and may be accounted on the books at cost or market value.
Even less information is available; however, this investment should be included in equity value using
a market based approach
Appendix 2 - Complex Adjustments in Calculating Multiples
In some firms and sectors, the following complexities may be material and should be considered in
the comps analysis: Differences in depreciation and amortization policies across the comps set,
Operating Leases, Employee Stock Option Plans, and Underfunded Pensions. Recommended
adjustments are summarized below and methodologies for calculations are covered in detail in
Chapter 9.
| P a g e 137
Table 7: Multiples Adjustment
Item Depreciation and/or Amortization

Issue Accounting policies differ across comp set
Adjustment Use EV / EBITDA multiples
Item Operating leases

Issue Some firms buy assets and finance; others use operating leases.
EBIT is lowered by operating leases. Operating lease expense hits EBIT so when a
firm leases, EBIT is relatively lower. A firm that buys and finances has depreciation
and interest; only depreciation is expensed in EBIT.
EV is relatively low with operating leases (compared to buy/finance) since the lease
is not capitalized and shown in debt.
Adjustment Capitalize operating leases (see Chapter 7) or use EV / EBITDAR multiples.
Item Pensions & Post retirement benefits

Issue Defined benefit plans may be under or over funded; Charge to I/S includes service
cost plus financial and other items.
Adjustment I/S: EBIT should reflect only service cost.
B/S: verify that underfunded pension & OPEB is on B/S; treat as debt in EV
calculations. In many countries the pension expense is tax deductible when paid
(rather than when expensed) so when converting to debt use the after tax value of
the underfunded pension liability.
Item Employee Stock Option Plans (ESOPS)

Issue Potentially dilutive.
Adjustment Include any dilutive options and RSUs in share count used for equity value
Verify that ESOP expense is included in EBIT. If so, no need for adjustment unless
value is unusually high or low for reporting period. If not, adjust EBIT for expense.
Item Off Balance Sheet Liabilities

Issue May be considered debt equivalent.
Adjustment If material, probable and measurable consider adjusting OBS liabilities to debt
equivalents; in addition to operating leases (see above) this includes litigation,
take-or-pay contracts, throughput arrangements; accounts receivable sold with
recourse; guarantees.
Other Items Associated with Comparables Analysis
Two other items can impact comparables analysis, though they are not issues for DCF analysis.
1. An acquisitive business model – if some firms in a sector expand organically while others grow
through acquisition, it may be difficult to compare the firms using multiples since the acquisitive
firms often have asset step ups and acquire intangibles. See Table 1 below. Take-away:
EV/EBITDA is comparable but not EV/EBIT.
| P a g e 138
2. The “Make or Buy” decision – if some firms in the sector produce in house while others
outsource, again comparability of multiples is reduced. Take-away: The firm multiples will be
comparable if EV/EBIT is used but not EV/EBITDA. See Table 2 below.
Table 8: The Impact of an Acquisitive Business Model
| P a g e 139
Table 9: Impact of “Make or Buy” Decision
| P a g e 140
Appendix 3 - Decomposing Steady State Multiples
All multiples reflect assumptions of risk appetite, growth and return on investment. Thus, when
perception of risk falls, estimates of growth rise or return on investment risks, trading multiples rise.
The converse is also true and this explains much about the changes in multiple valuations over time
and across sectors.
Until companies reach a steady state, all three factors can be moving in different directions.
However, once a company reaches a steady state, generally returns and growth rates stabilize.
While many IFC clients are in a high growth phase at the time of investment rather than a steady
state, decomposing the steady state multiples can enhance comprehension and use of multiples.
Below is an analysis the factors driving steady state enterprise and equity multiples. This analysis
can assist in understanding the link between multiples and DCF when using TV multiples for the
latter.
EV / EBIT Decomposition:
Consider Enterprise Value in the steady state.
In the steady state, using Gordon growth or perpetuity approach:
EV = Expected FCF / (WACC – g)
Growth, g, = ROIC * reinvestment rate
Reinvestment rate = g/ROIC
FCF = EBIT*(1-T)*(1 – reinvestment rate)
FCF = EBIT*(1 – T) * (1 – g / ROIC)
EV = [Expected EBIT*(1 – T)*(1 – g / ROIC)]/(WACC – g)
Then, the forward EV/EBIT multiple is:
EV / EBIT = [(1 – T) * (1 – g / ROIC)] / (WACC – g)
The Implication is that EV /EBIT multiples are driven by: ROIC, Growth rate, Tax rate and WACC.
When interpreting comparables output, an IO should be able to explain cross firm differences in EV
multiples by these factors. For example, can you explain the difference in multiple by analyzing
differentials in growth, returns, tax rates or capital costs?
| P a g e 141
P/E Decomposition
Consider equity value in the steady state.
Equity = FCF to Equity / (Ke – g)
or using the dividend discount model, Share price = Dividends / (Ke – g)
Dividends = Earnings – reinvested capital
Dividends = Earnings – Book Value * growth rate
D = ROE * BV – BV * g
D = BV * (ROE – g)
Then, Price = BV *(ROE – g) / (Ke – g)
Price / BV = (ROE – g) / (Ke – g)
Price / Earnings = P/B x BV / E = P / BV x 1 / ROE
The Implication is that in the Steady State Equity multiples are driven by: ROE, Cost of Equity and
growth rate.
Note that ROE reflects profit margins and the tax rate while Ke is impacted by capital structure and
risk. When interpreting comparables output, you should be able to explain cross firm differences in
Equity multiples by these factors. The table below highlights implied relationship between the P/E
multiple, ROE and P/B levels.
*********We suggest that the horizontal axis of the table above be reversed, i.e. it start from 4.0
and decline to 0.5. This way, optically the relation will be easier to read – higher the ROE , higher
the PE and PB**
| P a g e 142
Appendix 4 - Proof of the constant Growth Formula
According to financial theory, any financial asset can be valued as the present value of expected
future cash flows. The constant growth model, sometimes called the Gordon or perpetuity model,
calculates the present value of an infinite series of cash flows, CF, provided the cash flows grow at a
constant rate, g, given a discount rate, r. Let V = value.
V= CF1/(1+r) + CF1*(1+g)/(1+r)^2 + CF1*(1+g)^2/(1+r)^3….
Multiplying both sides of the previous equation by (1+g)/(1+r) gives:
V*(1+g)/(1+r) = CF1*(1+g)/(1+r)^2+CF2*(1+g)^2/(1+r)^3+ CF1*(1+g)^3/(1+r)^4+…
Subtract the second equation from the first equation to get:
V – [V *(1+g)/(1+r)] = CF1/(1+r)
Rearrange and simplify:
V = [CF1/(1+r)] * (1/[(1-(1+g)/(1+r))]
V = [CF1/(1+r)] *[(1+r)/(1+r-(1+g)]
Further simplifying:
V = CF1 / (r - g)
This applies to any infinite series where CF grows at a constant rate. For EV, the cash flows are
FCF and the discount rate = WACC>
Appendix 5 - Terminal Value Issues & Sensitivities
This chapter emphasized the two most common approaches to TV: applying a multiple or using the
constant growth model. In appendices 2 and 3 potential issues are presented and alternative
calculations introduced. Terminal Values are often a very significant component of total value and
yet it is difficult to forecast TV with accuracy. Calculating TV using a variety of approaches can help
since cross checking results to identify errors and assumptions can be done.
Two errors are common.
1. The multiple used to value TV at exit is set to the current multiple which reflects the firm’s
high level of growth. By the end of the forecast the firm’s growth rate will fall and the firm
should be trading nearer sector averages.
2. TV from a constant growth model is sensitized by varying the growth rate. The constant
growth TV is very sensitive growth. This impact is often magnified when TV is calculated
with an exit year FCF that increases with growth but ignores the impact of FCF from the
reinvestment required by higher growth.
| P a g e 143
Consider the following examples. Note that firm value is driven by investing in projects where the
ROIC exceeds the WACC. Consider the following cases of ROIC versus WACC.
Case 1 Case 2 Case 3

ROIC > WACC ROIC = WACC ROIC < WACC
Zero Growth 2% Growth 4% Growth Zero Growth 2% Growth 4% Growth Zero Growth 2% Growth 4% Growth
Exisitng capital 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
NOPAT - projected 110 110 110 110 110 110 110 110 110
ROIC 11.0% 11.0% 11.0% 11.0% 11.0% 11.0% 11.0% 11.0% 11.0%
WACC 9.0% 9.0% 9.0% 11.0% 11.0% 11.0% 12.0% 12.0% 12.0%
growth rate 0.0% 2.0% 4.5% 0.0% 2.0% 4.5% 0.0% 2.0% 4.5%
NOPAT projected 110 110 110 110 110 110 110 110 110
increase in capital 0 (20) (45) 0 (20) (45) 0 (20) (45)
Free cash flow - proj 110 90 65 110 90 65 110 90 65
FCF/NOPAT 100.0% 81.8% 59.1% 100.0% 81.8% 59.1% 100.0% 81.8% 59.1%
Reinvestment ratio 0.0% 18.2% 40.9% 0.0% 18.2% 40.9% 0.0% 18.2% 40.9%
Enterprise Value 1,222 1,286 1,444 1,000 1,000 1,000 917 900 867
Take-Away:
If ROIC exceeds WACC the higher the growth rate, the higher EV
If ROIC is less than WACC, value is destroyed
If ROIC equals WACC, the growth rate is insignificant
This makes sense, but is not always the result when models are sensitized. Now consider the
following data table analyzing the impact of growth rate and WACC on EV. This table is similar to
output often provided.
Assume firm has entered steady state
FCF - projected 500

WACC 9.0%
growth 3.0%
TV 8,333
Then, use data table to sensitize results

Growth
2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0%
WACC
10.5% 5,882 6,250 6,667 7,143 7,692 8,333 9,091

10.0% 6,250 6,667 7,143 7,692 8,333 9,091 10,000
9.5% 6,667 7,143 7,692 8,333 9,091 10,000 11,111
9.0% 7,143 7,692 8,333 9,091 10,000 11,111 12,500
8.5% 7,692 8,333 9,091 10,000 11,111 12,500 14,286
8.0% 8,333 9,091 10,000 11,111 12,500 14,286 16,667
7.5% 9,091 10,000 11,111 12,500 14,286 16,667 20,000
The problem with this analysis is that as the growth rate is increased, FCF is impacted in a positive
direction due to growth increasing but the related impact on FCF is ignored. FCF does not change
(unlike our example on the previous page). This is because FCF is forecasted as last year’s value
multiplied by (1 + growth rate). Yet if growth increases, CAPEX and investment in OWC must rise.
| P a g e 144
These additional reinvestment requirements are ignored. The table above overestimates the impact
of growth on value.
How to handle such situations?
• Create data tables where the change in growth rate is modest.

• Forecast one extra year to be used only for terminal value calculations. Ensure the final year
CAPEX, OWC etc. tie to growth.
• Calculate TV using multiple approaches to sanity check results.
• Consider the alternative TV approaches introduced in Appendix 6: Value driver and Half-life.
Appendix 6 - Alternative Approaches to Terminal Value
Given the significance and difficulty in calculating an accurate TV, calculate TV using several
approaches to check your results.
Here we consider 3 alternatives: the Book Value of Assets; Value driver and Half Life. Consider
using these TV estimates to check the analysis.
1. Book value of assets/Wind up value - estimate TV as the book value of the assets at the end of
the forecast. Exclude cash, investments and other noncore assets since these are valued
separately. This result is usually conservative.
2. McKinsey value driver approach - a restatement of the constant growth model which allows you
to "sanity check" the results and allows for a comparison between the long run growth rate and
the long run ROIC
Restate FCF as NOPAT *(1 - reinvestment rate).
This holds because NOPAT that is not reinvested is FCF. Then since growth equals the reinvestment
rate * ROIC can be restated as:
FCF = NOPAT * (1 - reinvestment rate)
Therefore, TVn = [Proj NOPAT * (1 – Reinvestment rate)] / (WACC – g)
Also write FCF as,
FCF = NOPAT * (1-g/ROIC)
TVn = [Proj NOPAT *(1 - (g/ROIC))] / (WACC - g)
| P a g e 145
Exercise: McKinsey Value Driver Approach
Find EV
Year 1 2 3 4 5
NOPAT 141 150 157 164 169
FCF 97 104 109 114 118
PV FCF 89 87 84 81 77
ROIC 11.0%
WACC 9.0%
LT growth rate 4.0%
Solution Constant Value

growth Driver
TV 5 yrs 2,452 2,230
PV of TV 1,594 1,450
EV 2,012 1,867
3. Half Life or Fade Rate
If a firm is still growing rapidly and it is not possible to forecast to steady state, consider using an
approach called the half-life or fade rate.
The formula for the half-life follows: Note that M is the number of years to transition from the
current growth rate to the long run growth rate.
TV = [FCF * (1 + LT growth rate) + FCF * (M / 2)*(Current growth rate – LT growth rate) / (WACC –
long run growth rate)
Exercise: Half Life

Assumptions
Free cash flow last forecast year 58
Long run growth rate 4%
High growth rate 15%
Transition years 10
WACC 10%
TV - using half life approach 1,537
TV with long run g only 1,005
| P a g e 146
Appendix 7 - Historic Estimates of the Equity Risk Premium
Note the impact of time period and approach
Source: “Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition
(Updated: March 2013)” The standard error is reported in brackets below the value.
Aswath Damodaranadamodar@stern.nyu.edu
US and Global ERP Data

| P a g e 147
Appendix 8 - Alternative Approaches to Estimating CRP
Four alternative approaches follow. Approach 1 is essentially the IFC approach. Other approaches
are provided for informational purposes since you may encounter these in valuations and
negotiations.
Approach 1: Add a Country Risk Premium to the Cost of Equity (or use local Rf)
a) Formula : Ke = Krf + US ERP * B + CRP or Ke= local Krf + US ERP * B
b) Key assumption: Every firm is exposed to country risk to the same degree; this is analogous to
using the local government rate as the risk free rate
c) Implementation: easy
Approach 2: Add the Country Risk Premium multiplied by the Firm’s Beta
a) Formula : Ke = Krf + B * (US ERP + CRP)
b) Key assumption: Firm exposure to country risk mimics exposure to other risks, this does not
always hold true.
c) Implementation: easy
Approach 3: Use an adjusted beta
a) Formula: Ke = Krf + US ERP * Adjusted B
Where beta is a globally based estimate of beta adjusted for historic spreads between the
country’s industry beta and the global industry beta and then levered for firm capital structure
b) The country industry beta best captures country risk since not all sectors are exposed to the
same level of country risk; this information may be easier to utilize than approach 2
c) Implementation: beta adjustments required
Approach 4: Add a country risk factor to the model
a) Formula: Ke = Krf + B * ERP +  * CRP
b) Key assumption: exposure
 to country
 is a second risk
adjustment which captures
c) Implementation: Must run regression with country risk as factor; while intuitively appealing, it is
not clear how to measure exposure to country risk. Some suggest portion of revenues earned
outside US, others earnings. Difficult to implement.
| P a g e 148
Appendix 9 - Exercises on calculating Pre and Post Money Valuation and IFC
Stake
The impact of a capital injection on enterprise and equity value
The net impact depends on the following:
• Is the capital injection excess cash?
• Is the capital for a new project or expansion?
• Have the project cash outflows been incorporated into the DCF?
• What is the net present value of the project?
• How will any value created be shared among capital providers?
Case 1: The Capital Injected is Excess Cash
Exercise 1: Find EV, Equity & Ownership Stake

First consider the case where the capital injection funds a cash balance (excess cash) rather than a
new project or expansion. This would be valuing the company on a stand-alone basis with no new
projects (and is not typical for IFC). For example, this money could be used for future acquisitions
not yet identified where the value of the opportunities is not considered in the valuation.
Consider the following example of a firm that is currently financed entirely with equity. The firm
value has been estimated at $65 million. Now the company seeks to raise $5 million. The firm has
no particular projects planned but wants cash on hand for opportunities.
Exercise 1:
Find the firm Enterprise Value and equity value. What percentage ownership should you obtain for the $5 million
investment? (All cash flows in thousands of USD - real)
Year 0 1 2 3 4 5
FCF 10,204.0 11,407.0 11,779.0 11,951.0 12,162.0
TV 35,000.0
Total CF 10,204.0 11,407.0 11,779.0 11,951.0 47,162.0
Discount rate - real 10.0%
EV 65,000.0
Exercise 1 – Solution
The firm now has $5 million in additional/excess cash.

Recall, Equity = EV + Cash - Debt
Pre money EV = $65, and thus equity = $65 as there is no debt or cash.
Post money EV = $65 still however, equity = $70 as there is excess cash or negative net debt.
Thus IFC stake = $5/ ($70) or 7%
The equity owners now have a claim on $5 million of additional value in cash that did not exist prior to the
investment.
| P a g e 149
Takeaway 1: Post money equity valuation is always higher than pre money valuation since there is
now additional cash in the firm. This case is illustrative as IFC would never invest in a company
without an identified use of proceeds. This case also demonstrates the stake IFC would negotiate for
valuing existing business lines only and zero value for new projects.
Post money: Equity = EV + New Cash Raised – Net Debt
Case 2: The Capital will Fund a Greenfield Project
Exercise 2: Find EV, Equity & Ownership Stake
Exercise 2:
My client seeks $5 million funding for a Greenfield project that has an expected NPV of $8.394 million
The project will be funded entirely with Equity. The cost of equity is estimated at 17%. IFC is considering
participating with $1.5 million investment. What stake should IFC negotiate? ( (All cash flows in thousands of USD –
real)
Year 0 1 2 3 4 5
FCF (5,000.0) 506.5 1,100.0 2,875.0 3,299.0 3,858.5
TV 15,000.0
Total CF
Discount rate
NPV - New project
IRR
Find the stake IFC should request for an investment of $1,500

Assume all equity financing of the project.
IFC investment 1,500.0
Total Investment
Equity valuation using cost of project
Percentage of shares owned by IFC
Equity valuation project NPV
Equity valuation using NPV plus investment
Considerations:
Have the project cash outflows been incorporated into the DCF?
In this case yes – the initial investment of $5 million is shown in year 0. Sometimes
the cash flows are shown without the initial investment. DCF analysis shows all
OPERATING cash inflows and outflows. Financing costs are only captured through
the discount rate.
What is the net present value of the project?
| P a g e 150
The NPV is about $8.4 million; this is the value NET of the $5 million investment
required. The NPV represents the total value created by the project and
incorporates project cash inflows and outflows as well as capital costs (through the
discount rate).
How will any value created be shared among capital providers?

This is where the negotiation starts. If IFC can enter at the same cost basis as the
owners (total $5.0 million), then IFC’s IRR will be 48.6%. However, if IFC comes in at
the negotiated equity value of the NPV of $ 8.4 million, then IFC’s return will be 17%
and other equity owners earn more than the project IRR of 48.6%. IFC would like a
higher return than the cost of equity, and the sponsor would like IFC’s return to be
lower than the project IRR.
The question faced here is whether the IFC stake should be calculated based upon:
• The project cost of $5 million?
• The project NPV of $8.4 million?
• The project NPV plus the funds invested of $13.4 million?
• Some other value?
Firms create value by undertaking projects where the ROIC > WACC
In cases like this, the challenge is to:
• estimate the value created; and

• determine the level at which IFC should share in the value created.
In this example, the NPV is positive, the IRR exceeds the WACC. This implies the project is returning
over the cost of capital – here 17%. The question: How to split the value created? There is no one
“right” answer. This is a negotiation.
Establish the Boundaries over which to Negotiate

• If IFC enters with a stake based on cost, IFC fully participates in value created and earns the
project IRR of 48.6%.
• If IFC enters at a stake based on project NPV (where required investment has been included
in the analysis) plus cash invested then IFC does not participate at all in the excess value
created and earns the cost of equity WACC of 17%.
Key elements in the Negotiation

• How comfortable is IFC with the estimate of $8.4 million in NPV?
• What is IFC’s contribution to the value creation of the project? Does the client agree?
• Often only In a greenfield, IFC can negotiate to come in at cost or close to cost with the
sponsor and receive the same IRR, because there is no existing business to value.
Ultimately the project may go far better or worse than expected. What are the boundaries of value
for negotiating purposes? Consider the following 3 equity stakes.
| P a g e 151
My client seeks $5 million funding for a Greenfield project that has an expected NPV of $8.394 million
The project will be funded entirely with Equity. The cost of equity is estimated at 17%. IFC is considering
participating with $1.5 million investment. What stake should IFC negotiate? ( (All cash flows in thousands of USD -
real)
Year 0 1 2 3 4 5
FCF (5,000.0) 506.5 1,100.0 2,875.0 3,299.0 3,858.5
TV 15,000.0
Total CF (5,000.0) 506.5 1,100.0 2,875.0 3,299.0 18,858.5
Discount rate 17.0%
NPV - New project 8,393.6
IRR 48.6%
Find the stake IFC should request for an investment of $1,500

Assume all equity financing of the project.
IFC investment 1,500.0
Total Investment 5,000.0
Equity valuation using cost of project 5,000.0
Percentage of shares owned by IFC 30.0% =1,500/5,000
Equity valuation project NPV 8,393.6
Percentage of shares owned by IFC 17.87% =1,500/8,393.6
Equity valuation using NPV plus investment 13,393.6
Percentage of shares owned by IFC 11.20% =1,500/13,393.6
Question: Why is the $5 million added to calculate the stake based on $13.4 million?
Because the $5 million cost is already embedded in the cash flow forecast used to find NPV. Thus
the $5 million is essentially excess cash for calculation purposes.
Consider the IFC IRR for each of the 3 stakes. Note if IFC enters at cost with a stake of 30%, then IFC
IRR = Project IRR and IFC fully participates in value created. If IFC enters at cost plus project NPV
with a stake of 11.2%, then IFC earns a return equal to the cost of equity of 17% and does not
participate in the new value created. At stakes between 11.2% and 30%, IFC participates, though
not fully, in the excess return/value created by the project. Note that these IRRs assume the cash
IFC IFC
Stake IFC IRR Investment IFC Share FCF based on Stake
Based on cost 30.00% 48.60% (1,500.0) 152.0 330.0 862.5 989.7 5,657.60
Based on Exp project NPV 17.87% 30.70% (1,500.0) 90.5 169.6 513.8 589.6 3,370.10
Based on NPV plus Investments 11.20% 17.00% (1,500.0) 56.7 123.2 322 369.5 2,112.00
Post project valuation boundaries:
The lowest valuation would be cost: $5.0mm
The highest is NPV + Investment $5.0mm + $8.4mm = $13.4mmm
| P a g e 152
Note: If the DCF is done excluding the investment required to generate the return, the resulting NPV
will be $13.4 million. The concept is the same as above. In this case, there will be no excess cash
because the $5 million will be used to buy capex which is not included in the DCF. This approach is
not recommended, especially considering that most projects have multi-year investment needs
which need to be modeled (e.g. working capital and maintenance capex)
Cash flows shown without initial investment in thousands of USD: (not recommended)
Year 0 1 2 3 4 5
FCF 506.5 1,100.0 2,875.0 3,299.0 3,858.5
TV 15,000.0
Total CF 0.0 506.5 1,100.0 2,875.0 3,299.0 18,858.5
Discount rate 17.0%
13,393.6
Takeaway 2: When evaluating new projects, Investment Teams should be negotiating for an
equity stake that produces a reasonable IRR for IFC. IFC will negotiate with the client between
their view of NPV and IFC’s view of our contribution to value creation (i.e., the more IFC brings,
the larger the ownership stake IFC can negotiate).
IFC’s leverage to negotiate depends on:

• Whether IFC’s money is transformational or incremental.
• The value IFC brings. How high is IFC’s additionality?
• The total financing package.
• The competitiveness of the bidding process. Can the client get financing elsewhere?
• Does IFC’s participation lower the risk perception of the project to other potential investors?
Exercise: IFC Participation in Value Created - Pharma
Negotiations will depend on the stage of product development.
• Concept stage?
• Or has the drug been tested?
• Patents /approvals in hand?
Exercise: IFC Participation in Value Created - Plantation
Negotiations will depend on the stage of development of the plantation.
• Design stage?
• Land acquired?
• Have the plants been tested?
Case 3: The Capital will Fund an Expansion
Exercise 3 – Find EV, Equity & Ownership Stake

Now assume IFC is considering an Equity investment in an existing firm considering an expansion.
The firm is funded entirely with Equity at an estimated cost of 17%. IFC is considering participating
with $1.5 million investment. The associated cash flows are shown below. What stake should IFC
negotiate? (Cash flows in thousands of USD)
| P a g e 153
Exercise 3:
Find EV, Equity & Ownership Stake (All cash flows in thousands of USD - real)
Year 0 1 2 3 4 5
FCF -Existing Business 10,204.0 11,407.0 11,779.0 11,951.0 12,162.0
TV - Existing Business 35,000.0
Total CF -Existing Business
FCF -New Business (5,000.0) 507.0 1,100.0 2,875.0 3,299.0 3,859.0
TV - New Business 15,000.0
Total CF -New Business
WACC 0.0
EV - Existing Business
EV - New Business
Total enterprise Value
As above, establish the boundaries between which to negotiate.
Enterprise Value - pre-project /pre-money

Total investment to start 5,000.0
IFC Investment 1,500.0
NPV of New Project
Excess Cash 0.0
Debt 0.0
Equity valuation using cost of project 57,298.0
Equity Valuation Using Project NPV
Equity valuation using NPV plus Investment
IFC IFC
IFC IRR IFC Share FCF based on Stake
Stake Investment
Based on cost 2.62% 21.60% (1,500.00) 280.4 327.4 383.6 399.2 1,728.40
Based on Exp project NPV 2.47% 19.60% (1,500.00) 264.7 309.1 362.2 376.9 1,631.70
Based on NPV plus Investments 2.28% 17.00% (1,500.00) 244.6 285.6 334.6 348.2 1,507.50
Input stake to analyze 2.00% 12.80% (1,500.00) 214.2 250.1 293.1 305.0 1,320.40
Considerations:
• How likely is the value creation of $8,394 million?
• Should the same discount rate be applied to the existing business and the new project?
• At what level does IFC participate in value created? E.g. percentage stake depends on
perception of IFC’s value add/additionality. Is IFC’s money transformational or incremental?
• Does the IFC investment also increase the value of the existing business as well? Possibly IFC
involvement lowers overall capital costs.
| P a g e 154
• Although the return on the new project remains the same (48%), some of the value in the
company is from the existing business which is likely being valued at its Ke (as zero debt this
= WACC) in this example.
Find the firm Enterprise Value and equity value. What percentage ownership should you obtain for the $5 million
investment? (All cash flows in thousands of USD - real)
Year 0 1 2 3 4 5
Total CF -Existing Business 10,204.0 11,407.0 11,779.0 11,951.0 47,162.0
FCF -New Business (5,000.0) 507.0 1,100.0 2,875.0 3,299.0 3,859.0
Total CF -New Business (5,000.0) 507.0 1,100.0 2,875.0 3,299.0 18,859.0
WACC 0.0
EV - Existing Business 52,297.6
EV - New Business 8,394.3
Total enterprise Value 60,691.8
As above, establish the boundaries between which to negotiate.
Enterprise Value - Pre-project /Pre-money 52,297.6

Total Investment to Start 5,000.0
IFC Investment 1,500.0
NPV of New Project 8,394.28

Excess Cash 0.0
Debt 0.0
Equity Valuation Using Cost of Project 57,298.0
Percentage of Shares Owned by IFC 2.62% =1,500/57,298
Equity Valuation Using Project NPV 60,691.8
Percentage of Shares Owned by IFC 2.47% =1500/60,691.8
Equity Valuation using NPV plus Investment 65,691.8
Percentage of Shares Owned by IFC 2.28% =1,500/65,691.8
Case 4: Unfunded Future Expansion with Potential Future Dilution
Another area of confusion is the evaluation of potential future dilution. This is a difficult area
because of the inherent uncertainly about how much capital is needed, what the return on the
capital will be and the uncertainty of the scope of new projects.
| P a g e 155
Exercise 4 – Unfunded Future Expansion
Now assume there is an immediate investment plus planned future expansion. IFC is considering an
immediate investment of $1,500. The expansion requires investment in Year 3. What do the Year 3
expansion plans and associated funding needs imply for potential dilution in the future?
Exercise 4:
Unfunded Future Expansion (All cash flows in thousands of USD - real)
Year 0 1 2 3 4 5
Total CF -Existing Business 2,100.0 2,500.0 2,800.0 3,200.0 21,581.0
FCF -New Business 0.0 0.0 0.0 (5,000.0) 3,299.0 3,859.0
Total CF -New Business 0.0 0.0 0.0 (5,000.0) 3,299.0 18,859.0
WACC 17.0%
EV - Existing Business 16,920.4
EV - New Business 7,240.5
Total enterprise Value 24,160.9
The above examples included only all Equity financed companies. However, even with debt funding,
the same conclusions apply. Note the following for debt financed companies:
• Do not compare IFC’s IRR to WACC but rather to the cost of equity
• The investment to fund the project comes from both debt and equity, thus subtract debt
from Enterprise Value to get to equity value on both the lower and upper boundaries.
• Don’t forget that when examining net debt, that some excess cash is counterbalanced by
new debt increase when examining post money valuation.
What happens in Year 3 when the firm needs to raise additional Equity?
If IFC does not participate, IFC will be diluted. Even if IFC participates, it will depend on whether IFC is
able to invest enough to maintain its stake. Regardless of IFC participation, the equity value of the
company will rise with the new investment. Even if diluted, while IFC would have a smaller stake, the
stake is in a larger firm so IFC’s Equity stake may still have risen. However, it is very difficult to
estimate the future value and potential dilution. This is another situation where the investment team
should run scenarios on potential dilution. One simple approach is to assume that future capital needs
will be provided by the existing shareholders including IFC in proportion of their respective
shareholdings. At the time of actual issuance, IFC can determine whether to participate or not
depending on whether the investment is accretive or not.
| P a g e 156

Equity Valuation Toolkit Additional Valuation Resources PDF

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Equity Valuation Toolkit Additional Valuation Resources PDF

Uploaded by

Copyright:

Available Formats

Official Use Only

Equity Valuation Toolkit

1.1. Valuation Overview

1.3. Standard EV Adjustments

1.5. Chapter Takeaways

1.1.2. Guiding Principles for a Valuation at IFC

1.1.3. Common Valuation Techniques

Comparable Relative valuation: Similar assets should trade at similar prices

Discounted Cash Intrinsic valuation: Present value of future cash flows

Internal Rate of Return based valuation

1. Analyze business and key drivers, forecast scenarios:

• Enterprise value (EV) = Value of core operations

1.2.2. Valuation Map

1.2.4. The Basic Enterprise Value Equation: Application to a Simple Firm

Scenario 1: Simple Firm

EV = Debt + Preferred Stock + Equity

To derive the equity, Equity = EV – Debt – Preferred Stock | P a g e 15

1.3.1. Excess Cash

Scenario 2: With Excess Cash

EV = Net Debt + Preferred Stock + Equity, or

EV + Excess Cash = Debt + Preferred Stock + Equity, or

Equity = EV – Net Debt – Preferred Stock

FAQ: Can Equity Value ever exceed Enterprise Value?

1.3.2. Non-Core Assets

Scenario 3: With non-core assets

EV of core operations + Non-core assets = Net Debt + Preferred Stock + Equity

Or, Equity = EV of core + Non-core assets – Net Debt – Preferred Stock

1.3.3. Minority Interest – Non-controlling Interest (NCI)

Use the information below to find the EV

Shares outstanding 1,000

Enterprise Value = 20,600 = Equity + Debt + NCI – Cash – Financial Investments.

Illustration of Exercise 1: Start with Equity value to calculate Enterprise Value

Scenario 5: With equity method investments

Use the information below to find EV and implied share price.

Firm EBITDA 350.0

EV 2,975.0 = 350 x 8.5

Illustration of Exercise 2: Enterprise Value drives implied equity value

1.4. Calculating Market Value of Associate Investments and Minority Interest

Proper valuation of adjustments is critical to correctly estimating equity value:

1.5. Chapter Takeaways

Exercise 3: NCI and Equity Investments

2.1 Market Capitalization: The Basics

2.3 Chapter Takeaways

2.1.1. The First Step in Comparable Analysis

2.1.2. How Much Liquidity is Sufficient?

2.1.3. Liquidity Measures

2.1.4. Market Capitalization: Basic Formula

Market Value of Equity =

Market Capitalization = # of shares outstanding * current share price

Exercise 2: Find EV and TEV using standard adjustments

EV + Excess Cash + Investments + Noncore Assets

Here, EV = Debt + NCI + Equity - Excess Cash - Investments

1. Use most current outstanding shares

2.2.1. Determining Share Count and Market Capitalization

Current vs Weighted Average Shares Outstanding

Multiple Share Classes

Exercise 3: EV and TEV with Diluted Shares

EV = Debt + NCI + Equity - Excess Cash - Investments

EV = $1,800 + $600 + $4,140 - $300 - $200 = $6,040

Adjusting Share Calculations for Options

Diluted Shares Outstanding = Common shares Outstanding + Net New Shares

Exercise 4: Impact of Options on Diluted Shares Outstanding