FBE 529 Spring 2020 Lecture 5 PDF

Financial Analysis & Valuation
 Enterprise Valuation – DCF Method

WACC Approach
FBE 529 – Scott Abrams – Spring 2020

303
Overview of the valuation process

 Understanding the business model
 Evaluating the historical financial performance of the firm
 Selecting the valuation method
 Applying the valuation model
 Consider other valuation methods and make the decisions

304
1
What are the purposes of an
equity valuation?
 Estimate the value of a private company’s equity
 Estimate/evaluate the market value of a public
company’s equity (fundamental analysis)
 Estimate the value of a public company’s equity in a
negotiated equity transaction
 Merger
 Tender offer
 LBO
 What is the objective?

 Price determination

305
Valuation Methods
 Intrinsic Valuation
 Discounted Cash Flows
 Equity Valuation
 Dividend Discount Model

 Free Cash Flow to Equity (FCFE) model
 Firm Valuation
 Free Cash Flow to the Firm (FCFF) model
 WACC Approach
 APV Approach
 Comparables / Market Multiples

 Precedent Transactions
 Asset based valuation
306
2
DCF Approach
Hollywood Studios, Inc.

Balance Sheet
Market value vs. Book value
Assets Liabilities and Shareholder Equity

Book Market Book Market
Current assets 400 600 Long-term debt 500 500
Fixed Assets in Place 1,800 3,000 Shareholder's equity 1,700 8,100
Growth Assets - 5,000
Total 2,200 8,600 Total 2,200 8,600

308
What is an Enterprise DCF

Valuation?
 Enterprise value represents the present value of future cash
flows in two segments
- Planning period (finite number of years)
- Terminal period (all years thereafter)
Note: Terminal value often represents more than 50% of enterprise value

309
3
WACC vs. APV Approach
 Enterprise valuations will vary according to the growth
strategies implemented by management
 WACC based approaches are widely used but do not take
into account changes to capital structure over time
 The adjusted present value (APV) approach provides an
improvement over traditional WACC approaches in that it
reveals how the firm’s financing decisions influence
enterprise value

310
WACC vs. APV Approach

 The two DCF methods have different ways of embedding the
value of the interest tax shields
 The WACC approach incorporates this value of financing by
adjusting the discount rate
 The APV approach values the unlevered assets and the tax
shields separately
 The two methods should theoretically get us to the same
place; the WACC method is more commonly used in practice

311
4
Steps in a DCF (WACC Approach)
 Step 1: Forecast unlevered free cash flows
 Assess quality of earnings; study historical growth rates &
margins to assess how future earnings will deviate from
historical experience
 Determine forecast assumptions and scenarios
 Determine the explicit forecast horizon
 We usually predict NOPLAT (after-tax operating earnings)

and make no attempt to predict one-time or non-recurring
earnings components (restructuring charges or merger
expenses)
 Assume all income taxes are paid currently in cash
 Use projected earnings to estimate future unlevered free
cash flows
312
Steps in a DCF (WACC Approach)

 Step 2: Estimate Terminal Value
 Using perpetuity formulas (Gordon Growth model)
 Using exit multiples
 Step 3: Estimate Cost of Capital

 Develop target capital structure
 Calculate WACC
 Step 4: Calculate and Interpret Results

 Discount the cash flows
 Perform sensitivity analyses
 Interpret results within decision context
 Present value range

313
5
Valuation with Explicit Forecast
Period
 Most companies we evaluate are not in a state of constant growth;
we breakdown our valuation into an explicit forecast horizon
(planning period) until we can assume it reaches a constant state of
growth
0 5 ∞
time
Explicit Forecast Period Perpetuity
𝐹𝐶𝐹 𝑇𝑉
𝑃𝑉
1 𝑟 1 𝑟
where
𝐹𝐶𝐹 1 𝑔 𝐹𝐶𝐹
𝑇𝑉
𝑟 𝑔 𝑟 𝑔
314
How long do we Forecast?

 Forecast horizon:
 Detailed forecast until company reaches steady state
 Useful to recreate historical statements of cash flows from the

balance sheet, income statement, etc.
 Helps understand where the operating, investing, and
financing activities are reflected in the balance sheet
accounts
 Take into account the end of the planning period if the
business in a cyclical industry
 In practice, valuation analysts use planning periods anywhere
from five to ten years

315
6
Steady State
 DCF-based continuing value:
 Firm earns an economic rate of return on invested capital that
is expected to persist indefinitely
 Probably close to the firm’s cost of capital (empirical evidence
indicates that a firm’s ROA and ROE revert back toward their
industry average)
 Reinvests constant proportion of its cash flows to sustain
constant slow growth (capex and working capital)
 This results in a constant growth rate and constant capital
structure
 Market Multiple-based continuing value:
 The underlying value drivers for the multiples of the
comparable companies are the same as the underlying value
drivers of the company being valued
316
Terminal Value
 A unique factor in valuation is the concept of indefinite life
 Once you have forecasted a firm’s cash flows and
appropriate cost of capital (WACC), you must address the
issue of a firm’s indefinite life through the estimation of a
terminal value
 The value of a business is the present value of ALL future
free cash flows
 We cannot estimate cash flow forever
 Apply an exit multiple or the perpetuity growth method

formula
 The terminal value should reflect the long-term growth
expectations beyond the forecast period
 Either method should be applied to a normalized method of
cash flow
317
7
Terminal Value ~ Gordon Growth
Method (Perpetuity Growth Method)
 The terminal value is calculated by assuming that the FCF
in the last year of the forecast horizon grows at a constant
rate into perpetuity
 This method relies on our cost of capital (WACC) and
assumed long-term sustainable growth rate
𝑭𝑪𝑭𝒏 𝟏 𝒈
𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆𝒏
𝒓 𝒈

318
Terminal Value ~ Exit Multiple

 Hybrid valuation combines DCF analysis with relative
valuation
 The present value of planning period cash flows are
discounted using the traditional DCF approach

 Terminal value is calculated using an exit multiple (such as
EV/EBITDA or P/E and end-of-planning period EBITDA or

earnings)
 The multiple is typically based on the current LTM trading
multiples for comparable companies
𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆𝒏 𝑬𝑩𝑰𝑻𝑫𝑨𝒏 ∗ 𝑬𝑩𝑰𝑻𝑫𝑨 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒆

319
8
Terminal Value ~ Exit Multiple
 Using EBITDA to calculate terminal value is beneficial
because it ties the analysis of distant cash flows back to
recent market transactions involving similar firms
 Used in establishing the enterprise value for IPO’s, LBO’s,
spin-offs, carve-outs, and equity valuation for investment

purposes
 EBITDA multiple and Gordon growth model should generate
very similar terminal value estimates when there are no
extraordinary capital expenditures or investments in net
working capital

320
Example ~ Immersion Chemical

Acquires Genetic Research Corp
Pre‐ and Postacquistion Balance Sheets for GRC Preacquistion Postacquisition
2014 2014
Current assets $ 41,865,867 $ 41,865,867

Gross property, plant and equipment 88,164,876 88,164,876
Less: accumulated depreciation (41,024,785) (41,024,785)
Net property, plant and equipment $ 47,140,091 $ 47,140,091
Goodwill ‐ 20,819,868
Total Assets $ 89,005,958 $ 109,825,826
Current liabilities 9,825,826 9,825,826

Long‐term debt 36,839,923 40,000,000
Total liabilities $ 46,665,749 $ 49,825,826
Common stock (at par) 290,353 400,000

APIC 20,712,517 59,600,000
Retained earnings 21,337,339 ‐
Total equity 42,340,209 60,000,000
Total liabilities and equity 89,005,958 109,825,826

321
9
Example ~ Immersion Chemical
Acquires Genetic Research Corp
Acquisition financing:
Assumed payables and accrued expenses $ 9,825,826
Long‐term debt (40% of enterprise value) 40,000,000
Sale of common stock 60,000,000
Total $ 109,825,826
Shares issued ($1.00 par value) 400,000
Net proceeds $ 60,000,000
Price per share $ 150

322
Example: Pro Forma Income Statement

Prea cqui si ti on Posta cqui si ti on Pro Forma Income Sta tement
2014 2014 2015 2016 2017 2018 2019 2020
Sales 80,000,000 80,000,000 83,200,000 86,528,000 89,989,120 93,588,685 97,332,232 101,225,521

Cost of goods sold (45,733,270) (45,733,270) (50,932,000) (52,969,280) (54,394,451) (56,230,229) (58,139,438) (60,125,016)
Gross profit 34,266,730 34,266,730 32,268,000 33,558,720 35,594,669 37,358,456 39,192,794 41,100,505
G&A Expense (17,600,000) (17,600,000) (17,984,000) (18,383,360) (18,798,694) (19,230,642) (19,679,868) (20,147,063)
EBITDA 16,666,730 16,666,730 14,284,000 15,175,360 16,795,975 18,127,814 19,512,926 20,953,442
Depreciation (6,500,000) (6,500,000) (7,856,682) (7,856,682) (7,856,682) (7,856,682) (7,856,682) (7,856,682)
EBIT 10,166,730 10,166,730 6,427,318 7,318,678 8,939,293 10,271,132 11,656,244 13,096,760
Interest expense (2,523,020) (2,523,020) (2,600,000) (2,549,847) (2,453,680) (2,307,941) (2,108,865) (1,852,465)
Earnings before taxes 7,643,710 7,643,710 3,827,318 4,768,831 6,485,613 7,963,191 9,547,379 11,244,295
Taxes (1,910,928) (1,910,928) (956,830) (1,192,208) (1,621,403) (1,990,798) (2,386,845) (2,811,074)
Net income 5,732,783 5,732,783 2,870,489 3,576,623 4,864,210 5,972,393 7,160,534 8,433,222

323
10
Example: Pro Forma Balance Sheet
Prea cqui s i ti on Pos ta cqui s i ti on Pro Forma Bal ance Sheet
Current assets 41,865,867 41,865,867 43,540,502 45,282,121 47,093,407 48,977,143 50,936,229 52,973,678
Gross property, plant, and equipment 88,164,876 88,164,876 96,021,558 103,878,240 111,734,922 119,591,604 127,448,286 135,304,968
Less: accumulated depreciation (41,024,785) (41,024,785) (48,881,467) (56,738,149) (64,594,831) (72,451,513) (80,308,194) (88,164,876)
Net property, plant, and equipment 47,140,091 47,140,091 47,140,091 47,140,091 47,140,091 47,140,091 47,140,092 47,140,092
Goodwill ‐ 20,819,868 20,819,868 20,819,868 20,819,868 20,819,868 20,819,868 20,819,868
Total assets 89,005,958 109,825,826 111,500,461 113,242,080 115,053,366 116,937,102 118,896,189 120,933,638
Current liabilities 9,825,826 9,825,826 9,975,651 10,131,469 10,293,520 10,462,053 10,637,329 10,819,613

Long‐term debt 36,839,923 40,000,000 39,228,419 37,748,922 35,506,789 32,444,078 28,499,462 23,608,049
Total liabilities 46,665,749 49,825,826 49,204,070 47,880,391 45,800,309 42,906,131 39,136,791 34,427,662
Common stock (par value) 290,353 400,000 400,000 400,000 400,000 400,000 400,000 400,000
APIC 20,712,517 59,600,000 59,600,000 59,600,000 59,600,000 59,600,000 59,600,000 59,600,000
Retained earnings 21,337,339 ‐ 2,296,391 5,361,689 9,253,057 14,030,971 19,759,398 26,505,976
Total equity 42,340,209 60,000,000 62,296,391 65,361,689 69,253,057 74,030,971 79,759,398 86,505,976
Total liabilities and equity 89,005,958 109,825,826 111,500,461 113,242,080 115,053,366 116,937,102 118,896,189 120,933,638

324
Example: Unlevered Free Cash Flow
Unlevered Free Cash Flow: 2015 2016 2017 2018 2019 2020

EBIT 6,427,318 7,318,678 8,939,293 10,271,132 11,656,244 13,096,760
Less: taxes (1,606,830) (1,829,670) (2,234,823) (2,567,783) (2,914,061) (3,274,190)
NOPLAT 4,820,489 5,489,009 6,704,470 7,703,349 8,742,183 9,822,570
Depreciation 7,856,682 7,856,682 7,856,682 7,856,682 7,856,682 7,856,682
Capex (7,856,682) (7,856,682) (7,856,682) (7,856,682) (7,856,682) (7,856,682)
Net working capital (1,524,810) (1,585,801) (1,649,235) (1,715,203) (1,783,810) (1,855,165)
Free cash flow 3,295,679 3,903,208 5,055,235 5,988,146 6,958,373 7,967,405
Discounting Period 1 2 3 4 5 6

WACC 8.8%
PV of FCF 23,892,552 3,029,116 3,297,341 3,925,135 4,273,432 4,564,185 4,803,342

325
11
Example: TV (Gordon Growth Method)
Terminal Value ‐ Gordon Growth Method
FCF ‐ 2020 7,967,405
Assumed growth rate 3%
FCF ‐ 2021 8,206,428
PV of Terminal Value in 2020 141,490,130
PV of Terminal Value 85,300,735
Enterprise Value
PV of Planning Period FCF 23,892,552
Enterprise Value 109,193,287

326
Example: TV (EBITDA Multiple)

Terminal Value ‐ EBITDA Multiple
EBITDA in 2020 20,953,442
Multiple 6x
Terminal Value 125,720,655
Enterprise Value
PV of Planning Period FCF 23,892,552
Enterprise Value 99,686,279

327
12
Why is a company’s effective tax
rate different from its marginal rate?
328
 Many firms, especially in the US, follow different accounting

standards for tax and book reporting purposes
 For example, straight line depreciation for books vs. MACRS for
tax leads to higher reported income than taxable income
 Firms sometimes use tax credits to reduce the taxes they pay
 Firms can sometimes defer taxes on income to future periods
 If firms defer taxes, the taxes paid in the current period will be at
a rate lower than the marginal rate; in a later period, when the
firm pays the deferred taxes, the effective tax rate will be higher
than marginal
 Firms that generate substantial income for foreign domiciles with
lower tax rates do not have to pay taxes until that income is
repatriated back to the domestic country
What tax rate should we use?

329
 Effective or the marginal tax rate?

 It is far safer to use the marginal tax rate since the effective
tax rate is really a reflection of the difference between the
accounting and the tax books
 By using the marginal tax rate, we tend to understate the
after-tax operating income in the earlier years, but the after-
tax tax operating income is more accurate in later years
 If you choose to use the effective tax rate, adjust the tax rate
towards the marginal tax rate over time (since none of the
four reasons for differences can be sustained in perpetuity)
13
What about multinational firms?
330
 One approach is to use the marginal rate of the country in

which is incorporated. This makes the implicit assumption
that the income generated in other counties will eventually
have to be repatriated to the country of origin at which time
the marginal rate will be paid
Tax Loss Carryforwards

 The present value of these benefits depends on how quickly
they can be realized.
 Since you most likely have no information on their nature and
timing, assume that the carryforwards are direct credits to
income taxes.
 The next tax law limits the utilization of these to 80% of taxable
income

331
14
What terminal growth rate should
we use?
332
 The stable growth rate cannot exceed the growth rate of the
economy but it can be set lower.
 If we assume that the economy is composed of high growth and stable
growth firms, the growth rate of the latter will probably be lower than the
growth rate of the economy.
 The stable growth rate can be negative. The terminal value will be lower
and would be assuming that your firm will disappear over time.
 Since we use nominal cashflows and discount rates, the growth rate
should be nominal in the currency in which the valuation is denominated.
 One simple proxy for the nominal growth rate of the economy is the
riskfree rate.

497
Risk-free Rates and Nominal

GDP Growth
 Risk free Rate = Expected Inflation +  Nominal GDP Growth = Expected
Expected Real Interest Rate Inflation + Expected Real Growth
 The real interest rate is what borrowers  The real growth rate in the economy
agree to return to lenders in real measures the expected growth in the
goods/services. production of goods and services.
The argument for Risk free rate = Nominal GDP growth

1. In the long term, the real growth rate cannot be lower than the real interest rate, since the
growth in goods/services has to be enough to cover the promised rate.
2. In the long term, the real growth rate can be higher than the real interest rate, to
compensate risk taking. However, as economies mature, the difference should get smaller
and since there will be growth companies in the economy, it is prudent to assume that the
extra growth comes from these companies.
10-Year Real GDP Nominal GDP Nominal GDP - T.Bond
Period T.Bond Rate Inflation Rate Growth growth rate Rate
1954-2015 5.93% 3.61% 3.06% 6.67% 0.74%
1954-1980 5.83% 4.49% 3.50% 7.98% 2.15%
1981-2008 6.88% 3.26% 3.04% 6.30% -0.58%
2009-2015 2.57% 1.66% 1.47% 3.14% 0.57%

498
15
What terminal growth rate should
we use?
334
Source: PIMCO
499
Example: Sensitivity Analysis

WACC and Growth Rates
Discount Rate 1% 2% 3% 4% 5%
7.8% 100,150,329 114,027,029 133,685,687 163,691,008 215,128,701
8.8% 86,089,677 95,942,687 109,193,287 127,964,969 156,616,485
9.8% 75,269,183 82,542,423 91,954,852 104,612,945 122,545,245
Terminal Value Methods (assuming 2% growth)
Terminal Value Enterprise Value
Discount Rate Planning Per. FCF Gordon Growth Exit Multiple Gordon Growth Exit Multiple
7.8% 24,742,435 89,284,594 80,111,354 114,027,029 104,853,789
8.8% 23,892,552 72,050,135 75,793,727 95,942,687 99,686,279
9.8% 23,084,677 59,457,746 71,745,158 82,542,423 94,829,835

336
16

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Financial Analysis & Valuation

 Enterprise Valuation – DCF Method

FBE 529 – Scott Abrams – Spring 2020

Overview of the valuation process

FBE 529 – Scott Abrams – Spring 2020

 What is the objective?

FBE 529 – Scott Abrams – Spring 2020

 Dividend Discount Model

 Comparables / Market Multiples

Hollywood Studios, Inc.

Assets Liabilities and Shareholder Equity

FBE 529 – Scott Abrams – Spring 2020

What is an Enterprise DCF

FBE 529 – Scott Abrams – Spring 2020

FBE 529 – Scott Abrams – Spring 2020

WACC vs. APV Approach

FBE 529 – Scott Abrams – Spring 2020

 Determine the explicit forecast horizon

 We usually predict NOPLAT (after-tax operating earnings)

Steps in a DCF (WACC Approach)

 Using exit multiples

 Step 3: Estimate Cost of Capital

 Step 4: Calculate and Interpret Results

 Perform sensitivity analyses

 Interpret results within decision context

 Present value range

FBE 529 – Scott Abrams – Spring 2020

Explicit Forecast Period Perpetuity

How long do we Forecast?

 Useful to recreate historical statements of cash flows from the

FBE 529 – Scott Abrams – Spring 2020

 Apply an exit multiple or the perpetuity growth method

FBE 529 – Scott Abrams – Spring 2020

Terminal Value ~ Exit Multiple

discounted using the traditional DCF approach

EV/EBITDA or P/E and end-of-planning period EBITDA or

multiples for comparable companies

𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆𝒏 𝑬𝑩𝑰𝑻𝑫𝑨𝒏 ∗ 𝑬𝑩𝑰𝑻𝑫𝑨 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒆

FBE 529 – Scott Abrams – Spring 2020

spin-offs, carve-outs, and equity valuation for investment

FBE 529 – Scott Abrams – Spring 2020

Example ~ Immersion Chemical

Current assets $ 41,865,867 $ 41,865,867

Current liabilities 9,825,826 9,825,826

Common stock (at par) 290,353 400,000

FBE 529 – Scott Abrams – Spring 2020

FBE 529 – Scott Abrams – Spring 2020

Example: Pro Forma Income Statement

Sales 80,000,000 80,000,000 83,200,000 86,528,000 89,989,120 93,588,685 97,332,232 101,225,521

FBE 529 – Scott Abrams – Spring 2020

Current liabilities 9,825,826 9,825,826 9,975,651 10,131,469 10,293,520 10,462,053 10,637,329 10,819,613

FBE 529 – Scott Abrams – Spring 2020

Example: Unlevered Free Cash Flow

Unlevered Free Cash Flow: 2015 2016 2017 2018 2019 2020

Discounting Period 1 2 3 4 5 6

FBE 529 – Scott Abrams – Spring 2020

FBE 529 – Scott Abrams – Spring 2020

Example: TV (EBITDA Multiple)

FBE 529 – Scott Abrams – Spring 2020

 Many firms, especially in the US, follow different accounting

FBE 529 – Scott Abrams – Spring 2020

What tax rate should we use?