Corporate

Valuation
FINA 4013

Vidhan K. Goyal
HKUST
September 2, 2021
Assessment
• Class Participation 10%
• Valuation Project 30%
• Case Submissions and Presentations 25%
• Final Exam 35%
Introduction to Valuation
Approach to Valuation
Valuation is a science
Valuation is an art
Valuation is magic
None of the above
Misconceptions about Valuation
• Myth 1: Since valuation models are quantitative,
valuations are objective.
• Truth: All valuations are biased. The question is how
biased they are and in which direction.
• Myth 2: A good valuation is a precise estimate of
value.
• Truth: There are no precise valuations. The payoff to
valuation is greatest when they are least precise.
Misconceptions - Continues
• Myth 3: The more quantitative the model, the
better the valuation.
• Truth: Simpler models do much better.
Valuation: You will learn it by doing it.
An Overview of Valuation
Drivers of intrinsic value
• Cash flows from existing assets
• Growth in cash flows
• Risk of cash flows
Drivers of price
• Market moods and momentum
• Surface stories about fundamentals

Accounting
Estimates Gap
G
Intrinsic Price Demand and Supply
Valuation
Value
Estimates
Good Valuation: Story + Numbers
Course Outline
Weeks 1-2: The Big Picture; Financial Statements
Weeks 3-4: Cost of Capital
Weeks 5-9: Intrinsic Valuation – DCF and CCF
Week 10: Relative Valuation
Week 11: Real Option Valuation
Week 12: Project Presentations
Week 13: Valuation wrap-up and Closing Thoughts
Project
• Objective: To apply the techniques we learn in
this course to value real world firms.
• Group project
• Step 1: Pick a company:
• Preferably publicly-traded
• Analyze profitability and key metrics
• First deliverable: We need company name and an
analysis of its historical performance on or before Sep
21
Intrinsic Valuation
• Step 2: Estimate the company’s cost of capital
• Due: Sep 30
• Step 3: DCF Valuation
• Develop your narrative for this company (your story
of how you see your company evolving over time
given what you know about it, its market, and the
competition)
• Tie your narrative to key numbers
• Value the stock using a discounted cash flow model
• Evaluate how sensitive your value estimates are to
change in your narrative. Due: Nov 2
Relative Valuation
• Step 4: Relative Valuation
• Prepare a list of ”comparable” companies
• Choose a multiple that you will use in comparing
firms across the group
• Evaluate your company against the comparable
companies
• Provide your estimate of the value of your company
relative to the market
• Due: Nov 11
Full Project Due
• Step 5: Final Write-up
• How would you reconcile the different estimates of
value? Make a final recommendation – buy, sell, hold.
• Due: Nov 21

• Step 6: Submit Presentation Slides

• Critique of a different valuation project (another
group’s project)
• Due: Nov 23 and 25
Approaches to Valuation
September 7, 2021
 Framework For Valuation
Discounted Cash
Multiples of
Flow models
Public Companies

Enterprise DCF Discounted Capital Cash Equity Cash Multiples of Recent

(WACC based) Economic Flow Flow Transactions
Profits
Adjusted PV
(APV) Real Option Models

Source: Graham, Smart and Megginson (2010)

Enterprise Discounted Cash
Flow

“D” – Discount Rate

(WACC)
DCF
“CF” – Free Cash Flow

Value of Operations = Present Value of Future Free

Cash Flows
What Are We Valuing?

FCF1 FCF2 FCFT TVT

EV = + +!+ +
(1+WACC )1 (1+WACC )2 (1+WACC )T (1+WACC )T

Enterprise Debt
Alternatively,
Value (EV)
Firm Value ECF1 ECF2
Equity = 1
+ 2
+!
(1+ rE ) (1+ rE )

Cash Equity
(Excess)
 FCFF Model

Reinvestment
Expected growth in needed to sustain
operating ncome growth

Free Cashflow to Firm

After-tax Operating Income
- (Cap Ex - Depreciation) Expected FCFF= Expected operating
- Change in non-cash WC income * (1- Reinvestment rate)
= Free Cashflow to firm

Value of Operatng Assets Length of high growth period: PV of FCFF during high
+ Cash & non-operating assets growth Stable Growth
- Debt When operating income and
= Value of equity FCFF grow at constant rate
forever.
Cost of capital
Weighted average of
costs of equity and
debt
Relative Valuation (Pricing)
• Look at how the market prices similar or
comparable companies.
• You need:
• Comparable or similar assets
• Standardized measure of value (divide price by an
operating metric – earnings or book value)
• Control for the differences (if assets are not perfectly
comparable)
• Pricing errors across similar assets are easier to
spot.
Contingent Claim (Option)
Valuation
• Options have several features:
• Derive their value from an underlying assets, which
has value.
• Payoff on a call (put) option occurs only if the value of
the underlying asset is greater (lesser) than an
exercise price specified at the time the option was
created.
• They have a fixed life.
Examples of Options in
Valuation
• Equity in a deeply troubled firm
• Reserves owned by natural resources firms
• Patent owned by a firm
• Rights possessed by a firm to expand
In Summary
• Three valuation approaches:
• Intrinsic valuation
• Relative valuation
• Contingent claim valuation
• The three approaches can yield different
estimates of value for the same asset at the same
point in time.
• Understand and use all three approaches.
Knowing when to use each and to be able to
apply it correctly is key to mastering valuation.
Understanding Financial
Statements
September 9, 2021
Ratios

Broad Categories

Profitability Productivity Financing Liquidity

Profitability Ratios
Assessing Profitability: And we can divide by:
• Net Income
• Sales
• Gross Margin
• EBIT • Equity
• EBITDA • Total Assets
• EBIAT • Capitalization

Other Measures of Cash Flow

Productivity Ratios
Asset Productivity
Sales
Asset Turnover =
Assets

Measures of Inventory Productivity

Cost of Goods Sold
Inventory Turnover =
Inventory
Inventory
Days Supply in Inventory DSI =
COGS/365
Collection Period, or
- Days Sales Outstanding (DSO)

Accounts Receivable
Days Sales Outstanding =
Sales/365
Payable Period, or
Days Payables Outstanding (DPO)

Accounts Payable
Days Payables Outstanding =
COGS/365
Receivables and Payables

IBM (2016) Whole Foods (2016) Amazon (2016)

Sales $79.92b Sales $15.72b Sales $135.99b

COGS $41.63b COGS $10.31b COGS $88.27b
AR $9.18b AR $0.24b AR $8.34b
AP $6.21b AP $0.31b AP $25.31b
Financing Ratios
• Asset to Equity Ratios
• Asset/equity
• Debt to Value ratios
• Debt to Equity ratio
• Interest Coverage Ratio
• EBIT/Interest expense
Liquidity Ratios

Current Assets
Current Ratio =
Current Liabilities

Current Assets − Inventory

Quick Ratio =
Current Liabilities

Do you want liquidity ratios to be high or low?

Current Ratio vs. Quick Ratio
 Return on Equity (ROE)
The Du Pont Decomposition
Return on Equity ROE = Probitability×Productivity×Leverage

Net Income Net Income Sales Assets

= ✕ ✕
Net Worth Sales Assets Net Worth

Profit Margin Asset Turnover Leverage

Reorganizing Balance Sheets
• Reorganize the items on the balance sheet into:
• Operating items
• Non-operating items
• Sources of Financing
 Balance Sheet
Accounts payable
Cash (operating) Operating current Accrued expenses
Trade accounts receivable Operating current liabilities Deferred revenue
Inventory assets Income taxes payable
Prepaid expenses

Net property, plant,

equipment (PPE)
Capitalized
Investments

Other operating Long-term deferred

Other long-term revenue
Liabilities
operating assets
- Debt (both ST and LT)
- Unfunded pension
obligations
- Retirement liabilities
Goodwill and Debt - Restructuring reserve
acquired intangibles - Hybrid securities –
convertible debt, preferred
stock, employee options
Excess cash and marketable securities
Equity investments - Equity
Nonconsolidated subsidiaries Equity - Minority interests
Other nonoperating assets
Nonoperating assets - Deferred tax liabilities (net
Retirement related assets (nonoperating) of deferred tax assets
 Reorganizing Balance Sheet

Operating Working
Capital
Debt

Net property, plant,

equipment (PPE)
Capitalized
Investments
Invested Capital

Other operating
assets, net liabilities
Total Funds Invested

Goodwill and Equity

acquired intangibles

Nonoperating assets
Working Capital
• Accounts Receivable
• Inventory
• Accounts Payable
Cash Conversion Cycle

Days Inventory (DSI) Days Receivable (DSO)

Cash Conversion Cycle

DPO

Receipt Pay for

of Raw Purchased
0 Collect Accounts
Materials Materials Receivable
Financial Policy at Apple,
2013
September 14, 2021
Case Discussion
Cash versus Profits
Sales
- Cost of Goods Sold
- Selling, General and Administrative Expenses
- Depreciation and Amortization
= EBIT
- Interest Expenses
= EBT
- Income Taxes
= Net Income (Profits)

Net Income ≠ Cash Flow

EBIT
Sales
- Cost of Goods Sold
- Selling, General and Administrative Expenses
= EBITDA
- Depreciation and Amortization
= EBIT
Earnings and Cash Flow
EBITDA
- Depreciation and Amortization
= EBIT
- Tax on EBIT
= EBIAT
+ Depreciation and Amortization

Net Investment
- Investment in net working capital
- Capital Expenditure (Capex)
= Free Cash Flow
FCF = EBIAT – Net Investment
Invested Capital
Invested Capital
(Net Operating Assets) = Fixed Assets
+ Intangible Assets
+ Net Working Capital

Return on Invested Capital (ROIC)

EBIAT
ROIC =
Invested Capital