Chapter Two: Corporate Valuation

What Is Corporate Valuation About?

Valuation is crucial in investment banking. How much is this entity worth? (i.e., book value
or market value)
When we discuss the valuation of a company, we may be referring to any of the following:
• Enterprise value: Valuing the company’s productive activities.
• Equity: Valuing the shares of a company, whether for the purpose of buying or selling a
single share or valuing all of the equity for purposes of a corporate acquisition.
• Debt: Valuing the company’s debt. When debt is risky, its value depends on the value of
the company that has issued the debt.
• Other: We may want to value other securities related to the company—for example, the
firm ’ s warrants or options, employee stock options, etc.

Enterprise Value (EV)

The key concept in corporate valuation is enterprise value. Enterprise Value (EV) is the value
of the company’s core business operations (i.e., Net Operating Assets), but to ALL
INVESTORS (Equity, Debt, Preferred, and possibly others) in the company. By contrast,
Equity Value (also known as the Market Capitalization or ―Market Cap‖) is the value of
EVERYTHING the company has (i.e., Net Assets), but only to the EQUITY INVESTORS
(common shareholders). Enterprise Value is important because it is not affected by a
company’s capital structure – only by its core-business operations. Enterprise value would
change only if the company’s net operating asset changed. Enterprise Value is a measure of
company’s total value, often used as a more comprehensive alternative to equity market
capitalization. Enterprise value gives an accurate calculation of the overall current value of a
business, similar to a balance sheet. As its name implies, enterprise value (EV) is the total
value of a company, defined in terms of its financing (debt and equity) right side of balance
sheet. On other hand, the left-hand side of the resulting balance sheet is the firm’s enterprise
value, defined as the value of the firm’s operational (productive) asset.

The Four Approaches to Computing Enterprise Value:

a) The accounting approach to EV moves items on the balance sheet so that all operating
items are on the left-hand side of the balance sheet and all financial items are on the right-
hand side. Although most academics sneer at this approach, the balance sheet of a company
is a useful starting framework for the valuation process.

b) The efficient markets approach to EV revalues—to the extent possible— items on the
accounting EV balance sheet at market values. An obvious revaluation is to replace the firm’s
book value of equity with the market value of the equity. To the extent that we know the
market value of other firm liabilities— debt, pension obligations, etc.—this market value will
also replace the book values.

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c) The discounted cash flow (DCF) approach values the EV as the present value of the
firm’s future anticipated free cash flows (FCFs) discounted at the weighted average cost of
capital (WACC). The FCFs can best be thought of as the cash flows produced by the firm’s
productive assets—its working capital, fixed assets, goodwill, etc. When used as the discount
rate for a firm’s anticipated free cash flows (FCFs), the WACC gives the enterprise value of
the firm. FCF is discussed at this point it suffices to say that the FCF is the cash flow
generated by the firm’s core business activities. The DCF has two approaches/methods are
consolidated statement of cash flows and a pro forma model for the firm’s financial statements. In
this course we use two implementations of the DCF approach. (Later to be discussed
separately in chapter4)

Summary of Enterprise Value (Under Book Value and Market Value Approach)

On the left side--- EV = NWC + L.T. Inv’t + NFA + Goodwill + Other Assets (Book Value Approach)
Networking capital (NWC) is computed by subtracting operational current liabilities from
operational current assets. Operating current assets may include account receivables,
inventory and other current assets; while, operating current liabilities consist account
payable, tax payable and other current liabilities.
On the right side--- EV = CS + (D – C) + MI + PS + Other Liabilities (Market Value Approach)
Equity value, simply it is outstanding common shares at market value (CS), this line item is
also known as "market cap". On the other hand net debt at market value is total financial
debt (D) minus cash and cash equivalents (cash and marketable securities) (C). (Here debt
refers to interest bearing liabilities, both long-term and short-term debt. Like… short term
borrowing/ debt, current portion of long term debt and long term debt).

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 In general form, the right side enterprise value includes both the current price of outstanding
common shares (market capitalization) and the cost to pay off debt (net debt, or debt minus
cash and/or marketable securities). These are combined to calculate the value of a company's
debt and equity, minus cash that is not used for day-to-day operations. Simply, market
capitalization and the cost to pay off debt (net debt or debt minus cash and/or marketable
securities).
Cash is subtracted because it reduces the net cost to a potential purchaser. The effect applies
whether the cash is used to issue dividends or to pay down debt. You would subtract the cash
balance, because once you have acquired complete ownership of the company, the cash
becomes yours.
Synonym terms: - ―Cash and cash equivalents‖ or ―cash and temporary marketable
securities.‖ ―Temporary marketable securities are sometimes also called short-term
investments‖. In some case ―Cash and cash equivalents and ―marketable securities‖ are
recorded separately. All they are listed at their fair value (current market value).

1. Book Values Approach to Value a Company: Firm’s Accounting Enterprise Value

In this section we show how accounting statements can help us define the concept of
enterprise value (EV). As a starting point, consider the balance sheet for XYZ Corp.

We rewrite this balance sheet:

• We separate the operational versus financial items in short-term assets and short-term liabilities.
• Operational current asset (Account receivables, inventory and other current asset)
• We move the operational current liability (Account payable, tax payable and other current liabilities)
to the left side of the balance sheet to determine net working capital.
• We move all the debt (short-term debt or short-term borrowing, current portion of long-term debt,
and long-term debt) into one debt item.
• We move liquid asset (cash, and cash equivalents, and/or marketable securities or short term
investment) from left side to the right side of balance sheet to assume the payment of financial debt.

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To be more specific ―Debt lenders and other obligations‖ can include short-term debts, long term debts,
current portion of long-term debts, capital lease obligations, preferred securities, non-controlling
interests, and other non-operating liabilities (e.g. unallocated pension funds).
Remember that, even though preferred stock is reported in the equity section of the balance sheet, it
does have debt component and are reported separately as these items represent share of other
shareholders. Therefore, EV treats preferred shares more likely debt for this calculation since they
often required a fixed dividend rate.
On other hand, equity value shows only the values of ordinary common shareholders (equity
shareholders); because shares of common stock are the fundamental ownership units of the corporation
and common shareholders are considered as the founder and the true (real) owners of the corporation.
Thus, to calculate equity value from enterprise value (EV), subtract debt and debt equivalents, non-
controlling interest and preferred stock, and add cash and cash equivalents and/or marketable
securities. Or simply, it is common stock price multiplied by number of common stocks outstanding
(―market cap‖).
Generally, equity value is concerned with what is available to equity shareholder’. Debt and debt
equivalents, non-controlling interest and preferred stock are subtracted as these items represent the
share of other shareholders.

In the next step we subtract liquid assets (cash and cash equivalents and/or marketable
securities, if any) from financial debts, to get the firm’s net financial debt. Notice that we
netted out liquid assets from the financial debts of the company. The assumption is that these
assets are not needed for the core business activities of XYZ. When we finish this step, we
have all of the firm’s productive assets on the left side of the balance sheet and all of its
financing on the right side. The left-hand side of the resulting balance sheet is the firm’s
enterprise value, defined as the value of the firm’s operational asset. These are the assets
that provide the cash flows for the firm’s actual business activities. Thus, the book value of
XYZ’s enterprise value is $5,750.

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2. The Efficient Markets Approach to Corporate Valuation
The XYZ example above assumes that the book value is a correct valuation of the company.
But a simple calculation shows how problematic this is: At the end of 2011 XYZ had 524
shares outstanding, and the market price per share was $18. This suggests that the XYZ’s
enterprise value is $11,032—a far cry from the book value of the enterprise value of $5,750.

The efficient markets approach to the valuation of XYZ’s equity and financial liabilities
assumes that the market value of a company’s shares or debt is simply the market value at
the time of valuation. This approach is better than the accounting approach. If markets
work—in the sense that there are many participants trading the corporate securities, that
there is a lot of information about the company in question, and that the valuator has no
special information—why not accept the market price as the true value of the company?

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 Applying the efficient markets approach to the XYZ Enterprise Value Balance sheet gives
11,032 for the right-hand side of the enterprise value balance sheet. This means, of course,
that we have to revalue the left-hand side of the balance sheet. One approach to bringing this
enterprise value balance sheet into balance is to assume that the net-working capital’s book
value is a reasonable approximation to its market value. We can then re-compute the market
value of the firm’s long-term (productive) assets to bring the balance sheet into balance.

If operational net working capital (named in this course) is positive, operational current
assets are greater than the operational current liabilities, we will potentially have more
than enough funds to cover our liabilities coming due. If operational net the working
capital is negative, operational current assets are less than the operational current
liabilities, we do not have enough resources to pay our operational current liabilities, a
operational working capital deficit, which means a firm is in liquidity problem (illiquid). For
this reason, operational working capital is regarded as a measure of a company’s near
term liquidity.

Note that we could also apply the market valuation to other components of the right-hand side of
the balance sheet—we could try to revalue the firm’s financial obligations, its pension liabilities, and
minority interest. This is usually not done, unless there is a convincing case that the book values for
these liabilities differ materially from their market value.