Chapter 14 Valuations and forecasting

1. Corporate Financial Strategy4th edition Dr Ruth Bender Chapter 14Valuations and forecasting

2. Valuations and forecasting: contents Forecasting – header slide Process of forecast preparation Triangulate the forecasts The declining base case Sensitivity analysis Changing forecast drivers Some common psychological biases • Learning objectives • Valuing companies – header slide • Three approaches to company valuation • Balance sheet methods of valuation • Discounted cash flow valuation using WACC • Terminal value (narrative) • Terminal value (graph) • Valuation on multiples • Valuation on multiples – generic equations • Problems with valuation on multiples • Valuing a loss-making business

3. Learning objectives • Apply the three main methods of valuing a company – assets, multiples, and discounted cash flow. • Appreciate the advantages and disadvantages of each method of valuation, and the need for sensitivity analysis. • Explain why a suite of forecasts needs to comprise an integrated income statement, cash flow, and balance sheet. • Question the assumptions underlying any forecast by understanding some common behavioural biases.

4. Valuing companies

5. Three approaches to company valuation In practice, several different valuation methods will be used, to check reasonableness

6. Balance sheet methods of valuation • Balance sheets are backward-looking • Historic cost convention distorts values • Intangible assets are only included if they were acquired • Debt can be stated at market value rather than the sums owing • Accounting policies can vary considerably For most businesses, the balance sheet does not provide a useful valuation mechanism

7. Discounted cash flow valuation using WACC The value of the company represents the present value of the future cash flows it is expected to generate • Determine a suitable time frame • Calculate Free Cash Flow over that period • Operating profit, adding back depreciation and amortization (EBITDA) • Less tax • Less expenditure on fixed assets • Add/less changes in working capital • Determine a Terminal Value • Discount these cash flows at an appropriate rate • Normal to use Target WACC • Add in the value of non-operating assets This gives the Enterprise Value • Deduct net debt This gives the Equity value

8. Terminal value • Take an initial period for which you can reasonably forecast • 10 years? • At the end of that period assign a Terminal Value • Based on assets? • Based on a multiple of profits? • Based on cash flow as a perpetuity? [cash flow  discount rate] • Based on cash flow as a growing perpetuity? [cash flow  (discount rate – growth rate)] • Other?? It is helpful in valuation to use several different methods for terminal value, as they will all give different answers

9. Terminal value Free cash flow Perpetuity growing at g% per year FCFn Perpetuity Time 0 n Initial period Perpetuity value is FCFn ÷ Discount rate Growing perpetuity value is (FCFn x (1+g) ÷ (Discount rate – g)

10. Valuation on multiples • Valuation on multiples compares a company with peers whose market value is known, and values on a comparative basis • Valuation on a P/E basis compares the eps of companies with their share prices • For the whole company, this is net income and market capitalization • Valuation on other multiples can eliminate differences due to capital structures • Enterprise value is calculated and compared with EBIT, or EBITA, or EBITDA • Valuation on multiples can be done on a historic or prospective basis • The income figures used should be ‘sustainable’, adjusted for one-off items affecting a year’s results

11. Valuation on multiples – generic equations Valuecomparators = (Average profit)comparatorsx (Average multiple)comparators Therefore, for our target company in the same business we can assume that Valuetarget = (Profit)targetx (Average multiple)comparators

12. Problems with valuation on multiples • It is difficult to find true comparator companies • Sustainable profit levels might be difficult to determine, for the target company or the comparators • Market values might not be ‘correct’ • E.g. during the dot.com bubble, or if there is low trading liquidity

13. Valuing a loss-making business • Why do you want to buy this company? • That might give you an idea where the future value is coming from • Assets basis • If it’s never going to make profits, just break it up and sell the assets separately • Multiples basis • Valuation on multiples is about future sustainable profits. Can you see such profits arising? If so, maybe do a valuation on multiples for, say, 3 years’ time when you expect profits to arise, and then discount that sum back to today • DCF methods • Probably the most useful – forces you to examine the underlying cash flow forecasts and see if/when/how the company will start generating profits

14. Forecasting

15. Process of forecast preparation • Determine the reason for the forecast and the required timescale • Obtain the supporting data Revise assumptions and forecasts as the picture becomes clearer • Prepare the forecast • Analyse the forecast • Do a sensitivity analysis

16. Triangulate the forecasts Income statement Triangulation is necessary but not sufficient to ensure sensible forecasts Balance sheet Cash flow forecast

17. The declining base case Trajectory if we undertake investment Current trajectory for the business Trajectory if we fail to invest

18. Sensitivity analysis

19. Changing forecast drivers

20. Some common psychological biases