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Quantitative Methods in Companies’ Valuation

Quantitative Methods in Companies’ Valuation. Offered to: Securities & Commodities Authority Trainer: Dr. Anis Samet , American University of Sharjah. Schedule & Outline. Day 1 Workshop pre-assessment (5 mn .) Session 1: Introduction to values (90 mn )

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Quantitative Methods in Companies’ Valuation

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  1. Quantitative Methods in Companies’ Valuation Offered to: Securities & Commodities Authority Trainer: Dr. AnisSamet, American University of Sharjah

  2. Schedule & Outline • Day 1 • Workshop pre-assessment (5 mn.) • Session 1: Introduction to values (90 mn) • Session 2: Discounted cash flow 1(135 mn) • Session 3: Discounted cash flow 2 (60 mn) • Day-1-assessment (10 mn) • Case study, part 1 (45 mn) • Day 2 • Session 1: Multiples 1 (90 mn) • Session 2: Multiples 2 (135 mn) • Alternatives and latest methodologies (60 mn) • Final-assessment (5 mn) • Case study, part 2 (45 mn) AnisSamet, Ph.D., American University of Sharjah

  3. Quantitative Methods in Companies’ Valuation Day 1 Anis Samet, Ph.D., American University of Sharjah

  4. Workshop Pre-Assessment Please answer the pre-assessment questions! Anis Samet, Ph.D., American University of Sharjah

  5. Financial Statements: A review Anis Samet, Ph.D., American University of Sharjah

  6. Financial Statements: Key Words Anis Samet, Ph.D., American University of Sharjah

  7. Financial Statements • Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements: • Balance Sheet - statement of financial position at a given point in time • Income Statement - revenues minus expenses for a given time period • Statement of Owner's Equity - also known as Statement of Retained Earnings or Equity Statement • Statement of Cash Flows - summarizes sources and uses of cash Anis Samet, Ph.D., American University of Sharjah

  8. Financial Statements: Balance Sheet • The balance sheet is based on the following fundamental accounting model: Assets  =  Liabilities  +  Equity • Assets can be classed as either current assets or fixed assets. • Liabilities (current & long term) represent the portion of a firm's assets that are owed to creditors • Equity is referred to as owner's equity in a sole proprietorship or a partnership, and stockholders' equity or shareholders' equity in a corporation Anis Samet, Ph.D., American University of Sharjah

  9. Balance Sheet: Tabreed Anis Samet, Ph.D., American University of Sharjah

  10. Financial Statements: Income Statement • The income statement presents the results of the entity's operations during a period of time Net Income  =  Revenue  -  Expenses • Revenue refers to inflows from the delivery of a product/service and expenses are outflows incurred to produce revenue Anis Samet, Ph.D., American University of Sharjah

  11. Income Statement: Tabreed Anis Samet, Ph.D., American University of Sharjah

  12. Financial Statements: Statement of Owner's Equity • The equity statement explains the changes in retained earnings. • The statement of retained earnings uses information from the Income Statement and provides information to the Balance Sheet • The following equation describes the equity statement for a sole proprietorship: Ending Equity  =  Beginning Equity  +  Investments  -  (Withdrawals/Paid Dividends)  +  Income Anis Samet, Ph.D., American University of Sharjah

  13. Financial Statements: Cash Flow Statement • The statement of cash flows is useful in evaluating a company's ability to pay its bills. For a given period, the cash flow statement provides the following information: • Sources of cash • Uses of cash • Change in cash balance • The cash flow statement breaks the sources and uses of cash into the following categories: • Operating activities • Investing activities • Financing activities Anis Samet, Ph.D., American University of Sharjah

  14. Cash Flow Statement: Tabreed Anis Samet, Ph.D., American University of Sharjah

  15. Financial Statements: Tabreed • Refer to the financial statements of Tabreed in Arabic and English • Arabic • English AnisSamet, Ph.D., American University of Sharjah

  16. Session 1: Introduction to Values Anis Samet, Ph.D., American University of Sharjah

  17. Introduction to Values • Valuation may be done by the seller prior to entertaining prospective buyers, by the buyer who identifies a specific target or by both parties during negotiations to resolve a dispute over price • Company valuation is not an exact science. There are numerous acceptable valuation methods and, in most situations, each will yield a different result • The formal mathematical valuation should only play one part in the overall pricing of the deal and in determining the transaction's true value to the parties Anis Samet, Ph.D., American University of Sharjah

  18. Introduction to Values (cont’d) • While all methods should, in theory, yield the same result, they rarely do, because of factors including, but not limited to, market conditions, the industry in which the target company operates and the type and nature of the business • All valuations are biased. The only questions are how much and in which direction • Simpler valuation models do much better than complex ones Anis Samet, Ph.D., American University of Sharjah

  19. Importance of Valuation • Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -- in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business • A sound investing is that an investor does not pay more for an asset than it is worth Anis Samet, Ph.D., American University of Sharjah

  20. Key Values Drivers • The firm’s value is driven by: • Earnings capacity • Growth opportunities • Real corporate performance, as compared to market benchmarks • Sales, operating margin, return on investment Anis Samet, Ph.D., American University of Sharjah

  21. Principal Valuation Methodologies Anis Samet, Ph.D., American University of Sharjah

  22. Accounting vs. Market Values • Accounting valuation is important, because the value of assets on a company’s financial statements needs to be reliable • Analysis of this valuation is just as important as the valuation itself • Some assets, such as real estate, which is carried at cost less depreciation, can be carried on the balance sheet at far from their true value Anis Samet, Ph.D., American University of Sharjah

  23. Session 2: Discounted Cash Flow (DCF) 1 Anis Samet, Ph.D., American University of Sharjah

  24. Discounted Cash Flow • Discounted Cash Flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money • All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question • Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management AnisSamet, Ph.D., American University of Sharjah

  25. Discounted Cash Flow (cont’d) • The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions Anis Samet, Ph.D., American University of Sharjah

  26. Discounted Cash Flow (cont’d) • CFt: Cash flow in period t • r: discount rate • T: life of the firm Anis Samet, Ph.D., American University of Sharjah

  27. Discounted Cash Flow (cont’d) • For an asset to have value, the expected cash flows have to be positive some time over the life of the asset • Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate Anis Samet, Ph.D., American University of Sharjah

  28. Process of DCF calculation: Step 1 • Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement Anis Samet, Ph.D., American University of Sharjah

  29. Process of DCF calculation: Step 2 • Step 2—Estimate the Discount Rate: the next order of business is to estimate the company's weighted average cost of capital (WACC), which is the discount rate that's used in the valuation process Anis Samet, Ph.D., American University of Sharjah

  30. Process of DCF calculation: Step 3 • Step 3—Calculate the Value of the Corporation: the company's WACC is then used to discount the expected cash flows Anis Samet, Ph.D., American University of Sharjah

  31. Process of DCF calculation: Step 4 • Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value Anis Samet, Ph.D., American University of Sharjah

  32. Free Cash Flow: A Reminder Operating cash flow (OCF) =Earnings Before Interest and Taxes (EBIT) + depreciation* - taxes = EBIT(1-T) + depreciation FCF = OCF – reinvestment = OCF - capital spending - working capital spending = OCF - capex – ΔNWC • Depreciation, or more generally any non-cash charges • Capital spending: changing in fixed assets • Working capital=total current assets-total current liabilities Anis Samet, Ph.D., American University of Sharjah

  33. Valuing a Firm Using DCF Firm value = PV of FCF during forecast period + PV of terminal value • Terminal value = proxy for all cash flows after the forecast period. Anis Samet, Ph.D., American University of Sharjah

  34. EBIT: Example Anis Samet, Ph.D., American University of Sharjah

  35. Valuing a Firm Using DCF: SCA company • FCF1=390 • FCF2=600 • FCF3=694 • Terminal Value=500 • WACC: 10% • Find the firm’s value using DCF Anis Samet, Ph.D., American University of Sharjah

  36. SCA Company’s Value: Using DCF Anis Samet, Ph.D., American University of Sharjah

  37. Session 3: Discounted Cash Flow 2 Anis Samet, Ph.D., American University of Sharjah

  38. Weighted Average Cost of Capital (WACC) • As seen before the discount rate that we have used to discount the future cash flow is the WACC • The WACC is the weighted average of the cost of equity and the cost of debt. The weights depend on how much of the firm’s activity is financed by debt and equity • The higher the cost of debt, the higher the WACC • The higher the cost of equity, the higher the WACC • The higher the WACC, the lower the firm’s value Anis Samet, Ph.D., American University of Sharjah

  39. WACC • Where: Ke= cost of equity Kd= cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt T = corporate tax rate Anis Samet, Ph.D., American University of Sharjah

  40. WACC: Example • D=2000 • E=3000 • Ke=12% • Kd=8% • T=20% • Find WACC Anis Samet, Ph.D., American University of Sharjah

  41. WACC: Example Anis Samet, Ph.D., American University of Sharjah

  42. How Risk is perceived in DCF? • Two companies that are different in term of risk should they have the same WACC? • No! Why? • Shareholders investing in the riskier company require a higher return and therefore a higher Ke • Banks lending money to the riskier company require a higher interest rate and therefore a higher Kd • So the riskier company has a higher WACC • A higher WACC lead to a lower value Anis Samet, Ph.D., American University of Sharjah

  43. WACC Components: Cost of Debt • The cost of debt depend on the interest paid by the company on the outstanding loans • The cost of debt is the weighted average of the costs of different debt instruments used by the company (e.g., bonds, sukuk, bank loans, ..) Anis Samet, Ph.D., American University of Sharjah

  44. WACC Components: Cost of Equity • The cost of equity represents the rate of return required by shareholders to invest in a company • The required rate of return depends on the riskiness of the company • If the company is a public company, we can estimate the cost of equity using the Capital Asset Pricing Model (CAPM) • If the company is a private company, we try to find a comparable public company to estimate the cost of equity using the CAPM Anis Samet, Ph.D., American University of Sharjah

  45. Capital Asset Pricing Model (CAPM) • CAPM is used to determine a theoretically appropriate required rate of return of an asset • E(R):is the expected return on the asset • Rf: is the risk-free rate of interest such as interest arising from government bonds • Β: is the sensitivity of the expected excess asset returns to the expected excess market returns • E(Rm): is the expected return of the market Anis Samet, Ph.D., American University of Sharjah

  46. CAPM • Rf: 5% • Β: 1.4 • E(Rm): 12% • Find E(R) • E(R)=5%+1.4*(12%-5%)=14.8% Anis Samet, Ph.D., American University of Sharjah

  47. Strengths and Weakness of CAPM • Strengths • CAPM is based on the idea that investors demand additional expected return if they are asked to accept additional risk • the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. • Weaknesses: • The model assumes that asset returns are normally distributed • The model assumes that all investors have access to the same information • The model assumes that the variance of returns is an adequate measurement of risk Anis Samet, Ph.D., American University of Sharjah

  48. Residual and Terminal Value • Terminal value is quite large compared to expected annual cash flows • DCF valuation is sensitive to the terminal value • It is difficult to estimate the terminal/residual value of a company Anis Samet, Ph.D., American University of Sharjah

  49. Strengths & Weaknesses of DCF Anis Samet, Ph.D., American University of Sharjah

  50. Manipulation of Values • It is very easy to manipulate the DCF analysis to result in the value that you want it to result in by adjusting the inputs • This is even possible without making changes that would be significant from an economist’s point of perspective, e.g. a change in the perpetual growth rate or in the WACC by just a few base points • Analysts or business professionals have no tools to estimate the input factors with that kind of exactness Anis Samet, Ph.D., American University of Sharjah

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