Business Valuation (When)

1. Business Valuation (When) • IPO • Privatization • Going Private (LBO, MBO) • Mergers and Acquisitions • Downsizing and Restructuring • Security Analysis • Value Management

2. Business Valuation (Who) • Acquirer, Target, and Intermediary • Managers • Investors • Investment Bank • Commercial Bank • Law Firm • Accounting Firm • Consulting Firm

3. Business Valuation (Why) • Successful Transaction or Negotiation: Overvaluation or Undervaluation? • Value Increasing or Decreasing? • Buy or Sell?

4. Approaches of Business Valuation (How) • Industry Multiple • Discounted Free Cash Flow • Discounted Cash Dividend • Book Value: not meaningful in finance • Liquidity Value: as the minimum value • Premium Analysis: used for M&A pre-offer market price / offer price

5. Industry Multiple • V = AI* Ind (V / AI) • V = market value of the firm or equity (B+S or S) • AI: choice of accounting item, e.g., asset, sales, EBIT, EBITDA, net income, free cash flow, cash dividend, replacement cost…… • How to choose AI? Manipulation vs Relevancy • Ind ( ) = Industry average or median • Assumptions: * V is related to AI and stable relationship * Industry influence

6. Industry Multiple • Notice 1: V can be dividend by number of shares or not • Notice 2: diversified firm • Notice 3: non-manufacturing firm, e.g., bank • Strength: easy, intuitive, and extensively used in industry practice and court cases • Weakness: bias of choosing comparable firm, bias of market influence

7. Discounted Free Cash Flow Model • Weakness: Must forecast future. Only if firm generates cash flow mainly from fixed asset investment. • Strength: must forecast future, focus on fundamental, extensively used • Four models: WACC, APV, Compressed APV, FTE

8. Discounted Free Cash Flow Model • FCFs= (EBIT-Int)*(1-T) + Dep - CE - ∆NWC – PR + New Debt • FCFB= Int* (1-T) + PR - New Debt • FCFA= EBIT*(1-T) + Dep – CE - ∆NWC = EBIT* (1-T) - ∆NFA – ∆NWC Note：CE= 資本支出 (capital expenditure) = ∆PPE ( property, plant, equipment) = ∆GFA (期末減去期初的固定資產毛額) PR=當期償還的本金 (principal repayment) ∆NFA= 期末減期初的固定資產淨額 NWC = (CA - cash - marketable security) - (CL - long-term debt matured in one year)

9. Discounted Free Cash Flow Model FTE: share value = {[ ∑ FCFs,t / (1+Ks )t] + cash and mkt security} ÷ number of shares How to compute Ks (cost of equity)? CAPM: Ks = rf + βs * [E(rm) - rf] investor’s historical realized yield in this firm or in this industry a. on the market basis: dividend yield plus capital gain return b. on the accounting basis: ROE long-term debt yield plus historical equity risk premium dividend growth model, e.g., Ks= D1 / S + g = expected dividend yield plus expected dividend growth

10. Discounted Free Cash Flow Model • WACC: • firm value =[∑ FCFA,t / (1+KA)t ] + cash and mkt security • share value = (firm value – B) / number of shares • KA= WACC = KS * S / (B+S) + KB * (1-T) * B / (B+S) • APV: • VU = Unlevered firm value = [∑ FCFA,t / (1+Ko)t ] + cash and mkt security • How to compute Ko (cost of capital for all-equity firm)? • Ko = rf + βo * [E(rm) - rf] • βo = [βs * S + βB * B * (1-T)] / [B * (1-T) + S]} • Hamada formula: ssume βB = 0, solve for βo

11. Discounted Free Cash Flow Model • VL = Levered firm value = VU + PV of Leverage • Where PV of Leverage includes • Tax shield (+) • 2.Government subsidization (+) • Financial distress (-) • Flotation cost (-) • share value = VL / number of shares

12. Discounted Free Cash Flow Model Where tax shield is most important PV of Leverage = ∑ (T * KB * Bt-1)t / (1 + KB)t = B * T, if assumes T, KB, Bt-1 are all constant over time Compressed APV assumes that the denominator (1+ KB) is replaced by (1+K0) and then the formula for VL will be simplified

13. Discounted Free Cash Flow Model • How to choose among these models? • If maintain a stable debt ratio in the future, then use WACC or FTE • If the year end outstanding debt in the future is certain and the debt ratio in the future will change, e.g., LBO, then use APV

14. MM Proposition II with No Corporate Taxes Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio

15. MM Proposition II with Corporate Taxes Cost of capital: r(%) r0 rB Debt-to-equityratio (B/S)

16. Business Valuation in practice • Step 1: Industry Analysis, e.g., SWOT or Boston Consulting Group Matrix 1. External Economic & Political Data • Business Cycle Stages • Inflation Trends • Interest Rate Trends • Exchange Rate Trends • Freedom of Cross-Border Currency Flows • Political Stability • Regulations • Taxation

17. Business Valuation in practice 2. Non-Financial Data • Distribution Channels • Labor Force Information • Labor-Management Relations • Organizational Form • Corporate Goals and Strategies • Information Flow and: Feedback System • Status of Technological Change in the Industry • Competitive Analysis of the Industry:vertical vs horizontal • Potential Competitive Reactions

18. Business Valuation in practice • Step 2: Financial Statement Analysis: Time-series and Cross-sectional • Liquidity ratio • Activity ratio • Leverage ratio • Profitability ratio • DuPont system

19. Business Valuation in Practice • Step 3: Perform the Business Valuation: Let’s take the Discounted Free Cash Flow Analysis as an example • Collect historical input data • Compute the weighted or un-weighted average for each input variable • Adjusted by subjective judgment • Use spreadsheet method or formula method: formula method must estimate the growth rate and investment rate • Sensitivity analysis

20. Business Valuation in Practice • How to estimate growth rate? • Use historical data: given 11 years of EBIT data a. Arithmetic average (a): unweighted / weighted ave annual growth rate b. Geometric average [Discrete compound annual growth rate (d)]: EBIT11=EBIT1×FVIFi%,10 or (EBIT11÷EBIT1)0.1-1 c. Continuously compounded growth rate (c) slope in regression of ln(EBIT) on year (1,2,3….) d. If EBIT is a straight line (no fluctuation), then d=ec-1. Also a＞d＞c 2. Judgment about firm’s prospect and business cycle is important! 3. Nominal growth rate is the sum of expected inflation rate and the real growth rate and is upper bounded by economic growth rate. 4. Foe zero growth firm, CE=Dep and ΔNWC=0 3. Use analyst or management forecast

21. Discounted Cash Dividend • Constant Growth Model: share value = D1 / (Ks – g) • Two-Stage growth model: high constant growth in the first n years, then followed by low constant growth forever

22. Discounted Cash Dividend • H Model: growth rate is negatively related to time in the first n years, then followed by a constant low growth rate forever • Three-Stage Model: constant high growth rate in the first period, growth rate is negatively related to time in the second period, constant low growth rate forever in the third period • Notice that growth rate is positively related to Ks, and negatively related to payout ratio

23. Conclusion • Valuation is science vs art • Due diligence and inside information is crucial • Must perform sensitivity analysis • Most suitable for stable, low tech, undiversified firm • Special cases for • Distressed firm • Diversified firm • Cyclical firms • Firms with unutilized or under-utilized fixed assets • Firms with cash flows not generated by fixed asset • Value of flexibility • Private firms