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Financial Valuation of companies

Financial Valuation of companies. Financial Valuation of companies. Objectives of the course: Unterstand the commonly used techniques in valuation of companies Be able to estimate a spread of values of a company Pr Dr Dominique Thévenin Associate Professor Grenoble Ecole de Management

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Financial Valuation of companies

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  1. Financial Valuation of companies

  2. Financial Valuation of companies • Objectives of the course: • Unterstand the commonly used techniques in valuation of companies • Be able to estimate a spread of values of a company • Pr Dr Dominique Thévenin Associate Professor Grenoble Ecole de Management Dominique.thevenin@grenoble-em.com

  3. Summary • 1. Asset Pricing: general rules • 2. Patrimonial valuation methods • 3. Analogy valuation methods • 4. Discounted methods • 5. WACC issues and statistical approach of CAPM • 6. Specific cases: techno companies, convertible bonds

  4. Summary • Course documents • Slides, • Exercices and small cases, • Cases • Required tools • Simple calculator, or PC Excel • Linear regression, statistics • Boursorama, yahoo finance, google finance • Bloomberg, www.infancials.com, • Course Book • Bryley & Meyers ( en) • Vernimen (Fr)

  5. 1. General rules about asset pricing Financial ressources investment operations

  6. 1.1 Overview on interest rates • Interest rate • Expected inflation • Report of consumption • Time (liquidity) • Risk premium • Short horizon interest rate • Decided by Central Banks • In the context of monetary policy • Long Horizon interest rate • Market rate cointegrated with short rates 2% (2010 €)3% ( pastaverage) 1-2% (5-15 years)0% - 4 -6% 1% € 2007-2010,0,25% yen, $, 2010

  7. 1.2. Overview: asset pricing • Value of an asset = transaction price = price • that the owner estimates to be enough. • that the investor should pay when buying this asset, • P° • What you pay = what you get • = sum of the future cash flows that you receive as long as you hold this asset • = Discounted future cash flows • Certain or safe cash flows: bonds • P°= present value of future cash flows @ right risk rate

  8. Overview: asset pricing • Uncertain cash flows: • Speculative pricing : discounted expectedcash flows • Interest rate = adjusted to the risk of the asset • P° moves in response to rates fluctuations and cash flow revisions • Real assets • P° sensitive to expected selling price, rents, and interest rates • Stocks • P° sensitive to dividends, profits, selling price and interest rates

  9. Overview of asset pricing: bonds valuation • The bondholder receives fixed subsequent payoffs. • Exemple : 500 € in fine bond @ 3%, maturity 10 years. • What is the value of this bond if market rate is ? • 5% • 8% • 12% • 2% • 1%

  10. 1.3 Valuation of a company • Firm = set of assets holded by shareholders • Shares are assets themselves • Value of a company = value of all of its assets • = Debt Value + Equity value • Creditors = money suppliers = stakeholders. Thus the good issue is the value of Equities. • Equity Value = Assets value – Debt Value • Direct valuation: valuate equities from dividends or profits • Indirect valuation: valuate assets and substract the debt

  11. Valuation of a company • Assets oh the company = set of • projects, investments in process, (no growth situation) • growth opportunities ( few are disclosed) • Value of the assets = • PV of the future cash flows of all the projects • + PV of growth opportunities • Discounted at the weighted cost of capital

  12. Main methods to valuate • Book value, or patrimony approach • Financial statements provide information about patrimony • information about past profitability • Information about competitors • Analogy approach • Duplicate the valuation from similar firms • Financial or discounted approach • The value of an asset or a security = present value of expected cash flows = sum of discounted expected cash flows. ( part 3)

  13. 2. Book value approach • A1: value of equities = book value of equities • Simple: just read it in the financial statements ! • Assets are valuated according rules and regulations. • Continental Europe focuses on safety principle, • with historical costs: does not reflect their market value. Far from reality. • Distinguish some liabilities from equities is not trivial • Convertible bonds ? • Options on stocks ? • Consolidated datas are not always safe • IFRS regulation improves the valuation of listed companies

  14. 2.1. Book value approach • A2: net reevaluated assets : • Valuate every asset in the balance sheet at its market value • Are all assets liquid ? • Are all assets profitable ? (useless assets) • Does every asset fully reflect future earnings ? • Brands, licences, specific assets ? • Some elements do not exist in assets and financial statements • Know how, human capital, specific assets, growth opportunities • On the other side: • dissimuated liabilities

  15. 2.1. Book value approach • Listed companies: IFRS • Assets and liabilities are valuated at their « fair value »  A2 approach • Only some untangible assets are valuated at the fair value: acquired brands and licences, financial investments, etc. • Goodwills are controversy • IFRS are sometimes contrevorsy, but the induced valuations are closer to market valuations • Nevertheless, the difference between market and book values are large

  16. 2. Book value approach • A3: the goodwills: Idea: valuate assets that accounting systems are not able to do, but generate profits. Untangible assets, know how, human ressources,… These additionnal value = Goodwill. But methodologies suggest hazardous formulas: No cash, no discount, no risk and no expectations! The Goodwill valuation approach has no backgroud But Goodwill exists : ex post, GW = Price of a firm – Book Value…

  17. Example: Hermes

  18. Example: Renault

  19. 3. the « multiples » • Underlying idea: markets evaluate identical firms at the same price. • Consider the PER: Market price /net income • Price Earning Ratio indicates how many times of annual profit you pay a company • PER Air liquide = 18  the price of the share = 18 times its annual net profit • The current net profit is commonly seen as the main reference to measure the profitability of a company. • the PER shows the expected growth of the profits • PER 6-8 = low growth • PER 10 = maturity • PER > 20 = growing company

  20. The multiples • Consider now the links between economic variables of the firm: income, sales, net assets, book value • Net profit = Sales x net margin in% • Sales = invested assets x turn over speed • Links between 1 economic variable and the market price are established • A « multiple » = market price / economic variable • there are links between market valuation and most economic variables. • Multiples are very closed among an industry, because companies run the same business model

  21. multiples • But the debt will infer. Thus separate these indicators • Market cap / net income, variables related to equities, • Enteprise value / variable limited to economic variables • Where Enteprise value = market cap + debt

  22. multiples Ev commonly means market value of assets = market cap + debt P:S, P:EBIT are often computed on market cap and not Ev . Please pay out

  23. examples

  24. The multiples • The use of the multiples if non listed company • Look for listed similar companies on a market • Compute main multiples • Duplicate the multiple to unlisted companies, or analyse the place of a company among its competors • Advantages • simple, easy • Cons • Difficult to build samples of similar companies • What else if no earnings… • What else if the maket price is very volatile • Book datas are delayed in regards to market datas

  25. Example 2006 • Strong differences even in the same industry!

  26. Value of equities = value of assets – value of debt. Assets = sum of investment projects Assets value = present value of future economic cash flows, discounted @ the cost of capital.  Infer equities Value of equities = present value of the future cash flows to shareholders  equities value = (economic cash flow – cash flow to bondholders) discounted @ the cost of equities 4. Discountedapproaches

  27. 4. Discountedapproach • Exemple: a company produces cheese and generate a stable and infinite EBITDA = 20 M. The balance sheet shows 50 M debt at 6% interest. Income tax = 30%, and shareholders require a 9% return. • 1. Estimate the value of its equities, • 2. Estimate the WACC and the value of its assets

  28. 4.1. The DCF method • DCF = Discounted Cash Flows. • Translate strategy into a stream of future economic cash flows. • Discount @ wacc • DCF gives the value of assets

  29. 4.1.DCF • « free cash flow » table • Economic cash flow including • operating flows after tax (NOPAT + depréciations) • + Delta Net Working Capital • - investment required to maintain operations possible • No interest or debt flows (except if you compute cash flow to shareholder) • Techniques • Assume depreciations = investment (roll over) • Cash flow every year as long as the visibility is correct • Troncate the subsequent flows at the end: « terminal price » • Assume a multiple • Or assume a long term growth rate • Discount the free cash flows  value of assets

  30. 4.1. DCF • Advantages • Translate a strategy into datas • Specific DCF if diversified company. Then consolidate. ( SOTP = sum of the part) • Cons • Few visibility over long period • DCF is very sensitive to the « terminal price » • Requires to know the WACC

  31. Example: Memscap • Memscap: high tech company at Grenoble. • IPO: january 2001  valuated by Société Générale Owen • Subsequent DCF are published:

  32. 4.2.Discountedapproaches:dividends or fundamentalapproach • Price of a stock = present value of the cash flows to shareholders • Dividends and capital gains: D1 and (P1-P0) if cash flo to shareholders are restricted to dividends • If D1 and P1 are estimated, the required return to shareholders wellknown,

  33. 4.2. dividends • = present value of inifinite dividend stream • If you introduce a long term growth rate: Gordon-Shapiro model. • Dividend and growth rate are not independant • Growth rate has to be < return rate • Reverse the model and get • Required return = dividend yield + growth rate • Fundamental and Gordon Shapiro models have a weak explainatory power: • < 40% in US stocks • 60% in France

  34. 4.2. dividends • Limits of Gordon Shapiro model • Valid with mature companies • Irrelevant with growing companies • Troncate the model into growing period and maturity • ROE often irrelevant (delayed) to estimate g with( way 2) • Irrelevant if the dividend policy is unstable

  35. 4.2. dividends • 3 ways to estimate the growth rate? • Try to translate the strategy into sustenable long terme growth rate • Link payout ( Dividend / Earnings) = b, and growth • (1-b) * Earnings are retained and invested • Ceteris paribus, • the book equities increase by (1-b)*ROE • Earnings and Dividends increase by (1-b)*ROE • g = (1-b)*ROE • g is the requested growth to get the same ROE • Observe subsequent dividends over time, and run an exponential regression t / t-1

  36. 4.2. dividends • Exercice: look at a listed company • Compute b, ROE, • infer growth rate, • Compute dividend yield • Infer the cost of equities • Download the dividends over the past 10 years • Regress and infer g

  37. 4.3. growth and stock price • Growth of sales and earnings should show a long term link • g = 0: b = 100%, dividends = earnings. P0= earnings / r  PER = 1/r, or r = 1/PER • If g>0: additionnal cash flows and earnings  Price moves up  PER moves up • r = 15% g = 0% b=100%  PER = 6.67 • R = 15% g =10% b=40%  ROE =16.66%  PER = 8 • r = 15% g =10% b=50%  ROE =20%  PER = 10

  38. French market 2006: average PER = 16 (13 in 1993) • PER were historicaly high 1998-2002. Earnings had to grow ! • Dec 2009: <10 • Growing company : PER > 20 - 25

  39. 4.4 Discountedapproach: Bates Model • Mix DCF + PER approaches • Firm is growing at g over n years, and retained earnings (1-b) are constant over time. • PERn reflects moderate growth. • PER0 can be estimated as follows: • Value of equities = PER0 x Net Income0

  40. Bates • Advantages • Valid for growing companies • Simple • Possible to run Bates with a multiple of NOPAT, and gives the value of assets • Limits • Positive Net income is required • Constant % dividend payout ( possible to input b=0%) • Requires to know the cost of equities

  41. Bates: example Google • Google sept 2011 • Cost of equities 10,3% ( beta 1, rf 1,8%, market 8,5%) • Net income 2010/2011 = 9013 M$ • Market cap = 174 000 M$  PER°=19,3 • b = 0 assumed for a long time • Forecasts = PER 2013 = 10,8 •  implicit growth rate = 47% over 2 years.

  42. Conclusion about valuation methods • Patrimonial approaches reflect the past • Correct if real assets • Avoid a priori Goodwills • Financial approaches are founded on expectations. They price growth opportunities. • It ensures volatility when expectations are revised. • Sensitive methods to hypothesis • Strong links with strategy • Financial approaches requires to estimate first the cost of equities, and/or the cost of capital ! • Strong links with capital structure

  43. 5. Discount rate • Discounted methods (part 4) require to know the discount rate • Cost of equities, or • WACC. • Cost of equities and WACC depend on the D/E leverage ratio • D/E ratio includes the market values and not the book values • Risk of « circular » estimation of discount rate

  44. 5.1 Cost of equities and CAPM • Stock return = risk free + risk premium • Stock risk = systematic risk + specific risk • Systematic risk = risk generated by the stock market on our stock • Specific risk = risk that can be eliminated by diversification of the portfolio owned by the shareholder • Only systematic risk is paid to shareholder • This risk = Market risk smoothed or incréased by the sensitivity of the stock in response to the market fluctuation

  45. 5.1 CAPM • Thus we get the derived equation of CAPM approach Where beta = sensitivity of stock / market = cov (stock, market)/market variance

  46. 5.1 CAPM • How to estimate the cost of equities of a listed company ? • Risk free is observable at a given date: T-Bonds à 10 years is the most commonly used proxy • Market risk premium: often published in financial newspapers. • Average of the market premium over time: 3.5% - 4%. • Never use 1/PER of the market • beta is sometimes published in financial newspaper • unsafe

  47. Risk premium over time

  48. 5.1 CAPM • How to estimate the beta of a listed company • Beta = regression coefficient of Ri = a + beta * Rm • Download stock price and stock index, exchange them into returns • Week data over 1 year is preferable • Regress Ri on Rm and get the beta coefficient • Run a Student test to decide if your estimation is acceptable • Sophisticated econometric tests should be conducted, due to non stationnary datas • Beta reflects the risk of a company, and is not stable over time, or after M&A

  49. 5.1 CAPM • How to estimate the beta of a non listed company • Estimate the beta of a listed company • Compute market D/E ratio • Exchange the beta into the economic beta and duplicate it to the non listed company, • Valuate the company under all equity financed hypothesis  value of assets • Adjust with the debt • Some iterations may be required • Avoid to compute the cost of equities and the WACC under book value D/E

  50. 6. Specific cases. 1. techno firms • Growth opportunities • Single cash flow sequence doesn not reflect correctly • Many stages with uncertain cash flow • Many stages where decisions can change a project • Decision trees • Real options

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