The valuation of cash flow forecasts

1. The valuation of cash flow forecasts • Main findings • Using the sample of HLTs, authors compare the transaction value with the imputed values from Compressed APV, comparable companies, and comparable transactions. The prediction error for the first one is generally smaller than the last two. • Estimate equity risk premium implied from transaction value and forecast cash flows. The result is similar to historical average. • Relate this risk premium to firm beta (＋), industry beta (＋), firm size (×), and firm B/M ratio (×). • Support CAPM but not Fama and French (1992).

2. Motivation: how well does the DCF perform? HLTs provide testing opportunity. • Limit of this study • APV should perform even better under firm specific basis • Cash flow forecasts are for legal filing purpose. They may not represent the expected cash flows. • Cash flow forecasts may be incorrect because of the future organizational changes. • High leverage may prevent the use of interest tax shields and the access to capital market.

3. Total firm value = PV of future cash flow + excess cash = S + B + PS + transaction fee • Transaction value = S + B + PS + transaction fee－excess cash = PV of future cash flow ＊Remember in APV, firm value is the sum of : (1) FCF for S and B = EBIT(1-T)+Dep-CE-ΔNWC and discounted by r0 (2) Interest tax shield = Int×T and discounted by rb ＊In compressed APV we discount both by r0 (Why?) Therefore, numerator becomes NI+Int+Dep-CE-ΔNWC

4. Two ways to estimate future cash flow: • Net income approach: NI+Int+Dep＋Amort-CE-ΔNWC＋after tax asset sale • EBIT approach: EBIT-corporate tax +Dep＋Amort-CE-ΔNWC＋after tax asset sale • After the last forecast year, to compute terminal cash flows, we assume • 4% perpetuity growth rate of each item (why? inflation rate and real growth rate) • CE=Dep+Amort (why? Because of growth, must ＞. But because of high leverage, must ＜)

5. Discount rate: 1. ro = rf + ßo * [E(rm) - rf] 2. ßo = [ßs*S + ßB*B*(1-T) + ßPS*PS] / [B*(1-T) + S＋PS] • and assume ßPS = ßB=0.25 (why?) • Estimate ßs with 3 ways: • For each firm • For each industry • Assume the market ßs=1 • How to compute E(rm) - rf ? arithmetic average • How to compute rf ? long-term T-bond

6. Industry multiple: transaction value as numerator and EBITDA as denominator • Comparable company • Comparable transaction • Comparable industry transaction

7. Data: • LBO/MBO and leveraged recapitalization • Have at least 4 years of cash flow forecast • May or may not explicitly state that forecasts reflect expected changes • Reverse LBO firms provide cash flow forecasts to commercial banks

8. Valuation error = ln (estimated value / transaction value), compare the mean, median, and standard deviation • Performance measure: • Percentage within 15% • Mean absolute error • Mean squared error • Sensitivity of compressed APV to: • E(rm) - rf • Terminal cash flow growth rate • Reflecting transactions only • Mean reversion beta

9. Results • industry beta and market beta methods perform better than firm beta method • comparable transaction and comparable industry transaction methods perform better than comparable firm method • Compressed APV is as good as option pricing model or industry multiple method. Authors prefer the former because of information advantage in practice.

10. Cross-sectional regression of transaction value on estimated value (why?) 1. To eliminate the size effect, may take natural log on both sides or divide both sides by EBITDA • F test: joint test of slope =1 and intercept = 0 • Univariate v.s. multivariate regression • Implied cost of capital: • Compute the implied discount rate ro that equates estimated value to transaction value • compute the implied risk premium = ro - rf • Compute the implied market equity risk premium = [E(rm) - rf]= ( ro - rf ) / ßo

11. Cross-sectional regression of implied risk premium ( ro - rf ) on • Firm asset ßo (expected sign +) • Industry asset ßo (expected sign +) • Transaction size (expected sign －) • Pre B/M ratio (expected sign +)

12. Cash flow forecast may be endogenous: Potential ex ante bias in cash flow forecast: 1. Management may bias upward (downward) cash flow forecasts if he believes true cash flows to be lower (higher) than those required by debt holders. 2. Investment banks and insiders have incentive to make conservative cash flow forecast to justify that the transaction price is fair.

13. Robustness check does not support the existence of bias: • Post HLT, the EBITDA forecast is slightly higher than the actual number but this may be due to the unexpected recession in that period. • Compressed APV should be more accurate for high debt sub-sample. Dealmakers or incumbent management may make over optimism cash flow forecast when the HLT is contested. Alternatively the APV valuation error may be lower if there are other bidders. However, authors found little difference in prediction errors across sub-samples based on post transaction leverage or outside competition. • IPO (reverse LBO) firms have incentive to raise their forecast but no incentive to lower the forecast. Therefore APV should produce less accurate valuation. But in fact, APV still produces reliable value estimate for IPO (reverse LBO) firms.