Valuation Methodologies

1. ValuationMethodologies Prof. Florencio López-de-Silanes Dilijan, Armenia December, 2018.

2. Valuation Methodologies Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

3. Valuation (1) • Behind every major resource-allocation decision a company makes lies some calculation of what that move is worth. • Whether the decision is to launch a new product, enter a strategic partnership, invest in R&D, or build a new facility, how a company estimates value is a critical determinant of how it allocates resources. And the allocation of resources, in turn, is a key driver of a company’s overall performance.

4. Valuation (2) • Managers need to be able to value operations, opportunities, and ownership claims. • Managers constantly need to understand the value of new projects or of potential acquisitions. • This is important for the entrepreneur: • to purchase a company, • to start a firm in attempting to evaluate the business’ value in the future • to harvest a venture, either through sale or taking it public. • The most basic valuation problem is valuing operations, or assets-in-place: • Often managers need to estimate the value of an ongoing business or of some part of one — a particular product, market, or line of business. • Or they might be considering a new equipment purchase, a change in suppliers, or an acquisition.

5. Valuation (3) • Whether the operation in question is large or small, whether it is a whole business or only a part of one, the corporation either has already invested in the activity or is deciding now whether to do so. • The question is: How much are the expected future cash flows worth, once the company has made all the major discretionary investments? • A public company could be valued by looking at the market value of equity. • A firm with a long history of financial accounts, could benefit from the analysis of earnings, and cash flow projections. • But the valuation of a small, privately held firm is difficult and uncertain. • Though executives estimate value in many different ways, the past 25 years has seen a clear trend toward methods that are more formal, explicit, and institutionalized.

6. Why Value a Business? (Top 10) • 10 - Marital dissolution • 9 - Business disputes (Shareholder buyout) • 8 - Estate tax filing • 7 - Estate planning • 6 - Estate gift tax filing • 5 – Employee stock ownership plan (ESOP) and Employee stock options • 4 - Buy-Sell Agreement • 3 – Purchase or sale of business (Fairness opinion) • 2 – Financing • First Nine: All required – Event driven • Last reason: Not required. But, benefits can be profound. • To gain insights on how to increase company value.

7. The Basis for Valuation • Many investors believe that the pursuit of 'true value' based upon financial fundamentals is a fruitless one in markets where prices often seem to have little to do with value. • There have always been investors in financial markets who have argued that market prices are determined by the perceptions (and misperceptions) of buyers and sellers, and not by anything as prosaic as cashflows or earnings. • Perceptions matter, but they cannot be all that matter. • Asset prices cannot be justified by merely using the “bigger fool” theory.

8. Misconceptions about Valuation • Myth 1: A valuation is an objective search for “true” value • Truth 1.1: All valuations are biased. The only questions are how much and in which direction. • Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid. • Myth 2: A good valuation provides a precise estimate of value • Truth 2.1: There are no precise valuations • Truth 2.2: The payoff to valuation is greatest when valuation is least precise. • Myth 3: The more quantitative a model, the better the valuation • Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. • Truth 3.2: Simpler valuation models do much better than complex ones.

9. What is Involved in a Business Valuation? • Business background/history • Economic outlook • Industry/competition outlook • Nature of the business: • Management • Products/services • Operations • Marketing/distribution • Financial analysis • Trends and Ratios • Comparison within the company over time • Comparison across the industry • Expectations for the future: • Earnings/dividend paying capacity

10. Valuation Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

11. What is Value? • The present worth of future benefits. • A matter of opinion – judgment is involved. • Buyer rarely buys what the seller thinks he is selling. • In actuality, buyers want only one thing – future cash flow.

12. Understanding Value • In the context of valuing companies, it is important to understand what we mean by value. • From an economic perspective, value is the present value of future free cash flows (FCF) expected to be produced by the company, discounted at the weighted average cost of capital (WACC) that reflects the risk of the cash flows. • For a definition of free cash flow, see cash flow template later • For an understanding of the WACC, see conceptual diagram later • This value, is often called the “Economic Value” or “Market Value” of the company. • Let us first clearly understand the differences between • Economic value of the company • Accounting or book value of the company

13. Understanding Value: Book Value • Consider a company whose balance sheet is shown on the next page. • The important points to note are: • Fixed assets represent the investment in property, plant and equipment, minus the depreciation • Cash is cash on hand • Accounts receivable is the amount due from customers. It is an interest free loan to customers. • Accounts payable is the amount owed to suppliers. It is an interest free loan from suppliers. • Accrued expenses are amounts owed to employees, government, etc. It is also an interest free loan. • Financial investments include holdings in other companies.

14. Understanding Value: Book Value

15. Understanding Value: Book Value • Finally the Shareholder funds in an accounting balance sheet (called the book value of equity) is the amount of equity capital invested in the company. This includes • The original equity capital invested when the company was started. • Additional equity invested in the company through subsequent external equity financings minus any equity repurchases. • Profits reinvested in the company. • It is important to understand that the value of equity in the accounting balance sheet is NOT what the shareholders can obtain if they sold the company and paid off all the debt.

16. Understanding Value: Book Value • Before we relate the accounting balance sheet to economic values, we slightly reconfigure the accounting balance sheet. • The cash on hand is decomposed into “operating cash” and “excess cash”. • Operating cash is the cash required for working capital purposes. • It is determined by the company’s cash budgeting process. • “Excess cash” is cash that is not required for working capital purposes. • It is presumably kept for strategic reasons • In this example, we assume that $25 cash is required for operating purposes. • Remaining cash ($175) is “Excess cash.” • Marketable securities and financial investments are taken out of current assets which is now re-labeled as “current operating assets.” • If there are any interest-bearing current liabilities, they are left on the sources side of the balance sheet. • Remaining items are re-labeled as “current operating liabilities.”

17. Understanding Value: Book Value Working capital

18. Understanding Value: Book Value • The total capital (on which a return must be provided) raised by the company is $2200: • Short-term debt = $150 • Long-term debt = $1000 • Equity = $1050 • Note that accounts payable and accrued expenses are not included as they are not interest-bearing liabilities. • This capital is used to • Acquire fixed assets = $1500 • Invest in working capital = $375 • Acquire financial holdings in other companies and invest in excess cash and marketable securities (for future investment needs) = $325 • Note that working capital is the difference between current operating assets and current operating liabilities.

19. Understanding Value: Book Value • The total capital (on which a return must be provided) raised by the company is $2200: • Short-term debt = $150 • Long-term debt = $1000 • Equity = $1050 • Note that accounts payable and accrued expenses are not included as they are not interest-bearing liabilities. • This capital is used to • Acquire fixed assets = $1500 • Invest in working capital = $375 = [25+350+400]-320-80 • Acquire financial holdings in other companies and invest in excess cash and marketable securities (for future investment needs) = $325 =175+150 • Note that working capital is the difference between current operating assets and current operating liabilities.

20. Understanding Value: Economic Value • Using the reconfigured accounting balance sheet as a model, we can now create an economic balance sheet. • The main difference is that • Values in the accounting balance sheet represent what has been invested. • Values in the economic balance sheet represent the current value of what has been invested. • The goal of companies is to ensure that the economic value exceeds the accounting value!!

21. Understanding Value: Economic Value Enterprise value • Fixed assets & working capital (accounting balance sheet) are replaced by the present value of the free cash-flows they are expected to generate ($2500) • This is the economic value of the firm’s operations, often called Enterprise Value. • Excess cash and marketable securities are usually valued the same as in the accounting balance sheet as their values are unlikely to be different. • Financial investments should be valued at market. Here we assumed that the market and book values are the same.

22. Understanding Value: Economic Value • The total value of the company is: • Enterprise Value + Excess cash + Marketable securities + Financial investments • In this example it is assumed the economic value of the debt is the same as in the accounting balance sheet. • This is more likely to be true for short-term debt. • The value of the long-term debt is more sensitive to changes in interest rates. • If the interest rates had increases since their issue, their value would decrease from the face value.

23. Understanding Value: Economic Value • In general, liabilities also include, in addition to debt, obligations to other parties such as • Legal and environmental liabilities • Liabilities to employees such as pension • The value of equity is the difference between the total value of the company and all its liabilities. [= 2835-1050] = 1675 • It is also called the market capitalization and is equal to the share price times the number of shares outstanding. • This is the current value of the equity, i.e., what the shareholder will receive if they were to sell the company off at its current value and payoff all the liabilities.

24. Constructing Economic Value: Balance Sheet • If a company is publicly traded, it is easy to construct the right side of the balance sheet: • Debt values can be obtained from the accounting balance sheet • Equity value can be calculated by multiplying the share price by the number of outstanding shares. • Value of items such as excess cash, marketable securities, and financial investments can be obtained from the accounting balance sheet and market prices of these items. • The enterprise value can then be calculated as the residual.

25. Valuation Methodologies Outline • Valuation General Ideas • Understanding Value: Book vs. Economic Value • Valuation Approaches • Net Asset Approach • Multiples (Relatives) Approaches • Discounted Dividends Model • Discounted Cash Flow Models • Valuation in Parts • Comparing Approaches • Bank Valuation

26. Valuation Approaches • Several tools exist to per perform a valuation: • Net asset approach • Multiples (or Relatives) approach • Discounted Dividends approach • Cash flow approach to valuation: • Discounted Cash Flow, • Capital Cash Flow, • Equity Cash Flow, • Valuation in Parts. • The best measure of value is typically attained through the cash flow approach because it is forward looking and utilizes the most complete set of information (coming from the income statement, the balance sheet and the statement of cash flows).