### Transcription of Valuation Basics - Financial Modeling Consulting, …

1 **Valuation** **Basics** Revised May 12, 2014. By Scott Beber, ExcelModels Table of Contents 1. INTRODUCTION .. 3. 2. METHODOLOGY 1: DISCOUNTED CASH FLOW .. 3. WEIGHTED AVERAGE COST OF CAPITAL .. 3. PRESENT VALUE OF FREE CASH FLOWS .. 3. 3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES .. 4. PRICE TO EARNINGS .. 4. EV TO EBITDA .. 5. 4. METHODOLOGY 4: INCREMENTAL VALUE-ADD .. 5. UNDERSTANDING SYNERGY .. 5. METHODOLOGY .. 5. 5. FORECASTING CASH FLOWS .. 6. STRAIGHT LINE .. 6. PERCENT OF SALES .. 6. COMPOUND ANNUAL GROWTH RATE (CAGR) .. 6. REGRESSION .. 6. Page 2. 1. INTRODUCTION. This document is intended to explain rudimentary company **Valuation** techniques. A rigorous **Valuation** will often rely on these, and other, measures, to arrive at a range.

2 2. METHODOLOGY 1: DISCOUNTED CASH FLOW. The Discounted Cash Flow method calculates a Net Present Value of the company as a whole. It is dependent on an accurate depiction of historical cash flow, the basis of which is used to make cash flow projections for future years, plus a residual value of cash flows in perpetuity thereafter. Each forecasted year is then discounted by the company's Weighted Average Cost of Capital (WACC) to bring all future cash flows into present-day terms. The value of any enterprise is the set of all expected future cash flows stated in today's dollars. Weighted Average Cost of Capital The definition of WACC can be formally stated according to the equation: WACC = Value of Company Debt x Cost of Debt + Value of Company Equity x Cost of Equity Value of Debt + Equity Value of Debt + Equity In basic terms, a company's WACC is the opportunity cost of a dollar investment in the company versus a dollar investment elsewhere.

3 Cost of Equity is estimated to be historical return on equity (or Average Net Income /. Average Equity Value for as many historical years are relevant to the forecast) as a percentage of the value of equity in the company's current capitalization. Cost of Debt is estimated to be the overall average interest rate paid to lenders and debt financiers as a percentage of the value of debt in the company's current capitalization. Stated differently, the WACC is the return equity that investors demand and the return that lenders demand according to the amount each has invested in the company. Present Value of Free Cash Flows The WACC figure is used as the denominator in each forecasted year's cash flow value, taking into account compounded interest for the number of years being used in the forecast (plus the residual value).

4 Residual values (also called **Valuation** horizons) are often chosen arbitrarily, but tend to be a number of years for which a realistic cash flow forecast and a realistic long-run growth rate can be made. The sum of all future years' cash flow projections, translated into present-day dollars according to the company's cost of capital, yields the company's Present Value of Free Cash Flows (PVFCF). The definition of PV can be formally stated according to the equation: PV = Cash Flow in year 1 CF year 2 .. CF year n PV (horizon value). 2 n n 1+ WACC + (1+WACC) + + (1+WACC) + (1+WACC). where PV (horizon value) = Cash Flow in year n+1. WACC - (long-run growth rate).

5 Page 3. 3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES. Using the PVFCF method to value the company has advantages and disadvantages over the other major **Valuation** method: applying a standard industry price multiple to the company's earnings ( net income). A benefit of the PVFCF model is the theoretical' accuracy. In addition to providing a company **Valuation** , this model is used constantly by companies to value individual projects they might undertake. The Net Present Value of a project, or the present value less the required capital investment, must be greater than $0 for the venture to be a good use of the company's money. Otherwise, the company is better off plowing the money back into the company and earning its expected WACC.

6 This is another reason why WACC represents a company's opportunity cost of capital. The problem with the PVFCF is that theoretical' accuracy requires a large number of assumptions, including: Accurate historical and projected cash flows Return on equity Return on debt WACC. Number of years to forecast Horizon value Long-run growth rate If each of these figures can be estimated to a reasonable degree of accuracy, the formula for PVFCF will give a very solid answer. NPV calculations for internal projects are generally safe to use because there is little alternative in how worthwhile a project may be, and because by definition they give management information on a smaller scale.

7 The value of a company, in contrast, is arguably the most important value (the holy grail ) in corporate finance and needs to be extremely accurate in order to be useful. In contrast, the price multiple **Valuation** method has the advantage of being extremely safe', in the sense that a public market has placed a value on a company or industry based on widely-available knowledge of historical and expected performance. Given the presumption that markets are highly efficient, such a multiple is considered to be the best available estimate of a company's value. The problem with using a price multiple is that no two companies are alike, and using another company's basis for **Valuation** may or may not be appropriate to use for another's.

8 This holds true for using the general price multiple for an industry as a whole. In either case, price multiples are as accurate as the similarity between a competitor's or industry's profitability, risks, and growth opportunities and the company being valued. In fact, using an industry price multiple is often a worse method than using another company's because it is theoretically possible to select a competitor whose business prospects more closely mimic those of ABC Corporation than using, for example, the price multiple of the industry as a whole. Nevertheless, it is worthwhile to use one or more price multiple **Valuation** methods, particularly as a check' against the PVFCF results.

9 Price to Earnings A price-to-earnings ratio is simply the market price of a company divided by its earnings, or net income. The newspaper gives the ratio of current price to the most recent earnings; however, investors are more concerned with price relative to future earnings. Since future earnings are difficult to know for certain, projections are used, which makes the P/E method closer to PVFCF in terms of accuracy, and helps support the argument for using PVFCF. instead. Typically, however, a P/E multiple is calculated without discounting future earnings, but rather, using past and present earnings as indicative of the company's expected performance. Page 4.

10 EV to EBITDA EV/EBITDA ratios are similar to P/Es but rather than Price in the numerator, the Enterprise Value is used; and EBITDA, rather than Net Income, comprises the denominator. One advantage of using EV/EBITDA over P/E is that EBITDA is higher up on the income statement and less subject to creative accounting. By the time an earnings estimate is derived, a lot of mitigating factors can significantly diminish the comparability between two firms. As for the numerator, EV takes the entire company into account, rather than just the value, or Price, of its Equity. For this reason, using a P/E ratio for an industry is a safer bet. Nevertheless, EV/EBITDA has its drawbacks.