 Methods in Valuation Part II

Valuation Methods  Comparable Companies Analysis  Discounted Cash Flow  Leveraged Buyout  Risk Adjusted (NPV)

Discounted Cash Flow  Study the target and determine key performance drivers  Project free cash flow  Calculate the weighted average cost of capital (WACC)  Determine Terminal Value  Calculate present value and determine valuation

Study Target  Learn about the target and sector  Performance Drivers  Sales growth  Profitability  FCF Generation  Internal vs. External  These will help to determine set of projections  Much easier with public company

Variance in Drivers  Profitability may vary by sector  Management  Brand  Customer Base  Product mix  Similarly, FCF may vary by sector  Capex  Working capital efficiency

Projecting Free Cash Flow

Components of FCF  EBIT  Marginal Tax Rate  Capital Expenditure  D&A  Working Capital

EBIT  Earnings before interest and taxes  Profit from operations (Operating profit)  Focuses on company’s ability to generate earnings from operations  Independent of Capital Structure (Short term and long term debt and equity)

Marginal Tax Rate  Amount of tax paid on an additional dollar of income  Pay more as income increases

Capital Expenditure  Funds used to upgrade physical assets  These expenses are spread over the useful life of the asset which is being improved  What are some examples of Capex?

D&A  Depreciation – allocating cost of tangible asset over useful life  A decrease in an asset’s value  Amortization – Spreading out of capex for intangible assets over a specific period of time  Usually done over asset’s useful life

Working Capital  WC = Current Assets – Current Liabilities  Short term financial health  Current asset – can be converted into cash within a year

Considerations for FCF  Historical Performance  Projection Period Length

CVX Historic EBIT

Projection Period Length  Usually five years but dependent on sector  Allows for planned initiatives  Early stage with rapid growth (>5years)

Projections  Sales Projection  COGS and SG&A  Tax  D&A  Capex  Change in net working capital  EBIT and EBITDA

Sales Projection  Usually first 2-3 years are given by analyst consensus  Look at long-term sector trends for remaining years

COGS and SG&A  COGS projected from gross margin  Gross Margin = Revenue – COGS / Revenue  SG&A projected from SG&A levels  SG&A Levels = SG&A / Sales  Both projections usually keep constant ratios (Grow with sales growth)

Tax  Marginal tax rate of 35 – 40% is assumed  EBIAT = EBIT (1 – t)  t is the marginal tax rate  This will give the effective tax rate of a company

D&A  Depreciation  Straight line  Accelerated (Loses most in beginning)  Computers  Amortization  Projection based on amortization rate (Useful life)

Depreciation Straight Line Depreciation Accelerated Depreciation

Capital Expenditure  Capex represents cash outflows  Historical capex usually good starting point for projection  Expansion vs conservation mode

Change in Net Working Capital

YoY Change  Find YoY change  Project based on historical ratios

EBIT and EBITDA  EBIT and EBITDA are easily calculated from existing projections  Project these usually 5 years forward  Ready to calculate WACC

WACC  Broadly accepted standard for use as discount rate to calculate present value  Represents weighted average of the required return on invested capital  Value comprised of:  After-tax cost of debt  Cost of equity  % of debt in capital structure  % of equity in capital structure

Determining Target Capital Structure  Debt and equity to total capitalization ratios  For public companies, existing capital structure is used  As long as within range of comparables  If at extremes median or mean is often used  For private companies mean or median of comparables is used

Optimal Capital Structure

Cost of Debt  Reflects credit profile at the target capital structure  Generally calculated from blended yield on outstanding debt instruments  Public and private debt

Public Debt  Non-Callable Bonds  Callable Bonds  YTW – Lowest potential yield that can be received without the issuer defaulting

Private Debt  Instruments such as revolving credit facilities and term loans  Revolving – Reset over a period of time  Term Loans – Repaid regularly over a period of time  Banker usually consults with an in-house DCM (Debt Capital Markets) specialist to ascertain current yield

Cost of Equity  Required annual ROR that a company’s equity investors expect to receive  CAPM model most commonly used

CAPM  Capital asset pricing model  Assumes that investors need to be compensated for additional risk (systematic) with a risk premium  Systematic risk depends on beta value  Unsystematic Risk (Sector/company dependent) is avoidable by diversification

Cost of Equity (r e )

Beta  Calculated as:  This represents the levered beta, used for public companies

Unlevered Beta  For private companies, neutralize effect of differing capital structures (also called asset beta )  Unlevering Beta  Re-Levering Beta

Market Risk Premium  The spread of the expected risk premium over the risk free rate (r m – r f )  Historic data is used for r m (Use the past 10 years)

Size Premium  Smaller sized companies are risker, so COE needs to be adjusted  Smaller companies risk not entirely captured in beta  New cost of equity:

Ready to Calculate WACC

Terminal Value  Captures value beyond projection year  Typically based on FCF of final projection year  Exit Multiple Method  Perpetuity Growth Method

Exit Multiple Method  Calculates remaining value of a company’s FCF after projection period  Terminal Value = EBITDA n (Exit Multiple)  Exit multiple (range) from comparable analysis

Perpetuity of Growth  Calculates terminal value by treating terminal year FCF as perpetuity growing at assumed rate  Perpetuity = Annuity with periodic payments that continue indefinitely  Terminal Value =  Where g is long term growth rate (i.e. nominal GDP growth rate)

Determining PV  Present Value is determined by discounting future cash flows at the appropriate discount rate  Discount Factor =

Important Takeaways  Implied Equity Value = Enterprise Value – (Net Debt + Preferred Stock + Non-Controlling Interest)  Implied Share Price = Implied Equity Value / Fully Diluted Shares Outstanding

Pros  Cash flow based – Reflects value of FCF  Market Independent – More insulated from market aberrations  Self-Sufficient – Does not rely on all comparable companies

Cons  Dependence on Financial Projections – must have accurate forecasting  Sensitivity to assumptions – Small changes in assumptions can lead to huge differences in valuation  Assumes constant capital structure – no flexibility provision for varying capital structure

Sensitivity Analysis  Determine how different factors such as WACC and others affect Enterprise Value

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