Valuation FIN 449 Michael Dimond

Introduction What this class will cover How do I get an A in this class? Relevance Schedule Tools & resources Student Information

So what’s the difference? Definitions Investment: Purchase of an asset which will create future cash flows. Speculation: Taking a significant business risk to obtain a commensurate gain. So what’s the difference? Gambling: To bet or wager on an uncertain outcome. Investment: Discuss definition of “Asset” Discuss expense vs investment Side of beef vs buying a calf Buying livestock vs buying stock in a company Real assets vs financial assets Savings account or Certificate of Deposit How does compound interest work? Speculation: Difference is significant risk. Risk = Uncertainty of outcome Downside risk Upside risk Gambling Uncertainty which does not have commensurate gain. Absolute Uncertainty: Would you bet a million dollars on a single coin flip? "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." -- Graham and Dodd's Security Analysis (original 1934 edition)

Value A fundamental question which must be addressed in any business decision is: “What is this worth?”

Valuation Concepts There is no single value. Value opinions can change dramatically depending on the answers to these questions: What is being valued? Why is it being valued? What is the appropriate standard of value? What is the appropriate premise of value? When is it being valued? How will you value it? What discounts or premiums are appropriate?

What is being valued? Certain assets Interest-bearing debt Preferred stock Common stock Controlling interest Non-controlling interest Enterprise Value (or market value of invested capital)

Why is it being valued? Transactions Tax Litigation Buying/Selling/Merging Privatization Strategic internal decisions ESOPs Tax Estate, gift & inheritance taxes Estate recapitalizations Charitable contributions Ad valorem taxes Buy/Sell agreements Litigation Dissolution of corporation or partnership Review/critique of another expert’s report Damages Lost profits Marital dissolution

What is the appropriate standard of value? FMV (Market Value) The “cash value” of an asset to a non-specific, hypothetical buyer when there is no compulsion to sell and both parties have reasonable knowledge of relevant facts. Investment Value Intrinsic value. The value to a specific strategic buyer, not a hypothetical buyer. For private firms, this is often used on family law courts. Fair Value Created by State legislatures, “Fair Value” is defined differently in different states. It is usually used as a standard of value for dissenting stockholder lawsuits and minority oppression lawsuits.

What is the appropriate premise of value? Value as a going concern Assets in continued use as a viable business enterprise Value as an assemblage of assets Assets not in current use in the production of income and not as a going-concern business enterprise Value as an orderly disposition Assets sold individually with normal exposure to the market Value as a forced liquidation Assets sold individually with limited or no exposure to the market

When is it being valued? Valuation date is at a particular moment in time Could be historic date or as of the current date Only data that is “known or knowable” as of the valuation date should be incorporated in the report Date depends on purpose Transaction-related (expected event, e.g. purchase) Tax-related (date of gift, date of death, etc.) Litigation (event date or change of value over a range of dates)

How will you value it? General Valuation Concepts: The economic value of any investment asset is derived from the present value of future economic benefit that will accrue to the owner The most theoretically correct way to value an investment is to project the future economic benefits of ownership and discount those benefits to present value at a rate which reflects the time value of money and the uncertainty (risk) associated with ownership.

Value A fundamental question which must be addressed in any business decision is: “What is this worth?” “Value” is the present value of future cash flows. We will be valuing companies based on their free cash flows Damodaran has variations on FCF which we will learn: FCFF = Free Cash Flow o the Firm FCFE = Free Cash Flow to Equity

Considerations in Valuation Price buyers are paying for similar assets Cash flow generating ability Risks associated with achieving projected cash flows Value of the net assets owned by the business Percent of ownership interest Right to vote and influence business decisions Marketability of ownership position Special perquisites of ownership or management

Approaches to Valuation Market Approaches Example: Relative valuation estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales. Income Approaches Example: Discounted cashflow valuation relates the value of an asset to the present value of expected future cashflows on that asset. Asset-based Approaches Example: Adjusted net asset value method adjusts all individual assets and liabilities to market value. The amount by which asset value exceeds liability value is the equity value. Option-based Approaches Example: Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

Basis for all valuation approaches The use of valuation models in investment decisions (i.e., in decisions of which assets are under valued and which are over valued) are based upon a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value. Implicit in most valuation is the assumption that markets make mistakes and that we can find those mistakes by using the right valuation models. An often unstated assumption is that markets will correct their mistakes, resulting in excess returns for investors. If you do believe that markets are efficient, valuation still may be a useful tool in different contexts: Valuing private businesses (where there is no market to yield a price) Valuing the effect of a restructuring or a merger, where the market has not had a chance to react to the changes being considered.

What discounts/premiums are appropriate? Value may be influenced by extenuating factors Premiums Control Strategic acquisition Discounts Lack of control Lack of marketability (liquidity) Trapped-in capital gain Key person Known (or potential) environmental liability Pending litigation Concentration of customer base or supplier base

Where are we going with all this? Facts & Information Risk & Cost of Capital Forecast Financials Recasting & Sustainable OCF Gateway Assessm’t Strawman Model Assignments Team Project Final Project DCF Calculations Comps Value & Perspective

Valuation – The Big Picture