VALUATION: Valuation, discount rate, discount rate, growth rate and project selection LECTURE 3

2 $45? $35? $55? Business Valuations 1

We know the cost of everything but the value of nothing. Learning Goal

Lecture outline Introduction Value creation Valuation models Discount rates Growth rates Project selection

Value creation Firms make various value-increasing decisions  New venture  New project Product innovation Process innovation Need to value those projects/ventures well for better management Lecture 5 looks at valuation of Technologies/IP

Valuation Framework 1.Gather latest information/data 2.Estimate expected revenue growth (past rates, mkt. rates, other factors ) 3.Sustainable operating margin (CVP analysis) 4.Reinvestment (plough-back rate = g/ROC) 5.Risk parameters (discount rates) 6.Start-up valuation (EPS) 7.Project selection

Valuation Measures ApproachDescription Subjective/Personal Accounting Book Replacement Deprival Market Breakup Liquidation Fair Value Intrinsic/Economic Enterprise Value Many different valuation methods……. 5

Valuation Measures ApproachDescription Subjective/Personal  Based on unique individual preferences Accounting Book  Historical cost from the financial reporting model Replacement  Cost to buy asset in the purchase market Deprival  Cost to compensate for the loss of an asset Market  Equilibrium price amongst actively traded parties Breakup Liquidation  Net realizable value in the sales market Fair Value  A “reasonable” value given information at hand Intrinsic/Economic  A estimate of value basing on earning potential Enterprise Value  The intrinsic value of a firm’s operating assets Many different valuation methods……. 5

In general Cost approach (accounting book) Income approach (Present value or discounted cash flow (DCF); Market approach Example:  Valuing a second hand car Accounting valuation vs. DCF valuation

1. Cost Approach measures the future benefits of ownership by quantifying the amount that would be required to replace the future service capability of the asset assumes that the cost of replacement commensurate with the value of the service that the asset can provide during its productive life

1. Cost Approach 1. Research and Development Expenditures: involves the capitalisation of R&D or product launch expenses has the double effect of reducing expenses in the income statement and building up the asset side of the balance sheet capitalisation of R&D expenditure is to recognise its future benefit and therefore should be amortised against future sales

1. Cost Approach Research and Development Expenditures: empirical evidence has failed to ‘find significant correlation between research and development expenditures and increased future benefits as measured by subsequent sales, earnings, or share of industry sales’.

1. Cost Approach Research and Development Expenditures: The professional practice is to take a conservative approach to R&D expenses and to remove intangible assets unless there is a history of profits and sales as justification (i.e. brand names)

1. Cost Approach 2. Tobin’s q combines the market value and the replacement cost methods for valuing assets in a way very similar to the market-to-book (M/B) value ratio expectations of future profits are the basic determinant of investment activity and these expectations are supposed to be reflected in a firm’s market value

1. Cost Approach 2. Tobin’s q Compare Tobin’s Q with 1.

1. Cost Approach Tobin’s q market value of the firm exceeds the value of its existing capital when investors’ perceive its expected earnings as high or increasing firm can be worth less than its existing capital when its prospects are considered uncertain or low investment in new real capital is profitable if q exceeds one

1. Cost Approach Tobin’s q Firms with high q ratios are normally those with attractive investment opportunities or a significant competitive edge, as would the case with most technology start-ups Tobin’s q ratio differs from the M/B ratio q ratio utilises market value of the debt plus equity It also uses the replacement value of all assets instead of the historical cost value

3. Adjusted Net Assets Method - One of the Cost Approaches i.The balance sheet is restated from historical cost to market value ii.A valuation analysis is performed for the fixed, financial, other assets, and liabilities iii.The aggregate value of the assets is “netted” against the estimated value of existing and potential liabilities to estimate the value of the equity iv.This value represents the minimum, or “floor,” value the company at liquidation 1. Cost Approach

Income Approach: Discounted cash flows method Focuses on the income-producing potential of the asset The value of the asset can be estimated from the present worth of the net economic benefit generated over the life of the asset The DCF approach captures the essence of the time value of money and risk.

The present value of all future cash flows discounted at a rate that reflects the time value of money and the certainty of cash flows. = Discounted cash flows method

Value of firm =

Who knows what future cash flow & discounts rate to use? The complexity of modeling an enterprise is daunting! Nice Idea But…

Step 1: Estimate Cash flows Cash flows are pre-financing, i.e., independent of the capital structure of the firm.  Do not take out interest expense from cash flows

Estimating Cash flows CF t = EBIT t *(1 - T) + DEPR t – CAPEX -  WK t + other t Where CF = Cash flow; EBIT = Earnings before interest and taxes; T = Corporate tax rate; DEPR = Depreciation; CAPEX = Capital Expenditure;  WK = Increase in working capital, and other = Increases in taxes payable, wages, payable, etc.

Industry based understanding Cash flow Time Cash flow diagram for an airline company Cash flow Time Cash flow diagram for a newsletter company

Multiple cash flow curves Cash flow Invest Harvest Growth option Time This occurs when after the first project, the firm has options to introduce related products/services to the market. This presents new growth opportunity to the company.

Projection vs. reality Reality Cash flow projection Time Cash flow Scenario 1 original projection Time Scenario 2 More time & money, succeeded Scenario 3: More time & money, failed

Need to understand the industry Group discussion exercise  The following common sized Financial statements were taken from 4 companies in 4 different industries. Could you please match the numbers to the companies? Utility Banking Grocery Pharmaceutical

Step 2: Estimate growth rate and discount rate Using CAPM to work out the cost of equity  Need risk free rate (note the matching principle)  Firm beta (leveraged vs. unlevered)  Market risk premium  Note on beta.  Use this as the discount rate for all equity firm

Estimating accounting beta The private firm’s accounting earnings can be used to regress against changes in earnings for a market equity index such as the S&P/ASX 200 to estimate an accounting beta.  Earnings f =  +  S&P/ASX200 +  where  Earnings f = the change in earnings of the firm;  = the intercept or constant;  = the beta of the market equity index;  S&P/ASX200 = the market equity index, and  = the random error term.

Bottom-up Betas This method involves breaking down betas into their business risk and financial leverage components to enable us to estimate betas without having to rely on past prices on a technology start- up Unlevered Betas (  u ): The systematic risk of a firm assuming that it is 100% equity financed and has no debt.  L  U = [1 + (D/E)]

Bottom-up Betas Levered Betas (  u ): Where the firm’s capital structure consists of both equity and debt financing.  L =  U [1 + (D/E)] The use of operating income (i.e. EBIT) would yield an unlevered beta while using the net income would yield the equity or levered beta. The limitations with this type of beta are the distortion of data caused by accounting adjustments and the lack of a long time series for earnings given the short history of most technology start-ups

Cost of Debt The best practices for estimating the cost of debt are to use the marginal borrowing rate and a marginal tax rate or the current average borrowing rate and the effective tax rate. The after-tax cost of debt, K d (1 – T), is used to calculate the weighted average cost of capital.

WACC as the discount rate Note: Weight of Debt and Weight of Equity are based on Market value

Venture Capital Rates of Return The required rates of return for venture capital at different development stages are illustrated below (Smith and Parr 2000): Venture Capital Rates of Return Stage of Development Required Rate of Return (%) Start-up50 First Stage40 Second Stage30 Third Stage25

Venture Capital Rates of Return The pharmaceutical industry provides a specific industry example, Hambrecht & Quist (Smith and Parr 2000) Development Stage Required Rate of Return (%) Discovery80 Pre-Clinical60 Clinical Trials – Phase I50 – Phase II40 – Phase III25 New Drug Application20 Product Launch 17.5 – 15

Growth Rates Damodaran (2002) suggests three ways of estimating growth for any firm as follows:  Historical growth rate  Market analysts’ estimates  Firm’s fundamentals

Valuing cash flows with the CCF method All equity (unlevered firm)

Valuing cash flows with the CCF method (cont.) Leveraged firm  Tax shield advantage when debt is taken as interest payment are tax deductible.  Value of tax shield, TS (time period t)

Valuing cash flows with the CCF method (cont)  The tax shields are discounted to PV to get PVTS  Assuming D stays constant for simplicity  WACC can be used as a discount rate

Valuing cash flows with the CCF method (cont)

Practice with NSK case Please work out the value of NSK company basing on the information of NSK and comparable companies provided in the case.

Next class Valuation with market based approach. Case: Tutor Time (A) (p. 131)