The Absolute Basics Bagish Kumar Jha 17 Bhansali Pinal Prakash 18 K. Sree Bhargava 45 Krithika S Iyer 46

What is Being Valued? Enterprise value – is the value of the firm to all providers of capital.. Equity, debt and other. Equity value – is the value of the firm to the providers of equity capital only, i.e. Shares.

Valuation Approach – the Choices Cashflow Valuation  DCF  EVA Multiples  Enterprise  Equity  Operating Asset based – break up scenarios

Presentation Logic Deals with: Cost of capital – common to all methods Capital structure – common to all methods Cashflow model Multiple model

Capital Structure Generally the capital structure consists of: 1. Equity – representing business and asset risk 2. Debt – representing financial risk

Capital Structure (contd.) Debt is lower cost than equity, but Using more debt adds financial risk, and Thus – increases the cost of equity Debt may have tax advantages.

Cost of Capital Value is destroyed unless projects and companies meet or beat their cost of capital: 1. Cost of capital is an opportunity cost – the sacrifice to investing in the company 2. Cost of capital represents the risks in investing in the company

Cost of Capital (contd.) Value is destroyed unless projects and companies meet or beat their cost of capital: 1. All providers face their own cost of capital – debt, equity, or a mixture 2. The company faces a mix or blend called weighted average cost of capital.

All Roads Lead to Cost of Capital Despite apparent differences, all valuation methods: 1. Can and are related to a cost of capital – DCF, EVA, asset value 2. Including multiples, can be directly linked to cost of capital through the reciprocal relationship 3. Express cost of capital components in one way or another

The Cost of Debt Capital The market cost of raising the marginal tranche of debt capital (the next increment) The riskfree rate (as proxied by [say] well traded government debt in country of cashflow origin) Plus 2. A debt premium reflecting industry and company business risk As determined by rating or market data.

Riskfree rate of interest – such as the interest paid on government bonds PLUS A premium for taking risk....

The Cost of Equity Capital The market cost of raising the marginal tranche of equity capital (the next increment) The riskfree rate (as proxied by [say] well traded government debt in country of cashflow origin) Plus 2. The premium for investing in equities (ERP equity risk premium) of 4.0% – 7.0% TimesEquity Beta (the index of company risk)

The Riskfree rate PLUS a premium for equity market risk adjusted by BETA... The company risk index

Two Betas – Equity and Asset Equity beta = asset beta / (1 – debt % )  Only equity beta can be measured in the market Asset beta = equity beta * (1 – debt % )  Asset beta must be derived from equity beta

Example The equity beta for the tele communications industry often sits at around The Debt to total capital ratio for the tele communication industry often sits at around 50% So: Equity beta = 0.80 Asset beta = 0.80 * ( ) = 0.40

Estimating Beta Building an equity beta:  Establish the equity beta for an industry  Find asset beta given industry capital structure  Use company capital structure to find company equity beta Draw data from Bloomberg, Reuters, Valueline or similar

Example Industry equity beta is 0.80 Industry Debt to capital is 50% My company Debt to total capital is 65% Asset beta is: 0.80 * (1 -.50) = 0.40) My equity beta is: 0.40 / (1-.65) = 1.14

Summarising.... Cost of debt = risk free + debt risk premium Cost of equity = risk free + (equity beta * ERP) In the capital structure of debt and equity:  Equity is valued at the cost of equity  Debt is valued at the cost of debt

Last twist: tax and cost of debt Debt cost is adjusted for tax deductibility... Multiply it by (1 – Tc).... The corporate tax rate. So: Corporate tax rate = 30% Cost of debt = 8.5% Tax adjusted cost of debt = 8.5%* (1 – 0.3) = 5.95%

Blend Equity and Debt Costs to calculate WACC Riskfree rate plus Beta times ERP times Percent Equity Riskfree rate plus Debt premium times Percent Debt

Weighted Average Cost of Capital Example

The Cashflow Valuation Equation Value of near term cashflows Plus Terminal value Discounted to Present value at: 1. The WACC for the value of the enterprise 2. The cost of equity for the value of equity

Cashflow to the enterprise is.... Earnings before interest and taxes (EBIT) Minus Cash taxes on EBIT Minus Investments PlusDepreciation Plus (minus)Change in Working capital equals Free Cash Flow…. Available to ALL INVESTORS

Estimating Terminal Value I 1. Estimate a constant growth rate ( g ) from last year of the near term flows out to “infinity” 2. Multiply the estimated cashflow of the last year of the near forecast period by 1 + g Last near term flow Growth (1 + g) Multiply them

Estimating Terminal Value II 3. Divide this value by cost of capital minus g to get terminal value 4. Discount TV back to the present using cost of capital. Divide by cost of capital Discount to present Gives Terminal Value

Enterprise and Equity Value Enterprise value = near term plus terminal Equity value = enterprise value less debt Test:  Cashflow sensitivities  Cost of capital sensitivities  Terminal value sensitivities (growth rate)

Why test?

The Valuation Multiple Equation Based on comparative analysis. Popular in media: Comparisons drawn from:  Market observations  Transaction observations  Fundamental data All adjusted to “normalise” data and allow as analysis of “like with like” to greatest extent possible or feasible.

The idea is that, on average, a company should, over time have roughly the same value as its peers. Example: If the ratio of Telco share prices to Telco earnings is 8.0 then a “typical” Telco earning $0.50 should trade at about: $0.50 x 8 = $4:00

Multiple Valuation - Process Process to calculate:  Identify an appropriate variable  Find the necessary inputs for the calculation  Normalise - adjust the numbers to remove extraordinary or one off effects  Compute ratio – numerous formulae available  Apply multiple to company being valued Check against another method

Enterprise Multiples Estimate value of the enterprise to all capital providers: EBITDA – most “cash like”, skirts accounting issues, captures operating costs, only deals with tax indirectly. Revenue – useful with negative or zero earnings, skirts accounting treatment, difficult to “launder”.

Equity Multiples Estimate value of the enterprise to equity capital providers:  P|EBIT – avoids tax and capital structure differences, pre tax relationship to other methods.  P|E – very popular, oft quoted, simple to understand, difficult to compare because of tax and capital structure differences. A helpful relationship: 1 / P|EBIT = (pre tax) ROIC

Operating Multiples Many industries have unique operating multiples which can be used comparatively:  MediaP | number of subscribers  EnergyP | KWh production capacity  AccommodationP | number of room  TourismP | visitor nights / spend  AgricultureP | output per stock unit  TelecomP | fixed / mobile subscribers Identical process to other cases. Identical weaknesses.

Multiples - Characteristics Advantages  Simple and resource light  Easy to communicate  Commonly used Disadvantages  Single variable focus simplistic  Assume “straight line” trend  Subjective in normalising and comparing

Conclusions Valuation is...  A blend of art and science but a disciplined and systematic blend.  Thoroughly dependent on all of the explicit and implicit assumptions made.  An estimation process whose outer limits ought to be tested for revision purposes.  Likely to perform best when it reflects “fit for purpose” decisions in design.