BASIC APPROACHES TO VALUATION Discounted Cash Flow (DCF) Valuation Models Relative Valuation Models Contingent Claim Valuation Models Asset-Based Valuation Models Ibanking Seminar RWMelicher

1. Discounted Cash Flow Valuation Models Utilizes the Present Value Method: >The value of any asset is the present value of its expected cash flows >Forecast the amounts and timing of future cash flows >Discount the cash flows to the present using a discount rate that includes the time value of money and reflects the riskiness of the cash flows

Three Paths to DCF Valuation Direct Equity Method: Value just the common equity stake in the firm Entity or Enterprise Method: Value the entire firm (includes common, preferred, & interest-bearing debt claimants) Adjusted Present Value (APV) Method: Value firm as sum of each component or piece (value of all equity-financed firm + PV of tax benefits – PV bankruptcy costs)

2. Relative Valuation Models Value is based on how comparable publicly-traded firms are valued in the marketplace Identify comparable firms (need to control for differences in growth, risk, etc.) Calculate standardized measures (e.g., price to earnings, price to sales, etc.) for the comparable firms Apply the standardized measure to the target firm to determine its value

3. Contingent Claim Valuation Models A contingent claim or option pays off only under certain contingencies An option’s value is a function of: >current value of the underlying asset >variance in value of the underlying asset >strike price >time to expiration of the option >riskless interest rate

4. Asset-Based Valuation Models Based on valuing the firm’s individual assets and summing them to arrive at firm value Variations: >Estimate sales proceeds from selling off assets >Estimate value based on replacement costs of assets

FIRM VALUATION: ENTERPRISE METHOD Estimate Free Annual Cash Flows to Enterprise Investors: [EBIT x (1 – tax rate)] + Depreciation – Increase in NWC – Increase in CAPEX Estimate the Terminal Value Cash Flow 1. Multiples Approach: Cash Flow Multiple x Last Annual Cash Flow from Part A 2. Perpetuity Growth Approach: Forecasted Next Annual Cash Flow/(Weighted Average Cost of Capital – Cash Flow Growth Rate)

ENTERPRISE METHOD (cont’d) ENTERPRISE METHOD (cont’d) C. Estimate the Cost of Equity Capital 1. CAPM/SML Approach Estimate Business Risk Using Comparable Firms & Unlevering Betas. Relever the Beta to Reflect the Firm’s Financial Risk 2. Dividend Yield + Growth Approach 3. Industry Realized Rates of Return Approach

ENTERPRISE METHOD (cont’d) D. Estimate the Weighted Average Cost of Capital (WACC) 1. Estimate the After-Tax Cost of Debt Capital Reflecting Default Risk 2. Estimate the Cost of Equity Capital 3. Determine the Capital Structure Weights and Estimate the Overall WACC

ENTERPRISE METHOD (cont’d) E. Discount Annual Cash Flows and Terminal Cash Flows to the Enterprise at the WACC to Calculate the Firm’s Enterprise Value F. Add Existing Surplus Cash (some analysts use all Cash and Cash Equivalents) and Subtract the Value of the Interest-Bearing Debt from the Enterprise Value to Determine the Equity Value