1. Chapter 14 Valuations and forecasting
Corporate Financial Strategy 4th edition
Dr Ruth Bender
Chapter 14 Valuations and forecasting

2. Valuations and forecasting: contents
Learning objectives
Valuing companies – header slide
Three approaches to company valuation
Balance sheet methods of valuation
Discounted cash flow valuation using WACC
Terminal value (narrative)
Terminal value (graph)
Valuation on multiples
Valuation on multiples – generic equations
Problems with valuation on multiples
Valuing a loss-making business
Forecasting – header slide
Process of forecast preparation
Triangulate the forecasts
The declining base case
Sensitivity analysis
Changing forecast drivers
Some common psychological biases

3. Learning objectives
Apply the three main methods of valuing a company – assets, multiples, and discounted cash flow.
Appreciate the advantages and disadvantages of each method of valuation, and the need for sensitivity analysis.
Explain why a suite of forecasts needs to comprise an integrated income statement, cash flow, and balance sheet.
Question the assumptions underlying any forecast by understanding some common behavioural biases.

4. Valuing companies

5. Three approaches to company valuation
(Net) Assets bases
Based on equity in the balance sheet.
May reflect revaluation of assets, or assets at replacement price, or liquidation values.
Multiples of profits
After-tax profits multiplied by appropriate price/earnings ratio
EBIT or EBITDA multiplied by appropriate ratios
Discounted cash flows
Forecast the free cash flow for many years ahead, and discount it back to today at an appropriate cost of capital
In practice, several different valuation methods will be used, to check reasonableness

6. Balance sheet methods of valuation
Balance sheets are backward-looking
Historic cost convention distorts values
Intangible assets are only included if they were acquired
Debt can be stated at market value rather than the sums owing
Accounting policies can vary considerably
For most businesses, the balance sheet does not provide a useful valuation mechanism

7. Discounted cash flow valuation using WACC
The value of the company represents the present value of the future cash flows it is expected to generate
Determine a suitable time frame
Calculate Free Cash Flow over that period
Operating profit, adding back depreciation and amortization (EBITDA)
Less tax
Less expenditure on fixed assets
Add/less changes in working capital
Determine a Terminal Value
Discount these cash flows at an appropriate rate
Normal to use Target WACC
Add in the value of non-operating assets
This gives the Enterprise Value
Deduct net debt
This gives the Equity value

8. Terminal value
Take an initial period for which you can reasonably forecast
10 years?
At the end of that period assign a Terminal Value
Based on assets?
Based on a multiple of profits?
Based on cash flow as a perpetuity?
[cash flow  discount rate]
Based on cash flow as a growing perpetuity?
[cash flow  (discount rate – growth rate)]
Other??
It is helpful in valuation to use several different methods for terminal value, as they will all give different answers

9. Perpetuity growing at g% per year
Terminal value
Free cash flow
Perpetuity growing at g% per year
FCFn
Perpetuity n
Time
Initial period
Perpetuity value is FCFn ÷ Discount rate
Growing perpetuity value is (FCFn x (1+g) ÷ (Discount rate – g)

10. Valuation on multiples
Valuation on multiples compares a company with peers whose market value is known, and values on a comparative basis
Valuation on a P/E basis compares the eps of companies with their share prices
For the whole company, this is net income and market capitalization
Valuation on other multiples can eliminate differences due to capital structures
Enterprise value is calculated and compared with EBIT, or EBITA, or EBITDA
Valuation on multiples can be done on a historic or prospective basis
The income figures used should be ‘sustainable’, adjusted for one-off items affecting a year’s results

11. Valuation on multiples – generic equations
Valuecomparators = (Average profit)comparators x (Average multiple)comparators
Therefore, for our target company in the same business we can assume that
Valuetarget = (Profit)target x (Average multiple)comparators

12. Problems with valuation on multiples
It is difficult to find true comparator companies
Sustainable profit levels might be difficult to determine, for the target company or the comparators
Market values might not be ‘correct’
E.g. during the dot.com bubble, or if there is low trading liquidity

13. Valuing a loss-making business
Why do you want to buy this company?
That might give you an idea where the future value is coming from
Assets basis
If it’s never going to make profits, just break it up and sell the assets separately
Multiples basis
Valuation on multiples is about future sustainable profits. Can you see such profits arising? If so, maybe do a valuation on multiples for, say, 3 years’ time when you expect profits to arise, and then discount that sum back to today
DCF methods
Probably the most useful – forces you to examine the underlying cash flow forecasts and see if/when/how the company will start generating profits

14. Forecasting

15. Process of forecast preparation
Determine the reason for the forecast and the required timescale
Obtain the supporting data
Revise assumptions and forecasts as the picture becomes clearer
Prepare the forecast
Analyse the forecast
Do a sensitivity analysis

16. Triangulate the forecasts
Income statement
Triangulation is necessary but not sufficient to ensure sensible forecasts
Cash flow forecast
Balance sheet

17. The declining base case
Trajectory if we undertake investment
Current trajectory for the business
Trajectory if we fail to invest

18. Sensitivity analysis
Change each input individually by a certain amount
Reverse-engineer the forecast to determine tolerance on each input
Prepare several different scenarios
Monte Carlo analysis

19. Changing forecast drivers
Some examples of changes to explore
Sales volumes
Decrease or increase by x%; slow (or accelerate) the sales growth plan by one year, or two years; change the rate of growth of the market as a whole, or the market penetration rate.
Profit margin
Change input costs individually; assume selling prices fall over time; assume that production costs or expenses change in a different pattern to that anticipated; look at the effect of a movement in the ratio of fixed and variable costs.
Tax rate
Flex the tax rate.
Working capital
Change the assumptions for inventory days, and debtor or creditor terms.
Capital expenditure
Examine the impact of price changes in the future, and of delaying or bringing forward capacity changes. Consider the impact of leasing rather than buying.
Timescale of competitive advantage
Run the forecast for one year more, or one year fewer, to see the impact. Change the terminal value assumptions in a DCF analysis.
Cost of capital
Flex the cost of capital. Change the timing of interest payments and loan repayments where appropriate in a forecast to evaluate funding requirements.

20. Some common psychological biases
Anchoring
Framing
Over-optimism
Over-confidence
Representativeness
Cognitive dissonance
Confirmation bias
Ambiguity avoidance