1. Overview of Corporate Valuation Techniques

2. 1 Overview of the session  Introduction  Discounted Cash Flow (DCF)  Trading Multiples (or market multiples)  Comparable deals

3. 2 Valuation skills are critical in most of Morgan’s businesses  M&A  Investment Banking  Equity Capital Markets  Principal investing  Equity derivatives  Global Credit  Asset Management

4. 3 Probing for evidence of analytical skills is a primary interview objective  Investment banking involves a great deal of modeling, forecasting, and valuation work  Investment bank interviewers typically ask questions about valuation techniques or finance transactions – e.g. “You are advising a large technology company on an acquisition of a smaller niche technology company. What are the issues you would consider in valuing it? How would you estimate its value?”

5. 4 General themes of this session  There is not one right way to value a firm – Consultants almost always evaluates DCF, trading values, and comparable transactions – Other techniques are appropriate in selected situations (dividend discount model, leveraged value, liquidation value) – Understanding differences between various valuation techniques is often critical to the appropriate decision

6. 5 Overview of the session  Introduction  Discounted Cash Flow (DCF) Value based on estimated future cash flows of a company discounted by a rate that reflects the risk of its business and capital structure  Trading Multiples (or market multiples)  Comparable deals

7. 6 Discounted cash flow analysis has three key components  Forecasted free cash flows – Cash flows before debt service or distributions to shareholders  Terminal value – Estimate of future value at “stable state”  Cost of capital – Represents current return requirements of debt and equity holders – Reflects target capital structure on a market weighted basis

8. 7 Projecting cash flows requires in-depth understanding of the business  Industry outlook – Anticipated industry growth – Major opportunities/risks  Competitive position – Pricing flexibility – Possible market share changes – Cost structure  Reinvestment needs – Working capital – Required capital expenditures – Discretionary investments  Expansion opportunities – New product/stores/format – Development costs – Economies of scale

9. 8 Defining free cash flow  Free cash flow is the cash that remains after all necessary reinvestments have been made  Free cash flow is measured prior to any debt service (interest and debt repayment), but after taxes  Free cash flow therefore is the amount of cash that can be distributed to shareholders and creditors  Free cash flow is typically defined as:

10. 9 The terminal value must also be estimated in a DCF valuation  Terminal Value is the portion of a company’s total value that can be attributed to cash flows expected in the period beyond the specific forecast period  The terminal value period is the time from the end of the specific forecast period to infinity  Terminal value should be estimated when the forecast reaches “steady state” – Long-term assumptions have stabilized – Little added value to forecasting more years – Usually around ten years  The terminal value is equivalent to making infinite year-by-year forecasts

11. 10  Perpetuity model  Price multiples (i.e., P/E ratios, EBIT multiples, market value/book value, etc.)  Liquidation value – for projects with a limited life which will not generate cash flows forever Different methods of determining a terminal value ___FCF___ (1 + WACC) FCF (1+g) (1 + WACC)² FCF (1+g)² (1 + WACC)³ Terminal value +=++...+ FCF WACC - g = FCF (1+g) (1 + WACC) n n-1 g = growth rate in perpetuity WACC = weighted average cost of capital FCF = free cash flow in terminal value year (year after last projected period) Where...

12. 11 The discount rate applied to free cash flows reflects several key factors  Cost of equity  Cost of debt  Target capital structure

13. 12 The cost of equity is the major component of the discount rate  The cost of equity reflects the long-term return expected by the market (dividend yield plus share appreciation)  J.P. Morgan, McKinsey and PwC always estimate the cost of equity using the capital asset pricing model (“CAPM”) – Risk-free rate based on government securities – A market-wide equity risk premium adjusted for the specific risk of the investment under consideration

14. 13 The CAPM has several components

15. 14 The cost of equity and debt are blended together based on a target capital structure  The target reflects the company’s rating objective – Firms generally try to minimize the cost of capital through the appropriate use of leverage  The percentage weighting of debt and equity is usually based on the market value of a firm’s equity and net debt position – Most firms are at their target capital structure – Adjustments should be made for seasonal or cyclical swings, as well as for firms moving toward a target  Using a weighted average cost of capital assumes that all investments are funded with an equal mix of equity and debt

16. 15 The cost of equity and debt are blended together based on a target capital structure  [ (D/(D+E)) x (k d (1-t)) ] + [ (E/(D+E)) x k e ]  EXAMPLE

17. 16 The three elements are pulled together to derive a value  The forecasted free cash flows and the terminal value are discounted by the weighted average cost of capital  The present value of these cash flows is an estimate of Firm Value, i.e. the value of the entire enterprise  The value of claims held by debt holders and preferred stock holders must be deducted to arrive at an estimate of Equity Value

18. 17 Overview of the session  Introduction  Discounted Cash Flow (DCF)  Trading Multiples (or market multiples) Estimate of the value at which a firm should publicly trade in today’s market based on the multiples of similar firms  Comparable deals

19. 18 Multiples analysis looks to the market for guidance on value  Multiples are ratios of total value to certain operating metrics such as earnings or cash flow  An example is the widely-used P/E ratio – Quoted market price= $24 – Earnings per share= $2.00 – P/E = 12 x  Multiples are useful because they allow us to normalize for differences in size

20. 19 Multiples analysis can be broken down into a 7-step process 1. Identify the peer group 2. Select appropriate multiples 3. Perform financial analysis on peers and establish values for ratios 4. Calculate summary multiples for peer group 5. Apply summary multiples to TargetCo’s forecasted results, derive values 6. Adjust implied values for debt & cash, establish equity value range 7. Assess position of TargetCo within value range

21. 20 The basics of trading multiples  Understand the company you are valuing  Understand its industry factors  Develop as similar a peer group as possible – Quantitative factors – Qualitative  Check for data errors – Whether done by hand, or using an automatic model which pulls in data and generates multiples, always check for mistakes  Review several multiples – Different multiples are important for different industries

22. 21 Trading multiples that are typically used 1 Operating profit before interest and taxes 2 Operating profit before interest, taxes, depreciation and amortization of goodwill 3 EBIT is often substituted for operating profit. This substitution does not create a problem unless interest income is significant 4 Net income projected by brokerage firms for the current fiscal year 5 Calculated using estimates for fiscal year one (current year) and fiscal year two

23. 22 Why trading values can differ from DCF  Market may view the firms’ outlook differently (different implied forecast)  Discounts – Lack of liquidity – IPO/Spin-off – Conglomerate  Supply/demand imbalance  Difference in capital structure  Company doesn’t distribute all of its free cash flow to shareholders  Option value  Acquisition speculation  Event risk

24. 23 Overview of the session  Introduction  Discounted Cash Flow (DCF)  Trading Multiples (or Market Multiples)  Comparable deals - Estimate value based on what buyers have paid for 100% of similar firms in the past

25. 24 Comparable deals analysis is usually problematic  Often a limited number of transactions  Dated information – Stock market has changed – Business has changed – Financing has changed – Bidders have changed  Missing data – Earnings usually unavailable on subsidiary transactions  Hard-to-find data

26. 25 Why bother with comparable transactions?  Important part of “deal-speak”  Our clients typically want to know deal history  Our competition will certainly provide this – Premium needed in the past to win bidding – Valuation techniques used by buyers – List of likely buyers – Bidding strategies  Industry-specific multiples can be important  Often necessary information for Board of Directors, fairness opinions, etc.

27. 26 Example of a comparable deals list Transaction multiples

28. 27 Valuing target based on transaction multiples Average multiples Median multiples JustLikeYou Inc. Valuation Summary 362 655 430 320 342 326

29. 28 When can transaction values differ from DCF  Cost of capital differences – Buyer may have a lower cost of capital  High level of synergies – Revenue enhancements – Cost savings  Cross-border – Differences in capital costs, tax rules, repatriation levels, etc.  Differences in view of the future – Buyer may have a dramatically different view of the future than the market Other strategic reasons -Buy vs. build -Platform for other investments -Defensive acquisitions

30. 29 Conclusion  There is not one right way to value a firm – Morgan almost always evaluates DCF, trading values, and comparable transactions  Understanding differences between various valuation techniques if often critical to the appropriate decision

31. 30 Preliminary analysis is summarized for the client by indicating a value range Share price as of [date] Total equity value US$ millions Comparable trading analysis – Base case – Aggressive case – Conservative case Discounted cash flow analysis Comparable transaction analysis

32. 31 Summary of valuation methodologies  Analysis of purchase prices of selected transactions  Can be difficult to draw conclusions due to dissimilarities in transactions  May provide insights into acquisition strategy of potential competing buyers/industry peers  Includes control premium Selected transaction multiples analysis Discounted cash flow (“DCF”) analysis  Preferred measure of intrinsic value  Present value of free cash flows to debt and equity holders  Incorporates both short-term and long-term expected performance  Risk in cash flows and capital structure captured by discount rate  Free cash flow incorporates future requirements to reinvest in working capital and fixed assets  Provides ability to separate sources of value – Business by business – Standalone value vs. synergies Selected trading multiples analysis  Analysis of how selected companies trade relative to business being valued  Applied using historical and prospective multiples  Key multiples include [price/earnings] and [firm value/EBITDA]  Does not include a control premium