Chapter 14 Valuations and forecasting

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Chapter 14Valuations and forecasting

Corporate Financial Strategy

4th edition

Dr Ruth Bender

Valuations and forecasting: contentsLearning objectives

Valuing companies – header slide

Three approaches to company valuation

Balance sheet methods of valuationDiscounted cash flow valuation using WACCTerminal value (narrative)Terminal value (graph)Valuation on multiplesValuation on multiples – generic equationsProblems with valuation on multiplesValuing a loss-making business

Forecasting – header slideProcess of forecast preparationTriangulate the forecastsThe declining base caseSensitivity analysisChanging forecast driversSome common psychological biases

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Learning objectivesApply

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.

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Valuing companies

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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

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Balance sheet methods of valuationBalance sheets are backward-lookingHistoric 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 considerablyFor most businesses, the balance sheet does not provide a useful valuation mechanism6

Discounted cash flow valuation using WACC

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 The value of the company represents the present value of the future cash flows it is expected to generate7

Terminal valueTake 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

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Terminal value

Time

Free cash flow

Initial period

Perpetuity growing at g% per year

Perpetuity

0

n

Perpetuity value is FCF

n

÷ Discount rate

Growing perpetuity value is (FCF

n

x (1+g) ÷ (Discount rate – g)FCFn

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Valuation on multiplesValuation on multiples compares a company with peers whose market value is known, and values on a comparative basisValuation 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 EBITDAValuation on multiples can be done on a historic or prospective basisThe income figures used should be ‘sustainable’, adjusted for one-off items affecting a year’s results10

Valuation on multiples – generic equationsValue

comparators

= (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

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Problems with valuation on multiplesIt is difficult to find true comparator companiesSustainable 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

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Valuing a loss-making businessWhy 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 separatelyMultiples basisValuation 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 todayDCF methodsProbably the most useful – forces you to examine the underlying cash flow forecasts and see if/when/how the company will start generating profits

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Forecasting

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Process of forecast preparation15

Determine the reason for the forecast and the required

timescale

Obtain the supporting data

Prepare the forecastAnalyse the forecastDo a sensitivity analysis

Revise assumptions and forecasts as the picture becomes clearer

Triangulate the forecasts16

Triangulation is necessary but not sufficient to ensure sensible forecasts

Income statement

Cash flow forecast

Balance sheet

The declining base case17

Current trajectory for the business

Trajectory if we undertake investment

Trajectory if we fail to invest

Sensitivity analysis18

Changing forecast drivers19

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 expenditureExamine 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 advantageRun 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 capitalFlex the cost of capital. Change the timing of interest payments and loan repayments where appropriate in a forecast to evaluate funding requirements.

Some common psychological biases20