CEF Course_Firm Valuation (MSc_BF) 2024 PDF

Module Corporate & Entrepreneurial Finance Firm Valuation: DCF Methods Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Content and Learning Objectives Content Objectives Discounted Cash Flow Analysis 1...

Module Corporate & Entrepreneurial Finance Firm Valuation: DCF Methods Building Competence. Crossing Borders. Prof. Dr. Mehdi Mostowfi [email protected] Content and Learning Objectives Content Objectives Discounted Cash Flow Analysis 1. Refresh your knowledge on the DCF methodology 2. Know how to apply the DCF methodology and how to collect the required input data for public and privately owned companies 2 Agenda 1 Discounted Cash Flow Methods 2 Brenntag DCF Case 3  Discounted Cash Flow Methods Entity versus Equity Approach Entity versus Equity Approach Entity Approach (using WACC) Equity Approach 1.Step: Calculate the Enterprise Value (= Asset Direct calculation of Equity Value: Value) of the Company. Forecast “Equity Free Cash Flows“ defined as cash Forecast “(Entity-) Free Cash Flows“ flows after interest payments (taking into account the defined as cash flows before interest actual capital structure of the company). payments and after “adjusted taxes“ Discount “Equity Free Cash Flows“ with the cost of (assuming that the company is fully equity equity. financed). Usually applied when valuing stocks of financial institutions Discount Free Cash Flows with Weighted (banks and insurance companies). Average Cost of Capital (WACC) taking into account the capital structure of the company and the “tax shield“. 2. Step: Calculate Equity Value by deducting the value of debt (=Net Debt) from the Enterprise Value. Standard Approach to value companies across different sectors/industries (exception: financial institutions). 4 Entity DCF Method Cash Flows Available Interest for Distributions Payments Shareholders Company Debtholders Tax Adjustment Free Cash Flows Discounted by WACC Enterprise DCF Value – Net Debt Equity DCF Value 5 Entity Approach DCF-Method Two Stages Model Enterprise Value Discounting Free Cash Flows and (Future Value of) Terminal Value with WACC (k) (Asset Value) CF1 CF2 CF3 CF4 CF5 CFT CFT 1 1./. Net Debt    ...  (1 k)1 (1 k)2 (1 k)3 (1 k)4 (1 k)5 (1 k)T ( k  g ) (1  k ) T Equity Value = Fair Market Value 1 2 3 4 5...T t CFt : Projected Free Cash Flows „Terminal Value“ Analysing Historical Detailed Projections Stable Growth Stage Figures (Stage 1) (Stage 2) g: long term growth rate of CFT+1 Valuation Date T CFt CFT 1 /(k  g) DCF-Formula:   = Present Value of Free Cash Flows t 1 (1 k ) (1 k) t T 6 Calculation of (Entity-) Free Cash Flows Net Profit + Taxes + Net interest payments = Earnings Before Interest and Tax (EBIT) - Taxes on EBIT (“adjusted taxes“) [= EBIT * Tc] = Net Operating Profit Less Adjusted Taxes (NOPLAT) [= EBIT * (1-Tc)] + Depreciation +/- Increase/Decrease of Long Term Provisions (Non-Cash) Current Assets -/+ Increase/Decrease of Net Working Capital minus -/+ Capital Expenditure/Divestments Non-Interest-Bearing Debt = Free Cash Flow Note: The Free Cash Flow as defined above is an Unlevered Cash Flow because the calculation does not include an interest deduction and the tax calculation assumes all- equity financing. The Unlevered Cash Flow is not impacted by the capital structure. 7 Discount Rate Applied for the Entity DCF Method WACC (Weighted Average Cost of Capital) E D WACC : k   rE   rD (1  TC ) ( E  D) ( E  D) Equity ratio Debt ratio „Tax shield“ rE = Cost of Equity rD = Cost of Debt E = Market Value Equity D = Market Value Debt TC = Corporate Tax Rate Open issues 1) Using acquirer`s or target`s WACC? 2) How to determine the Equity and the Debt ratio 3) How to calculate the Cost of Equity rE? 8 Practical Solutions to the Circularity Problem Alternative Approaches 1 Use the Market Cap as proxy for the MV of Equity (for listed firms only) 2 Calculate Equity/Debt ratios based on a target capital structure 3 Use an iterative approach 9 Cost of Equity Calculation based on CAPM rE  rf   E (rM  rf ) Rf = Risk-free rate E = Equity (geared) Beta-faktor rM – rf = Expected market risk premium rE Security Market Line rf βE 10 Unlevering and Relevering of Betas Leverage has an impact on the beta factor of a company. Given an estimate of each firm’s equity beta (levered Beta), an unlevered beta based on the firm’s capital structure can be calculated. The unlevered beta is the beta of the company if it had no debt. The relationship between the beta of a levered firm (βL) and the beta of an unlevered firm (βU) is as follows: D  L  U [1  (1  Tc )] E We can also call βU as the beta of the total capital and βL as the beta of the equity. In practise “unlevering” and “relevering” is used to calculate the beta factor of a firm based on the beta factors of comparable companies. 11 Unlevering and Relevering Betas An Example We now would like to estimate the beta factor for the listed pallet transporter Friedhorst AG. The following table shows the capital structure and betas of comparable companies. In a first step, the betas of the comparable firms need to be “unlevered”: Comparable βL D/E Tc βU Company 1 1,21 1,5 30% 0,59 2 1,54 0,8 30% 0,99 3 1,05 0,55 30% 0,76 4 0,92 0,48 20% 0,66 5 0,86 0 20% 0,86 Average 0,77 Second Step: “Relever” the average βU of the comparable firms by using the leverage ratio (D/E) of Friedhorst AG which is 1.2 (market value based) and the tax shield of 30%:  LFried  0,77 *[1  1,2 * (1  30%)]  1,42 12 Projecting the Terminal Value Terminal Value Calculation: Projecting CFT+1 Projection of perpetuity growth CFT+1: Based on the Cash Flow of the last detailed projection period CFT  In simple, “quick and dirty” valuation models the general assumptions is CFT+1 = CFT*(1+g) or CFT+1 = CFT  More sophisticated valuation models apply a modified CF which is derived by adjusting CFT for non-recurring items  Value Driver Formula: Allows to calculate a Free Cash Flow based on long term average Capex assumptions which are in line with the growth assumptions CFT+1 = NOPLATT+1 *(1-g/ROIC), whereby NOPLATT+1 = NOPLATT*(1+g) To apply this formula the expected long term ROIC needs to be estimated. 13  Exercise 1: DCF Valuation of Eau de Cologne (1/2) The private German mineral water producer “Eau de Cologne“ is up for sale. Johnny Sprite, the European Head of Corporate Development at Loca Lola (a large multinational player in the beverages industry), is considering submitting a bid for “Eau de Cologne“. You are Loca Lola`s M&A adviser and get the assignment from Johnny Sprite to determine the stand-alone value for Eau de Cologne using the Discounted Cash Flow methodology. After an extensive three days due diligence exercise in Eau de Cologne`s data room Loca Lola`s management consultants provide you with the following financial projections for Eau de Cologne: (m EUR) 2024 2025 2026 2027 2028 CFT+1 EBIT 16 20 22 24 25 23 Depreciation and Amortisation 2 2 2,5 2,5 3 2,5 Net additions to Long Term Provisions 1,5 1,5 1,5 2 2 1 Increase in Net Working Capital -3 2 2 2,5 2,5 2,5 Capex 2,5 2,5 3 3 3,5 3 The yield for 10 ytm German government bonds is 3.5% and the market risk premium is estimated at 6%. The Beta-factor is calculated using the Betas of listed comparable companies (see information on the following slide). For the Terminal Value calculation you assume that the perpetuity growth cash flow grows at a rate of 2.5%. Eau de Cologne has net financial liabilities of 70m EUR with an average cost of debt of 5.2%. The company tax rate is 30%. (a) Calculate the (Entity-) DCF value of Eau de Cologne as of December 31st, 2023 assuming a debt-to-equity ratio of 0.333. (b) Compare the assumed capital structure with the capital structure implied by the results of the DCF-valuation. (c) Recalculate the DCF value using the value driver formula to determine CFT+1. For this purpose assume the following: Invested Capital as of Dec. 2021: EUR 130m. As an estimate for the Long term ROIC use the average of ROIC2026 and the WACC. 14 Exercise 1: DCF Valuation of Eau de Cologne (2/2) Comparable βE D/E-ratio Corporate Companies Tax Rate Babsy Co. 1.20 1.50 35% Sugardrinks Holdings 1.50 0.80 35% Selters Int. 1.05 0.55 25% San Perrier Co. 0.90 0.48 25% 15 Exercise 2: Questions on Free Cash Flow Calculation Which of the following statements regarding the calculation of free cash flows in the context of the Entity Discounted Cash Flow method is true/false: Statement True False Adjusted taxes, in the context of the free cash flow calculation, are lower than actual taxes payable by the firm. An increase in inventory compared to the previous year implies, ceteris paribus (all other things equal), a higher free cash flow in the current year. An increase in trade payables compared to the previous year implies, ceteris paribus (all other things equal), a higher free cash flow in the current year. The lower the interest expense, the higher ceteris paribus (all other things equal) the firm’s free cash flow. 16  Generating the Data to Arrive at Meaningful FCF Forecasts 1. Business Plan/Management Projections (as made available in the information memorandum and in the data rooom) - Might be used without any adjustments as a first step or a case in its own right (Management Case) - Prepare an adjused Management Case based on plausibility checks, peer comparison/benchmarking (financial reports of peer group companies, analyst reports) 2. If the target is listed: Analyst reports about the target (Analyst Case) 3. Your own assessment of the firm and the market (combined with 1 and 2)) supported by industry experts and Management Consultants and probed using analyst reports of target’s peers (Your Case) General recommendations: - Always start with the top line (meaning sales projections): top-down approach or a bottom-up approach - Project the COGS margin (look at the COGS margin in the past, and estimate future COGS margins considering potential changes in the product mix and efficiency gains in the future) - Next step: Projecting «fixed costs» like SG&A - Estimate NWC requirements (receivables, inventory and payables) as a function of revenues and cost of materials. Last point to estimate: Capex (based on the long term assets which are required to generate the planned revenues) 17 How to Estimate the WACC Problems in Sourcing the Data and Potential Solutions 1. Risk Free Rate Generally: YTM of (zero coupon) long term government bonds with a maturity of at least 10 years (preferably>=30 years, if available) Source: Bloomberg, Reuters et al.; if you use the observed yield of government bonds: make sure that they apply to zero bonds (adjustment with the Svensson method) 2. Beta Factor - Regression Analysis using the historical returns of the target (if the firm is listed) - Average asset beta of peer group companies and relevering the beta (preferred approach, even if the target firm is listed, because it is a better estimator for the future beta of the target firm) Sources: Bloomberg, Reuters etc., if you use peer group betas, it is recommendable to use pure and not adjusted betas, Damodaran industry betas 3. Market risk premium - Historical risk premium (requires very long historical periods, 40 to 100 years, and is of course very sensitive to what historical period has been used; whether you use arithmetic or geometric averages has also a significant impact on the result). - Implied market risk premia: DCF Value = Current Market prices of stocks in the index, solved for the market risk premium (very sensitive to the FCF/analyst estimates that you use) Sources: Research papers (empirical studies), guidelines of the firm (investment bank or professional services firm) your are working for, Damodaran.com 4. Cost of debt calculation: - YTM of long term bonds issued by the target firm (in theory: apply an expected loss to the ytm; in practice this is not done because it is difficult to estimate the expected loss) - YTM of long term bonds issued by peer group - Calculation based on interest expense and average debt in the B/S 5. Capital structure assumptions for the WACC calculation: see slide 9 18 Agenda 1 Discounted Cash Flow Methods 2 Brenntag DCF Case 19 Case Study: DCF-Valuation Brenntag AG (pre-IPO) You are a buyside research analyst working at the Asset Management Company Fraudility LLC. Given the planned IPO of the German chemical distribution company Brenntag in a couple of weeks (in early 2010) Fraudility‘s chief investment offiicer has asked you to prepare a DCF valuation model for the purpose of deciding whether or not to subscribe Brenntag‘s shares in the forthcoming IPO (valuation date: 31.12.2009). You decide to use the company report prepared by HSBC (one of the syndicate banks advising Brenntag on the IPO) as a basis for your valuation model. 1. Replicate HSBC‘s Free Cash Flow projections by completing the missing data in the Excel Sheet Template Brenntag IPO. 2. Model the WACC as a function of its variables (cost of equity, cost of debt, equity and debt ratio, tax rate) using HSBC‘s assumptions (already entered in the excel sheet) first. 3. Model the DCF value (Enterprise and Equity Value) of Brenntag based on the assumptions specified above. 4. Replace HSBC‘s assumptions for the risk free rate, the market risk premium, the beta factor and the cost of debt by empirical figures as of today. For the beta estimation use the average industry beta (for the European Chemical Diversified sector) from Aswath Damodaran‘s website. 5. Prepare a valuation matrix for the DCF Equity Value using a terminal growth rate range from 0.0% to 3.0% and a WACC range from 7% to 9% (0,5%-increments). 20