Valuation I 2023-24 PDF

VALUATION I Pr. Antoine RENUCCI 1 Valuation Learning Objectives: 1. Use Comparables to Value Projects , Recognize the Caveats of the method regarding Start-Ups. 2. Compute the DCF, Recognize the Caveats of the method regarding Start-Ups. A. Renucci, Paris-Dauphine 2023-24 2 Valuation Learnin...

VALUATION I Pr. Antoine RENUCCI 1 Valuation Learning Objectives: 1. Use Comparables to Value Projects , Recognize the Caveats of the method regarding Start-Ups. 2. Compute the DCF, Recognize the Caveats of the method regarding Start-Ups. A. Renucci, Paris-Dauphine 2023-24 2 Valuation Learning Objectives: 1. Use Comparables to Value Projects. A. Renucci, Paris-Dauphine 2023-24 3 1) COMPARABLES Comparables provide a quick and easy way to obtain a “ballpark” valuation for a firm. Suppose that in the food-processing industry, firms are worth 10 times the volume of their sales. Then, if Danone exhibits 35,740,000,000 of sales, its market value is $ 357,400,000,000. A. Renucci, Paris-Dauphine 2023-24 4 STEPS  1.1 Step 1: Identify firms with similar characteristics: - Risk, - Growth rate, - Capital structure, - Size and timing of cash-flows. A. Renucci, Paris-Dauphine 2023-24 5  1.2 Step 2: Identify ratios ….. In public markets, common ratios are: - Share price divided by the earnings per share (the P-E ratio), - Market value of the firm’s equity divided by the shareholder’s equity on the balance sheet (market-to-book ratio), - Market value of the firm divided by total revenue. A. Renucci, Paris-Dauphine 2023-24 6 Firm Value or Equity Value? DEBT ASSETS EQUITY Interests Dividends Revenue (sales) Earnings A. Renucci, Paris-Dauphine 2023-24 7  1.3 Step 3: Just Multiply !!! For example: Implied Market Value of equity of Ford = Price Earnings Ratio of (General Motors + VW)/2* Ford’s Earnings A. Renucci, Paris-Dauphine 2023-24 8 Case: Paul Falk, CEO of Chipgen, would like to assess the value of his biotech company. He uses as a benchmark data from two competitors (public firms). Data are for the 2011 financial year ($ million). These firms have no debt. Sales Earnings Book value Geniusgen Caregen 200 385 25 70 50 110 Market Value/Sales Market to book ratio Price-Earnings ratio Chipgen Implied Value Geniusgen Caregen Average ($m) 2 4 3 69 8 14 11 66 16 22 19 na A. Renucci, Paris-Dauphine 2023-24 Chipgen 23 -1 6 9  1.4 Problems Accounting-based comparables are … less suitable where companies are often unprofitable and experiencing rapid growth. One must therefore look for other sensible measures of value: - Internet business: number of subscribers enrolled by a firm, - Biotechnology firm: number of patents awarded, = non-financial, industry-specific measures. A. Renucci, Paris-Dauphine 2023-24 10 -Difficult to ascertain what valuations have been assigned to other privately held firms. Key ratios may not be calculable because accounting and other performance information on private firms are often unavailable 11 -Use of public market comparables to value private companies Because shares in private firms are less marketable than those of publicly traded firms, it may be appropriate to apply a discount for liquidity. Size of the proper discount will depend on the particular circumstances. Between 25% and 30% in practice . Average value for Chipgen: 67.7 m => 45 m A. Renucci, Paris-Dauphine 2023-24 - Valuations assigned to comparable firms may be misguided: Periodically, whole classes of firms have been valued at prices that seem unjustifiable on a cash-flow basis A. Renucci, Paris-Dauphine 2023-24 12 Valuation Learning Objectives: 1. Use Comparables to Value Projects, Recognize the Caveats of the method regarding Start-Ups. 2. Compute the DCF, Recognize the Caveats of the method regarding Start-Ups. A. Renucci, Paris-Dauphine 2023-24 13 2) DISCOUNTED CASH FLOWS DCF = CF0 + [CF1 / (1 + r)1] + [CF2 / (1 + r)2] +… ..+ [(CFT + TVT ) / (1 + r) T] … even though start-ups may present characteristics that render this computation difficult A. Renucci, Paris-Dauphine 2023-24 14 Firm Value or Equity Value? DEBT ASSETS EQUITY Interests Dividends Revenue (sales) Earnings A. Renucci, Paris-Dauphine 2023-24 15  2.1 Step 1: Compute the Cash-Flows CF t = EBIT t * (1 -  ) + DEPR t - CAPEX t - NWC t + othert where: CF EBIT DEPR = = = = Cash flow Earnings before interest and tax corporate tax rate Depreciation CAPEX = Capital expenditures  NWC = Increase in net working capital other =  in taxes or wages payable, etc.  (1) 16 A. Renucci, Paris-Dauphine 2023-24 Why correct for DEPR t As of Dec. 2016: Sales (registered) : $100 Costs including DEPR($10): $50 Financial statements Cash Flows Revenues $100 + $100 Costs (exc. DEPR) $40 (-) $40 DEPR $10 (-) $0 EBIT $50 Taxes (40%) $20 (-) $20 Profits $30 Net $40 17 Financial statements Cash Flows Revenues $100 + $100 Costs (exc. DEPR) $40 (-) $40 DEPR $10 (-) $0 EBIT $50 Taxes (40%) $20 (-) $20 Profits $30 Net $40 DEPR Cash flows = (+) $10 EBIT (1-t) + DEPR 18 18 $50 (1-40%) +10 = $40 A. Renucci, Paris-Dauphine 2023-24 Why correct for NWC t As of Dec. 2016: Sales (registered) : $100 Payments by clients: $50 Costs: $50 Financial statements Cash Flows Revenues $100 + $50 Costs $50 (-) $50 EBIT $50 Taxes (40%) $20 (-) $20 Profits Net $(-)20 $30 19 Financial statements Cash Flows Revenues $100 + $50 Costs $50 (-) $50 EBIT $50 Taxes (40%) $20 (-) $20 Profits Net $(-)20 $30 20 Variation of net working capital Cash flows = (+) $50 $50 (1-40%) -50= $(-)20 EBIT (1-t) – Var NWC A. Renucci, Paris-Dauphine 2023-24 By December 2016, Jersey Inc. will invest $5 million in plant and equipment. Capital expenditures will amount to $6 million in December 2017. Capital expenditures are depreciated the year following the investment. The tax rate is 40%. Net working capital is expected to increase by $1 million in 2017, $2 million in 2018, and $2,5 million in 2019. The growth rate of the cash flows is expected to be 5% after 2019. Jersey Inc. has $10 million debt interest payments in 2017 and 2018, and $5 million in 2019. Financial projections are summarized below (end-of-year values). Revenues Costs EBIT 2017 180 320 -140 2018 500 397,5 102,5 A. Renucci, Paris-Dauphine 2023-24 2019 600 467,5 132,5 21 - Discounted Cash-Flow computation: 2016 2017 EBIT Tax -140 A. Renucci, Paris-Dauphine 2023-24 2018 2019 102,5 132,5 22 - Discounted Cash-Flow computation: 2016 2017 EBIT Tax Cap Expenditures Depreciation -140 0 A. Renucci, Paris-Dauphine 2023-24 2018 2019 102,5 132,5 0 38 23 - Discounted Cash-Flow computation: 2016 EBIT Tax Cap Expenditures Depreciation investment in NWC 2017 5 A. Renucci, Paris-Dauphine 2023-24 -140 0 6 5 1 2018 2019 102,5 0 120 38 6 2 2,5 24 - Discounted Cash-Flow computation: 2016 EBIT Tax Cap Expenditures Depreciation investment in NWC Net Cash-Flow 2017 5 -5 A. Renucci, Paris-Dauphine 2023-24 -140 0 6 5 1 -142 2018 2019 102,5 132,5 0 38,0 6 2 106,5 2,5 92 25 2.2 Step 2: Calculate the Terminal Value Equation (2) gives the formula for calculating a terminal value (TV) at time T using the perpetuity method: TV T = [ CF T * (1 + g)] / (r - g) where: g = Growth rate in perpetuity r = Discount rate ( r > g !!). (2) TV T = [ 92 * (1 + 5%)] / (r – 5%) We need r! A. Renucci, Paris-Dauphine 2023-24 26  2.3 Step 3: Determine the Discount Rate … Using the Weighted Average Cost of Capital (WACC) formula: r = (D / V) * r d * (1-  ) + (E / V) * r e where:  D E V rd re = = = = = = (3) Corporate tax rate Value of debt Use target values for D, E Value of equity and V if the firm is not at its target capital structure! D+E Discount rate for debt Discount rate for equity 27 A. Renucci, Paris-Dauphine 2023-24 Example (cont’d): The tax rate is 40%. The risk-free rate is 8%, while the market risk premium amounts to 9%. The pre-tax rate of return on debt is 10%. The target financial structure is 50% debt and 50% equity (2020-21). The target B is 1.5. r= 28 A. Renucci, Paris-Dauphine 2023-24  2.4 Step 3: Compute the Expected Rate of Return on Equity … Using the Capital Asset Pricing Model (CAPM): E(r e) = r f +  * [E(r m) - r f ] (4) Where rf rm = = Risk-free rate Market rate of return E(r m) - r f = = Market risk premium Beta  29 A. Renucci, Paris-Dauphine 2023-24 re= r= TV T = 30 A. Renucci, Paris-Dauphine 2023-24  2.5 Step 4: Calculate the NPV Combining Equation (1) with Equations (2), (3), and (4), and using Equation (5’) if necessary, allows to compute the NPV: DCF = CF0 + [CF1 / (1 + r)] + …. ...+ [(CFT + TVT ) / (1 + r) T] = - 5 - 142 / (1.1375) + 106.5 / (1.375)2 + 92 / (1.375)3 + 1092 / (1.375)3 31 A. Renucci, Paris-Dauphine 2023-24 … and don’t forget a sensitivity analysis (i.e. try different values for the parameters) !!! Sensitivity analysis: Costs (-) 10% 0 (+)10% (-) 10% 808,00 678,00 434,00 Revenues 0 980,00 760,00 560,00 (+)10% 2 300,00 1 450,00 657,00 32 A. Renucci, Paris-Dauphine 2023-24  2.6 Step 3: If Necessary, Compute the Relevant  If the firm is not at its target capital structure, it is necessary to “unlever” and “relever” the beta. To simplify, forget about taxes (for full formula, see the Corporate Finance Course, 2nd term) - Unlever:  u =  L * [E / (E + D)] (5) where: u = Unlevered beta L = Levered beta 33 A. Renucci, Paris-Dauphine 2023-24  2.6 Step 3: If Necessary, Compute the Relevant  To simplify, forget about taxes (for full formula, see the Corporate Finance Course, 2nd term) -Relever the beta: ’ =  u / [E’ / (E’ + D’)] (5’) where: u = Unlevered beta ’ = Target beta E’ = Target Value of equity D’ = Target Value of debt 34 A. Renucci, Paris-Dauphine 2023-24 Example (cont’d): The tax rate is 40%. The risk-free rate is 8%, while the market risk premium amounts to 9%. The pre-tax rate of return on debt is 10%. The current B is 1. The current financial structure is 25% debt and 75% equity. The target financial structure is 50% debt and 50% equity (2020). 35 A. Renucci, Paris-Dauphine 2023-24 - Unlever:  u =  L * [E / (E + D)] u= -Relever the beta: ’ =  u / [E’ / (E’ + D’)] ’ = Our « target » beta 36 A. Renucci, Paris-Dauphine 2023-24  2.7 Some Problems Even with these steps, the DCF method still has some drawbacks: - Lack of comparable companies - to find the current , - to estimate the target capital structure. A valid comparable company should have financial performance, growth prospects, and operating characteristics similar to those of the company being valued. A public company with these characteristics may not exist. 37 A. Renucci, Paris-Dauphine 2023-24 - Terminal value sensitivity Typical start-up company cash-flow profile (large initial expenditures followed by distant inflows)  the bulk of the value is in the terminal value (TV). TVs are very sensitive to assumptions about both discount and terminal growth rates. - Is beta is the proper measure of firm risk? Numerous studies suggest that firm size or the ratio of book-tomarket equity values may be more appropriate. Few have tried to implement these suggestions in a practical valuation context. A. 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