Valuations and Forecasting in Corporate Financial Strategy

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

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 2 Corporate Financial Strategy

Learning objectives 1. Apply the three main methods of valuing a company assets, multiples, and discounted cash flow. 2. Appreciate the advantages and disadvantages of each method of valuation, and the need for sensitivity analysis. 3. Explain why a suite of forecasts needs to comprise an integrated income statement, cash flow, and balance sheet. 4. Question the assumptions underlying any forecast by understanding some common behavioural biases. 3 Corporate Financial Strategy

Valuing companies 4 Corporate Financial Strategy

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

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 6 Corporate Financial Strategy

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 1. Determine a suitable time frame 2. 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 3. Determine a Terminal Value 4. Discount these cash flows at an appropriate rate Normal to use Target WACC 5. Add in the value of non-operating assets This gives the Enterprise Value 6. Deduct net debt This gives the Equity value 7 Corporate Financial Strategy

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 8 Corporate Financial Strategy

Terminal value Free cash Perpetuity growing at g% per year flow FCFn Perpetuity Time 0 n Initial period Perpetuity value is FCFn Discount rate Growing perpetuity value is (FCFn x (1+g) (Discount rate g) 9 Corporate Financial Strategy

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 10 Corporate Financial Strategy

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 11 Corporate Financial Strategy

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 12 Corporate Financial Strategy

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 13 Corporate Financial Strategy

Forecasting 14 Corporate Financial Strategy

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

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

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

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

Changing forecast drivers Some examples of changes to explore 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. Sales volumes 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. 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. Capital expenditure Timescale of competitive advantage Cost of capital Run the forecast for one year more, or one year fewer, to see the impact. Change the terminal value assumptions in a DCF analysis. Flex the cost of capital. Change the timing of interest payments and loan repayments where appropriate in a forecast to evaluate funding requirements. 19 Corporate Financial Strategy

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