Palmer WU law school ppt business valuation

Valuation ModelsAsset Based Valuation Discounted Cashflow Models Relative Valuation Contingent Claim Firm Valuation Models Cost of capital approach APV approach Excess Return Models Sta

An overview of the art of business valuation – determining a range of values

for operating businesses

Robert D Palmer

Co-founder and Managing Director

Expectations regarding future growth

and interest rates are imputed in current market multiples; combining future expectations with unknown

business performance create substantial levels of variability/risk

There are no precise valuations

Industry specific knowledge, substantial due diligence, quality

management and the use of talismans (lucky charms) can mitigate this risk

Why merge or acquire another firm?

Results –

Most mergers fail to meet expectations!

„ Post-merger “success” defined as earnings on

invested funds > cost of capital

„ McKinsey & Co estimates 61% fail while only 23% succeed

Why do mergers fail?

synergies not realized

“Would you please elaborate on

‘Then something bad happened’.”

Sources of complexity in valuation

„ The inconsistent nature of accounting standards

„ Inconsistency in applying accounting principles (Operating leases, R&D etc.)

„ Fuzzy Accounting Standards (One-time charges, hidden assets)

„ Complex types and mixes of businesses

„ Multiple businesses (Eg GE)

„ Multiple countries (Eg Coca Cola)

„ Structuring of businesses

„ Creative holding structures

Sources of complexity in valuation

„ Control Issues

Over my career when I sensed there were problems with a deal, when we dug into the issues No matter how bad things I thought things were, the reality was

always worse

James Quella The Blackstone Group

Approaches to Company Valuation – in

the order TGMG performs them

1 Relative Value (Comparables/Ratio Analysis) – quick

and dirty, will they sell?

2 Book Value/Asset Value – less quick and dirty, need

financials to perform

3 Option Value/Contingent Claim Analysis – nebulous,

inherent in high risk deals

4 Net Present Value Approach (NPV) – imprecise

measure, the reality check - Do we want to buy it?

Valuation Models

Asset Based

Valuation

Discounted Cashflow Models

Relative Valuation Contingent Claim

Firm Valuation Models

Cost of capital approach

APV approach

Excess Return Models

Stable Two-stage

Option to expand

Option to liquidate

Reserves

Young firms

Undeveloped land

Equity in troubled firm

Dividends

Free Cashflow

to Firm

Aswath Damodaran

Very short time horizon

Long Time Horizon

Liquidation value Discounted Cashflow value

Investor Time Horizon and Valuation Approaches

Option pricing models

Relative valuation

Markets are correct on

average but make mistakes

on individual assets

Discounted Cashflow value

Views on market and Valuation Approaches

Option pricing models Relative valuation

Markets make mistakes but correct them over time

Asset markets and financial markets may diverge

Liquidation value

Aswath Damodaran

EBITDA Valuation - Example

ABC Widget Manufacturing:

„ EBITDA = $5 million

„ Value of debt = $2 million Comparable company: XYZ Widget Manufacturing:

„ EBITDA = $4 million

„ Value of debt = $3 million

„ XYZ recently sold for $20 million Value of XYZ:

„ Enterprise Value (EV) = $20 million

„ Total Enterprise Value (TEV) = 20M + 3M = $23 million

If ABC and XYZ are comparable, they should trade at same TEV/EBITDA

„ Implied EV for ABC = 5 (x ebitda) * 5 (ebitda) = $25 million

„ TEV for ABC = 25M + 2M = $27 million

EV = Enterprise Value

TEV = Total Enterprise Value

Acquisition Multiples

„ Average total debt/EBITDA ratios increased 18.2% from 4.4x

in 2006 to 5.2x in 3Q07 for large corporate loans (1)

„ Average total debt/EBITDA ratios increased 12.5% from 4.8x

in 2006 to 5.4x in 3Q07 for middle market loans (1)

„ Due to the collapse of sub-prime lending and tight credit

conditions, covenant-lite, dividend recap, “Story” and 2nd lien junior debt deals as well as large LBO’s (>$50mm) have fallen out of favor with lenders

Demystifying Cash Flow Assumptions

  Sales Revenue (Less)  Cost of Goods Sold (COGS)   (Less)  Selling, General and Administrative (SG&A) 

How to compute comparables:

1 Start with a sample of securities whose business characteristics are similar to the company being valued.

2 Assume that the company has similar financial ratios to the “comparable” companies

3 A number of different ratios are typically used: Price/Earnings, Market/Book, Market Value/Sales, EBIT, Comparable Transaction

Comparables Approach relies on two primary assumptions:

flow expectations and risks similar to the

firm being valued

proportional to value

* total EBITDA X Enterprise Firm revenue (ttm) * EBITDA % * EBITDA (ttm) TEV Value

^ Mobile Mini & Williams Scotsman Revenue and Margin information derived from companies annual report 12/31/06

* Mobile Mini & Williams Scotsman market value based on data provided by Capital IQ - 7/22/07

Mobile Mini & Williams Scotsman Revenue and Margin information derived from companies annual report 12/31/06

Mobile Storage Group based on data provided by Mobile Storage Group on 2003 sale to Welsh, Carson, Anderson & Stowe

Williams Scotsman enterprise value based on Algeco purchase for $2.2 B

Total revenue includes sales and non rental service revenue `

Problems with Comparables Approach

„ Generally tough to find appropriate companies to

be comparable

„ Which ratio/comparable do you use? There isn’t a

“right” answer, so comparables approach will give

a range of values rather than one?

„ Many comparable companies have different capital structures.

„ Leverage will mechanically affect some financial ratios.

Discounted Cash flow Approach

„ Capitalizes the cash flows the firm is expected to generate.

„ Strength: Reflects actual benefits that investors care about (cash flows) better than other methods.

„ Weakness: Relies heavily on projections.

„ Valuations are only as good as assumptions

supporting the projections!

Valuing Firms using Discounted Cash Flow Analysis

The total value of a firm also equals the sum of value of the claims against its cash flows.

VF = PV(FCF) + PV(TV) + NOA

Where:

VF = the value of the business

PV(FCF) = the present value of the total free cash flows

PV(TV) = the present value of the terminal value

Net Operating Assets (NOA) = the market value of excess or non-operating assets (including assets that could be sold without affecting operations such as excess land, cash reserves, etc.)

Revenue 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133 3,334,133Costs other than depreciation (2,642,999) (2,466,327) (2,466,327) (2,466,327) (2,466,327) (2,466,327) (2,466,327) (2,466,327) (2,466,327) (2,466,327)Interest Portion of Debt Payment (10,669) (243,791) (238,464) (233,253) (228,156) (223,170) (218,293) (213,523) (208,857) (204,293)Tax Depreciation - equipment - - - - - - - - - -Earnings Before Tax 680,465 624,015 629,342 634,553 639,650 644,636 649,513 654,283 658,949 663,513(Less income taxes) - NOL write down (272,186) (249,606) (251,737) (253,821) (255,860) (257,854) (259,805) (261,713) (263,580) (265,405)Net income - Tax 408,279 374,409 377,605 380,732 383,790 386,782 389,708 392,570 395,369 398,108Depreciation add-back - equipment - - - - - - - - - -Principal Portion of Debt Payment (2,914) (66,592) (65,137) (63,714) (62,321) (60,960) (59,627) (58,324) (57,050) (55,803)Less Capital Expenditures - - - - - - - - - -Equity Investments Asset Purchases (3,455,670) - - - - - - - - -Change in NWC 133,365 - - - - - - - - -Cash flow (2,916,940) 307,817 312,468 317,018 321,469 325,822 330,080 334,245 338,319 342,305

Total Debt / Equity 0.0x 0.9x 0.9x 0.8x 0.8x 0.8x 0.8x 0.8x 0.8x 0.7xLeverage Ratios

Senior Debt / EBITDA 0.2x 3.5x 3.4x 3.4x 3.3x 3.2x 3.1x 3.1x 3.0x 2.9xSenior Debt / (EBITDA - CAPEX) 0.2x 3.5x 3.4x 3.4x 3.3x 3.2x 3.1x 3.1x 3.0x 2.9xTotal Debt / EBITDA 0.2x 3.5x 3.4x 3.4x 3.3x 3.2x 3.1x 3.1x 3.0x 2.9xTotal Debt / (EBITDA - CAPEX) 0.2x 3.5x 3.4x 3.4x 3.3x 3.2x 3.1x 3.1x 3.0x 2.9xCoverage Ratios

EBITDA / Total Interest 64.8x 3.6x 3.6x 3.7x 3.8x 3.9x 4.0x 4.1x 4.2x 4.2x(EBITDA - CAPEX) /Int Exp 64.8x 3.6x 3.6x 3.7x 3.8x 3.9x 4.0x 4.1x 4.2x 4.2x(EBITDA-CAPEX / Total Interest 64.8x 3.6x 3.6x 3.7x 3.8x 3.9x 4.0x 4.1x 4.2x 4.2xTotal Enterprise Value 5.0x 3,455,670 4,339,031 4,339,031 4,339,031 4,339,031 4,339,031 4,339,031 4,339,031 4,339,031 4,339,031

6.0x 4,146,804 5,206,837 5,206,837 5,206,837 5,206,837 5,206,837 5,206,837 5,206,837 5,206,837 5,206,8377.0x 4,837,938 6,074,643 6,074,643 6,074,643 6,074,643 6,074,643 6,074,643 6,074,643 6,074,643 6,074,643

Discounted Cash Flow Analysis with Ratios

SAMPLECO

Strengths and Weakness of the DCF/NPV Method

„ Assumes that firm’s capital structure remains constant over time

„ Betas for private firms and smaller companies cannot be easily estimated

„ Terminal value calculation can artificially increase the value of the project (especially when low discount rates are used)

What is the proper discount rate?

return/hurdle rate

OR

(WACC)

Uncertainty about the

DCF/NPV Method

How does TGMG approach it?:

„ Estimate value assuming ‘best’, ‘most likely’ and ‘worst’ case scenarios.

„ Assign probabilities to each scenario and compute the

probability-weighted firm value.

„ Specify probability distribution of each cash flow.

„ Then simulation program such as ‘at Risk’ will generate

distribution of firm values.

„ Approach relies on knowing distributions of cash flows, which

in practice can be difficult to estimate.

Sample valuation output

@RISK Output Graphs Simulation: 1 / Output: NPV @ 30% discount rate

Distribution for NPV @ 30% discout rate/C20

Balance Sheet Valuation Models

shown on the balance sheet.

derived if the firm’s assets were liquidated

its assets less its liabilities.

Dealing with Complexity in Valuation

The Aggressive Analyst: Trust the firm to tell the truth and

value the firm based upon the firm’s statements about their

value.

The Conservative Analyst: Don’t value what you cannot see.

The Compromise: Adjust the value for complexity

„ Adjust cash flows for complexity

„ Adjust the discount rate for complexity

„ Adjust the expected growth rate/ length of growth period

„ Value the firm and then discount value for complexity

Common Business Valuation Errors 1

„ Overpayment – this error can often times end the party

„ Underestimating working capital flows

Common Business Valuation Errors 2

„ Assuming overhead is fixed for long periods and for

supporting growth

„ Using historical percentages for such things as marketing

costs and administrative costs when the cash flow forecast involves a significant change in the business

„ Valuing a highly leveraged cash flow stream at a discount

rate that does not reflect its risk

„ Mistaking EBITDA for Free Cash Flow (FCF) (by not including Capital Expenditures (CAPX) and capitalized operating

expenses)

The Elements of a Successful Acquisition

standardized reports, financial and operational measures.

of goals

the investors.

The key to high equity

returns in an LBO is the recognition that growth is not required to create value Lets take a look at a simple model for value creation without growth, efficiencies or multiple increase

What if a firm can:

1 First pay for what is - buying into what maybe

2 Improve margins through cost cutting and

creating efficiencies (not expensive and relatively easy)

3 Increase sales (expensive and hard)

4 Plow the excess cash created into paying down debt

5 Sell the firm for an increased multiple of EBITDA

to what we paid

First the most simple model

Purchase Price $ Cost 15,000,000 of capital 10%

Deal Costs 0% $ - Tax rate 38.5%

$ discount 15,000,000 rate 0%

Purchase Multiple of EBITDA 3 Loan Term 5

Sale Multiple of EBITDA 3 Yearly Revenues $ 50,000,000

-Sale of firm - - - - - - 15,000,000

EBITDA (3,000,000) 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 15,000,000 Interest Expense (1,200,000) (1,003,443) (787,230) (549,396) (287,779) - Principal Expense (1,965,570) (2,162,127) (2,378,339) (2,616,173) (2,877,791) - Less taxes (1,463,000) (1,538,674) (1,621,916) (1,713,482) (1,814,205) (5,775,000) Net income (3,000,000) 371,430 295,756 212,514 120,948 20,225 9,225,000

(3,000,000) 371,430 295,756 212,514 120,948 20,225 9,225,000

What if costs are reduced by

5% and use the increased

cash to reduce debt?

no improvements in:

„ revenues

„ sale multiple

Purchase Price $ 15,000,000 Cost of capital 10%

Deal Costs 0% $ - Tax rate 38.5%

$ discount 15,000,000 rate 0%

Purchase Multiple of EBITDA 3 Loan Term 5

Sale Multiple of EBITDA 3 Yearly Revenues $ 50,000,000

-Sale of firm - - - - - - 22,500,000

EBITDA (3,000,000) 5,000,000 7,500,000 7,500,000 7,500,000 7,500,000 22,500,000 Interest Expense (1,200,000) (966,300) (564,477) (137,943) 314,824 - Principal Expense (1,965,570) (2,199,270) (2,601,092) (3,027,627) (3,480,393) - Less taxes (1,463,000) (2,515,475) (2,670,176) (2,834,392) (3,008,707) (8,662,500) Net income (3,000,000) 371,430 1,818,956 1,664,254 1,500,038 1,325,723 13,837,500

(3,000,000) 371,430 1,818,956 1,664,254 1,500,038 1,325,723 13,837,500

What if we cut costs 5% and

increase sales by 5% and use the increased cash to

reduce debt?

No improvements in:

„ sale multiple

Purchase Price $ 15,000,000 Cost of capital 10%

Deal Costs 0% $ - Tax rate 38.5%

$ discount 15,000,000 rate 0%

Purchase Multiple of EBITDA 3 Loan Term 5

Sale Multiple of EBITDA 3 Yearly Revenues $ 50,000,000

-Sale of firm - - - - - - 27,348,891

EBITDA (3,000,000) 5,000,000 7,875,000 8,268,750 8,682,188 9,116,297 27,348,891 Interest Expense (1,200,000) (966,300) (541,415) (66,184) 463,700 - Principal Expense (1,965,570) (2,199,270) (2,624,155) (3,099,386) (3,629,270) - Less taxes (1,463,000) (2,659,850) (2,975,024) (3,317,161) (3,688,299) (10,529,323) Net income (3,000,000) 371,430 2,049,581 2,128,156 2,199,456 2,262,428 16,819,568

(3,000,000) 371,430 2,049,581 2,128,156 2,199,456 2,262,428 16,819,568