Beruflich Dokumente
Kultur Dokumente
Valuation Handbook
A UBS guide
August 2009
Valuation handbook 2009 protected.doc
Table of contents
SECTION 1 Introduction ______________________________________________________________ 1
1.1 Introduction ______________________________________________________ 2
1.2 Principal valuation methodologies ____________________________________ 3
1.3 Pros and cons of valuation methodologies _____________________________ 5
1.4 General principles to consider _______________________________________ 8
1.5 Capital structure adjustments________________________________________ 8
1.6 ROCE vs. ROE ____________________________________________________ 10
1.7 Enterprise value (“EV”) vs. equity value_______________________________ 10
1.8 Effect of gearing on valuation ______________________________________ 11
1.9 Valuation process_________________________________________________ 11
1.10 Tips for success __________________________________________________ 12
Table of contents
SECTION 1
Introduction
1
Valuation handbook 2009 protected.doc
Introduction
1.1 Introduction
This book is intended as a reference guide for IBD executives. It encompasses best practice, practical
examples, advice and generally adopted methodologies that all IBD teams can use as part of their valuation
analysis. It does not cover in-depth theoretical or academic discussion underlying valuation techniques but
rather seeks to point out the key pros and cons of the various methodologies available to us. In addition to
this document, UBS Equity Research has a team dedicated to analysing the latest developments in accounting
and valuation. Various materials are available from them in the “Valuation & Accounting” section of
researchweb, and they may be contacted (on a no-names basis) for advice as to some of the issues raised in
this document.
At UBS we approach valuation in a number of ways. Whilst these methodologies are all useful in their own
right, ultimately valuation is at least as much of an art as a science and it is important to have a proper
qualitative overlay to analysis presented both internally and to clients. Specifically, it is critical to have a full
understanding of the business being valued in order to exercise judgement in drawing conclusions from
quantitative analysis.
Nevertheless, a rigorous quantitative approach must underlie every valuation exercise we do. It is particularly
important to remember that valuations rely on forward-looking perspectives (rather than historical) and the
date of valuation is key as benchmarks or standards which are accepted as a “given” may well become
rapidly outdated.
Valuations can be categorised as follows:
Trading valuation
– reflects the theoretical value of one share as part of a listed entity
Transaction valuation
– reflects the value an acquirer can derive from controlling a company
Fundamental valuation
– reflects the net present value of the cash flows of the business
The chart overleaf lists the “standard” methodologies which are used under each of the headings above and
illustrates how this is typically laid out as a valuation summary in client presentations, using a “football field”
chart. Please note that not all of these methodologies are applicable in every scenario:
SECTION 1: Introduction 2
Valuation handbook 2009 protected.doc
Methodology EV 1 (GBPm)
Notes:
1 Net debt, minorities, pension obligations and other liabilities of GBP23.3m
2 As at close of 24 December 2008
3 8.0–9.0x 2008E EV/EBITDA (EBITDA GBP6.96m)
4 Based on geographic split
5 10.5–11.5x LTM EV/EBITDA (EBITDA GBP6.52m)
6 Base case IRR of c. 20–25% and exit multiple of 9.0x EV/EBITDA
7 Assuming a WACC of 8.2%, a terminal growth rate of 2.0% and an exit multiple of 8.0x EV/EBITDA
SECTION 1: Introduction 3
Valuation handbook 2009 protected.doc
SECTION 1: Introduction 4
Valuation handbook 2009 protected.doc
SECTION 1: Introduction 5
Valuation handbook 2009 protected.doc
A DCF valuation is often used as a cross-check for other valuation methods. However, on some occasions, it can
be the most (or indeed the only) appropriate method to use—for example in the case of a project with finite
cash flows, or a wasting asset such as a mine or a pharmaceutical patent. In addition, the reliance placed to a
DCF valuation may increase if there is a lack of comparable transactions or companies (for example, when
Eurotunnel was floated, the bankers working on that deal had no real relevant comparable companies and so
based most of their analysis on DCF methodologies). DCF is also useful for companies seeking to evaluate
potential acquisitions and particularly whether the price they might pay is justified by all of the cash flows of the
deal (including synergies, additional costs incurred etc) when discounted at a specific hurdle rate.
SECTION 1: Introduction 6
Valuation handbook 2009 protected.doc
Precedent Reflects value that purchasers have Past transactions are rarely directly
transactions been prepared to pay for control of comparable either due to company
analysis “similar” assets specific factors or the fact that
“Real” benchmark in the sense that acquisitions happened at a different
past transactions were successfully point in the cycle
completed at certain prices Public data on past transactions can be
Indicates a range for premia offered incomplete, non-existent or misleading
(for quoted companies only) Typically based on historic financial
Trends, such as consolidating information for target companies—
acquisitions, foreign purchasers, or full analysis around expected future
financial purchases may become clear performance is required
SECTION 1: Introduction 7
Valuation handbook 2009 protected.doc
SECTION 1: Introduction 8
Valuation handbook 2009 protected.doc
in a liquidation scenario. Equity typically has a subordinate claim on cash flows (i.e. dividends are only paid
out after interest has been paid to debt providers) and debt has a senior claim.
1.5.1 Debt
Debt should be included in the capital structure at its market value. In the majority of cases this will simply be
equal to book value shown on the balance sheet, but for companies with long dated bonds that were issued
in a different interest rate environment, or for companies in financial distress, an adjustment to market value
should be made.
1.5.5 Leases
Companies frequently have a choice as to whether to own or lease assets used in its business. If the asset is
owned, this is reflected by the debt or equity on its balance sheet which has been raised to purchase the
asset and through the depreciation in its P&L. Alternatively, if a company operates with a number of leased
assets, it will have lower debt but a lease charge flowing through the P&L. To compare two such companies
(asset owner vs. lessee) we need to adjust the balance sheet, capitalising the rents, thereby reflecting a truer
picture of the capital structure of the businesses.
SECTION 1: Introduction 9
Valuation handbook 2009 protected.doc
Alternatively, where less information is readily available, consider applying a P/E multiple to the total minority
interest in the P&L. This is likely to be more accurate than book value.
(EBIT x (1-tax rate)) ÷ (average shareholders funds + net debt) = ROCE post tax
It is a measure of the profit earned by the business irrespective of the capital structure.
ROE is the return a business generates only on its equity capital. It is impacted by the level of debt but is
normally higher than ROCE (companies typically generate greater returns on their equity than the interest
rate they pay on their debt).
The DuPont formula, also known as the strategic profit model, is a common way to break down the ROE into
three components: profit margin, asset turnover and equity multiplier.
This analysis allows identifying where superior return is derived from by comparison with companies in similar
industries or between industries. Certain industries will rely on high profit margins (e.g. fashion), others on
high asset turnover (e.g. retailers), whilst others on high leverage (financials).
The best way to analyse debt is to look at the historical trend in debt financing compared to the trend in ROE
to see whether a company has maintained a level of ROE by increasing its debt. This could indicate that a
company is compensating for declining profit margins and increased asset efficiency with more debt to
maintain the same level of shareholder return.
When calculating both ROCE and ROE it is usually more accurate to calculate an average denominator for the
calculation to reflect changes during the year in which the relevant return is generated. Also ensure the
numerator and denominator treat minority interest consistently, i.e. either net income and equity including
minority interests or excluding it.
SECTION 1: Introduction 10
Valuation handbook 2009 protected.doc
A B
Low debt High debt
Market cap 90 50
Net debt 10 50
EV 100 100
The EV is the same, so, if the companies generate the same EBITDA, the EV/EBITDA multiples will be the
same. However, if you use an equity value multiple, you get a very different picture. This needs to be taken
into account when comparing P/E multiples across companies.
A B
Low debt High debt
EBITDA 20 20
D&A (5.0) (5.0)
EBIT 15.0 15.0
Interest (1.0) (5.0)
PBT 14.0 10.0
Tax @ 30% (4.2) (3.0)
Net income 9.8 7.0
SECTION 1: Introduction 11
Valuation handbook 2009 protected.doc
SECTION 1: Introduction 12
Valuation handbook 2009 protected.doc
SECTION 2
2.1.1 Benchmarking
Benchmarking is used to compare performance against peers and “absolute standards”. Once a company’s
performance has been classified against its peers, we are able to place it in context and apply appropriate
valuation metrics.
Different industries use different valuation metrics and value drivers to benchmark the performance of
companies against one another. Below are some of the most common measures used:
Key performance indicators including growth, margins and returns
Valuation multiples including EV/Sales, EV/EBITDA, EV/EBITA, P/E and EV/FCF
The table below shows typical output from a comparable company analysis. Remember that benchmarking
can be sector-specific and it is important to consider more specific operational metrics where data is available.
Centrica PLC 2.5 75 13.0 15.5 0.7 0.6 5.7 4.8 7.6 5.5 12.7 9.8 30.6 1.0 11.5 13.5
Cez A.S. 29.8 57 16.0 18.9 2.7 2.6 5.6 5.4 11.4 8.8 9.1 8.3 4.1 7.4 49.5 47.4
Drax Group PLC 5.9 62 2.0 2.3 1.2 1.5 4.0 5.7 4.9 7.9 5.4 8.0 40.5 (20.0) 29.1 25.8
Electricite de France S.A. 31.4 44 57.1 131.4 2.0 2.0 8.8 7.5 24.2 nm 13.4 11.7 7.8 4.2 23.2 26.1
Energias de Portugal S.A. 2.8 66 10.2 28.1 2.0 2.3 9.0 8.5 nm 45.9 9.2 11.3 26.2 (10.4) 22.5 26.6
EnBW AG 36.2 67 9.5 16.9 1.0 0.9 6.8 6.5 13.6 13.7 10.5 8.3 10.8 9.2 15.3 14.6
Endesa S.A. 15.3 53 16.2 36.4 1.6 1.8 5.0 5.3 4.5 12.3 7.1 6.7 28.8 (9.7) 31.8 33.4
Enel S.p.A. 3.9 53 24.0 89.0 1.5 1.5 6.5 5.9 13.4 11.2 4.7 6.5 13.1 (3.8) 22.4 25.5
E.ON AG 23.1 50 44.0 92.8 1.0 1.1 10.6 6.7 nm 24.0 47.0 8.0 25.6 (1.8) 9.8 15.9
Gas Natural SDG S.A. 11.0 32 9.9 15.0 1.1 1.3 5.9 5.8 10.3 40.9 4.7 6.4 34.1 (14.2) 18.5 22.1
GDF Suez 23.8 53 52.3 98.4 1.2 1.2 7.3 7.0 33.4 32.2 11.0 9.6 11.9 (3.8) 16.2 17.7
Iberdrola S.A. 5.7 58 27.8 64.2 2.5 2.5 9.8 8.5 18.9 11.9 11.3 10.2 5.0 3.5 26.1 28.9
International Power PLC 2.5 50 3.8 11.2 2.9 2.9 9.1 7.7 11.9 8.8 7.9 7.5 28.4 (0.6) 32.1 38.1
RWE AG 55.9 64 31.4 47.4 1.0 1.0 5.7 5.4 12.3 13.1 11.4 8.3 15.2 (1.1) 17.0 18.0
Scottish & Southern PLC 11.6 68 10.7 15.6 0.9 0.9 8.9 8.0 23.5 17.9 10.2 9.4 8.8 0.9 10.1 11.1
Mean 1.6 1.6 7.2 6.6 (11.8) 18.1 11.7 8.7 19.4 (2.6) 22.3 24.3
Median 1.2 1.5 6.8 6.5 12.1 12.7 10.2 8.3 15.2 (1.1) 22.4 25.5
Source: Company fillings and consensus estimates
Notes:
1 Enterprise value = fully diluted market value + debt outstanding – cash; assumes in-the-money convertibles are equity
2 “nm” denotes EV/revenues multiples greater than 10x or negative, EV/EBITDA multiples greater than 50x or negative and P/E multiples greater than 50x or negative
2.1.2.1 Growth
Growth is often seen by equity markets as a key driver of valuation. As such we compare sales, profitability
and cash flow growth of comparable companies. Benchmarking a company’s growth relative to industry
peers is a key input in determining relative performance. Typically we consider compound annual growth
rates (“CAGRs”) for a period of 3–5 years or more, in order to eliminate year on year inconsistencies and to
capture medium term trends.
The formula for calculating CAGR is as follows:
2.1.2.2 Margin
The ratio of profits to revenues for a company or business segment shows how much of each dollar of
revenue generated by the company is translated into profits. Margins will vary from company to company,
and certain ranges can be expected from industry to industry, as similar business constraints exist depending
on both structural (e.g. ability to charge higher prices) and asset ownership distinctions (e.g. asset ownership
vs. operating leases). Key ratios are EBITDA and EBIT margins although where leases or rental expenses form
a significant part of the capital structure, EBITDAR margins should also be compared. High margins
sometimes attract a higher valuation multiple because they indicate a high quality, robust business that will
be sustainable in a downturn, but this logic does not always follow, e.g. a low margin might mean an
opportunity to cut costs and achieve high profit growth, therefore justifying a high current valuation multiple.
2.1.2.3 Return
ROCE and ROE are both measuring returns of a company. ROCE gives a sense on how well a company is
using its money to generate returns and ROE reveals how much profit a company generates with the money
shareholders have invested (see section 1.6 for formula). It should be noted though that these measures are
subject to the various accounting policies of the company, and therefore subject to manipulation.
Cross sector comparison is not meaningful given that asset intensity can vary significantly. For example, an
aircraft manufacturer needs more assets than a software company. However, whatever industry the company
is in, it must strive for a ROCE (with capital marked to market) in excess of the targeted return, often
WACC—otherwise the company is theoretically destroying rather than creating wealth.
Similarly, the ROE should not be used to compare companies in different businesses. It is normally lower in
capital intensive businesses. The comparison can also be distorted by different financial structures: a more
heavily indebted company would have a higher ROE for example, as illustrated in the formula in section 1.6.
A clear example of this occurs when companies engage in a sale and leaseback of assets (most often
property). They are able to return the capital raised by selling the assets. This reduces shareholders funds,
increasing ROE. However, the company then faces additional fixed costs which both reduce profit and
increase operational gearing.
Healthcare
Hospitals
Revenues or EBITDAR/number of beds, maintenance capex/sales (measures how much the company needs
to spend to keep their operations running)
Biotech
Technology value: calculated as “market value less cash” and shows how strongly investors believe in the
pipeline products of the company
Infrastructure
EBITDAR/fleet: measures the return the company generates on the fleet employed (at either substitution
or replacement cost)
Energy
Integrated companies and/or E&P (Exploration and Production)
Total production measured in millions or thousands of barrels of oil equivalent ("boe"), 1P reserves
(mmboe), 2P reserves (mmboe), Reserve life (production over reserves, years), Production growth, F&D
(Finding and development) costs (US$/boe), Total replacement costs (US$/boe), RRR (Reserve replacement
ratio) as % (both shown as incl. and excl. acquisitions/disposals), EV/DACF (applicable to integrateds)
Leisure
Gaming
Offline = admissions, spend per head
Online = active customers, new active customers, yield per active customer, cost per customer acquisition
Hotels
Occupancy, ARR (average room rate), RevPAR (revenue per available room, a function of occupancy and
room rate)
Cruise
Occupancy, net revenue per diem (pricing per actual berth day sold), net yield (net revenue per available
berth day, a figure similar to RevPAR in that it takes into account price and utilisation)
Restaurants
Like for like sales, spend per head and roll-out of new restaurants
Pubs
Beer volumes, wet sales per head, food spend per head, rental income from pub tenants
Theme parks
Visitors, average admission price, in–park revenue per capita
Travel
Capacity (i.e. holiday packages on offer), load factor (a measure of how efficiently the airline capacity is
used), average spend per package and average cost per package
Fitness
New member sales, attrition %, average member sales, membership income per head, secondary spend
per head
2.1.3.2 EV/sales
This a valuation measure that compares the enterprise value of a company to the company's sales. It gives
investors an idea of how much it costs to buy the company's sales.
Pros
– the least susceptible to accounting differences as revenue is not easy to manipulate or distort
– particularly relevant in cyclical, distressed and high growth industries or start up companies (e.g.
technology) where near term profits may not reflect the true measure of a business’s potential
– usually not as volatile as other multiples
Cons
– it can be a crude measure that does give an indication about the profitability of a company
– does not capture differences in cost structures across companies
2.1.3.3 EV/EBITDA
EV/EBITDA is the most commonly used multiple as it is unaffected by a company's capital structure. It
compares the total value of a business including debt capital, to earnings before interest, tax and D&A and
avoids problems of different accounting policies for depreciation and amortisation.
Pros
– EBITDA is often seen as a “proxy” for cash flow
– useful comparing firms with different degrees of leverage
– is not distorted by situations where capex is historically at a different level to that forecast
– less susceptible to distortions as a result of accounting differences (compared to P/E)
Cons
– there are industries which experience differing levels of capital intensity (high capex/working capital
requirements) and EV/EBITDA multiples do not capture such features
– EV/EBITDA may give misleading answers when comparing companies from different jurisdictions as it
does not pick up differences in tax rates
Cons
– different companies in the same sector may have different accounting policies/rules, which may distort
earnings after tax and lessen comparability of P/E across companies
– one-off expenses or income may suppress or increase earnings, distorting your view of the company’s
long-term profitability. It is therefore important to adjust earnings for any non-recurring,
extraordinary items
– a company’s leverage (amount of debt) can affect earnings but is not a driver of the
long-term profitability
– earnings can be negative even for companies which have positive value, in which case P/E is
meaningless
– can be difficult to ensure comparable number of shares are used (e.g. basic/diluted, year-end/average)
FCF = Cash from operations – capital expenditures (property, plant and equipment)
Pros
– cash flow is harder to manipulate than earnings
– reliance on cash flow rather than earnings handles the problem of differences in the quality of
reported earnings
– ultimately, a business is worth the cash it generates rather than the profits it reports under a particular
set of accounting rules
Cons
– cash flow can sometimes be more volatile depending on the industry and the cycle
– do not benefit from the accruals concept used by accountants in producing the P&L which matches
the timing of revenues and costs
It is important to try to strip out growth capex (e.g. one off expenditure on a new factory) in order to get to a
sustainable figure for FCF.
Pros
– book value is theoretically more stable than earnings, so it may be more useful when earnings are
volatile or negative
– does not reflect the role of intangible economic assets such as human capital
Cons
– should only be used in asset-heavy industries (e.g. real estate or banking)
– can be misleading when there are significant differences in the asset size of the company because in
some cases the company’s business model dictates the size of its asset base (e.g. outsourcing)
– different accounting conventions can obscure the true value; inflation and technological change can
cause the book and market value of assets to differ significantly
In some industries, intangible assets are excluded from shareholders equity in order to arrive at P/B. This in
particular excludes the impact of goodwill arising from acquisitions.
P/B will be more useful to the extent that assets are subject to regular revaluations, for example in the real
estate industry.
Pros
– reflects the value that investors attribute to the total capital invested in the company – in theory
capturing the return that the company is able to generate
– useful for sectors where tangible assets are key
Cons
– depends on accounting policies, which can distort the true value of the assets
Mining
EV/Resource: EV divided by Mineral Resources (typically Measured & Indicated) in terms of contained
metal (for base & precious metals) or tons of ore (coal, iron ore)
EV/Reserves: EV divided by Mineral Reserves (Proven & Probable) in terms of contained metal (for base &
precious metals) or tons of ore (coal, iron ore)
EV/Production: EV divided by target production capacity (typically only used for comparing development
projects and optional to include capex)
P/NAV: Price over broker net asset value to assess valuation premium (for all gold, silver and platinum
companies) or discount (again mostly for development companies)
Infrastructure
EV/Fleet: EV divided by the value of the fleet (at substitution or replacement cost)
Telecoms
EV per line or POP
Energy
Integrated and/or E&P (Exploration and Production)
EV/Reserves (shown in US$/bbl), NAV per share, Share price premium/(discount) to NAV, EV/DACF
R&M (Refining and Marketing)
EV/Capacity (refining capacity in US$/bbl)
EV/Complexity barrels (in US$/bbl): Complexity barrel calculated by multiplying capacity (bpd) by Nelson
complexity index and divided by 1 million
OFS (Oilfield services)
EV/backlog
Valuations by reference to such measures of production capacity effectively assume that certain “normal”
profit margins on the relevant operations can be obtained.
10
8
Average = 7.6
6
EV/EBITDA (x)
0
2003 2004 2005 2006 2007 2008 2009
EV/EBITDA multiples for each year can be calculated as the EV at year-end divided by the following year’s
EBITDA, or the EV at the mid-year divided by the average of the current and following year’s EBITDA, in either
case it is important to footnote the methodology used.
This should then be supplemented with qualitative information regarding the current stage of the cycle, and
whether there are any exceptional events in past cycles which skew the results. All judgements of this type
should be flagged at the highest level of your deal team given the significant impact on value they have.
Off-
balance
sheet Non-core
items assets
(inc.
Pension
associate)
deficit
Minority
interests Total
enterprise
Net debt value
Core
enterprise
Equity value
Value
At yr yr yr yr yr
issue 1 2 3 4 5 Calculation
Balance sheet
Equity
Option value 21.7 21.7 21.7 21.7 21.7 21.7 Equal to issue price less price of comparable
non-convertible bond
P&L cum impact (3.7) (7.7) (12.0) (16.6) (21.7) Cumulative accrued interest
Net equity impact 21.7 18.0 14.0 9.7 5.0 0.0 Option value less accrued interest
Liabilities
Beginning of year 78.3 82.0 86.0 90.3 95.0 Price of comparable non-convertible bond
Accrued interest 3.7 4.0 4.3 4.6 5.0 Difference between interest expense and
coupon paid
End of year 78.3 82.0 86.0 90.3 95.0 100.0 Sum of beginning of year plus accrued
interest
Answer:
Step 1: Compute 2008 basic EPS
basic EPS = US$115,600 = 0.58
200,000
If valuing a subsidiary company (from its own perspective), intercompany debt should be included as a form
of debt. From a group perspective, the same intercompany debt should be eliminated as the parent would
have both "balance receivable" and "balance payable" in its consolidated accounts.
Book value
The balance sheet value of minority interests represents the minorities’ share of reported net assets in the
balance sheet, except for goodwill which only relates to the parent shareholders. This amount is unlikely
to be a good proxy for the fair value of minorities given that book value primarily reflects a historical cost
measurement basis and does not account for intangible assets
2.2.5 Pensions
Pension schemes can be divided into two broad types: Defined Benefit and Defined Contribution schemes.
Defined benefit (“DB”) schemes were very common in industrial companies in the UK and the US until
companies realised that they were bearing all of the risk relating to the performance of the assets in the
pension scheme (as the liabilities are fixed relative to the salaries of retirees). More recently, defined
contribution (“DC”) schemes have become the norm whereby the employee bears the risk of asset
performance but the company makes fixed contributions to its employees’ schemes.
(ii) not make any election, in which case the TFR-portion of their compensation is contributed by default into
external certified pension funds, which operate as defined contribution schemes. Once the employee retires,
he will receive from the fund an annuity integrating the regular, State-controlled pension payments
In both cases, current TFR-related payments are already included in the cash personnel cost of the company, and
therefore fully reflected in the company’s EBITDA. The pension liability is not on the balance sheet of the company
but instead is reported on the balance sheet of either the Italian Social Security or the external funds. As a result,
no adjustment to the calculation of the company’s EV is required to reflect the post-2007 TFR schemes.
However, prior to January 2007, TFR’s sole purpose was to fund a severance payment. The TFR-portion of
compensation was retained by the company, which had the obligation to pay the entire accrued TFR amount
to its employees upon termination of employment. As a result, the TFR was a non-cash item, that created an
unfunded liability on the company's balance sheet. The TFR provision related to pre-2007 schemes is still
present on the balance sheet of Italian companies. As severance payments are made over time, the size of the
TFR provision is gradually decreasing. Nonetheless, the pre-2007 TFR provision should be added to the
company's EV. This value is clearly reported on the balance sheet, under both IFRS and Italian GAAP.
Spain
Corporate pension assets in Spain are externally managed by a specialised company to provide its
beneficiaries with a greater guarantee of efficiency and security. As a result of such external management
and the fact that companies do not bear the cost or risk of the pension schemes, no pension adjustment
typically needs to be incorporated when valuing a company in Spain.
US
Over the years, US companies with defined benefit schemes have moved to defined contribution schemes.
However, substantial legacy defined benefit schemes remain in some sectors and large unfunded positions
when market headwinds prevail (e.g. steel, coal, auto, airlines). In addition, companies operating in the
US offer post-retirement health benefits. These also have a defined benefit character. Thus the total defined
benefit obligations of a company include defined benefit pension schemes and other post employment
benefits (OPEB).
Defined Benefit Schemes & OPEB
Per US GAAP, the P&L includes pension income/costs that are unrelated to current period operations. Both
the P&L and balance sheet are sensitive to actuarial assumptions, many of which are not disclosed.
Furthermore, the figures reported on the balance sheet rarely convey the actual funding level. In fact, the
balance sheet may show a net surplus or pension asset while the pension is actually in deficit.
Adjustments to EV and EBIT/EBITDA should be effected with data coming from the footnotes:
– add tax-adjusted “funded status” to EV
– add to EBIT/EBITDA the entire Periodic Pension Charge except for Service Cost (which should not be
backed-out)
UK
In the UK, DB schemes have historically been common although these have largely been closed to new
members. DC schemes are now the norm for new employees and some companies are even converting
existing DB schemes to DC schemes.
Under IAS 19, the net pension liability arising from DB schemes (i.e. the deficit) will appear on the balance
sheet net of deferred tax and should be added to enterprise value. The pension footnote will provide
information on pension financing costs which should be added back to EBITDA or EBIT as described in
section 2.2.5.5.
It is important to note that the accounting deficit may differ materially from the actuarial deficit. The latter is
the basis on which the trustees and the company agree a schedule of future contributions to make up the
deficit. Such contributions are not captured in the P&L (they are accounted through the cash flow statement)
and so it may be necessary to make a further adjustment to EV, for example by adding the NPV of agreed
future deficit contributions. This should be reviewed on a case by case basis.
2.2.6 Leases
It is important to consider the effect of leases on valuation in order to compare two companies who may
choose to operate their businesses with different levels of asset ownership vs. leases. A lease is a contract
between two parties: one party (lessee) has right to use an asset which is owned by another (lessor) for a
fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return
for paying the lessor a fixed or determinable payment. The lessor retains the legal ownership of the asset.
There are two types of leases:
Operating leases
An operating lease is usually signed for a period considerably shorter than the useful life of the asset and the
present value of lease payments are generally lower than the actual price of the asset. At the end of the life
of the lease, the physical possession of the property reverts back to the lessor, who can either offer to sell it
to the lessee or lease it to somebody else. Under an operating lease, the lessee may have the option to cancel
the lease and return equipment to the lessor, before the expiry of lease agreement although this option is
likely to carry additional cost for the lessee. Thus the ownership of the asset resides with the lessor, with the
lessee bearing little or no risk if the asset becomes obsolete. An example of operating leases could be retail
businesses which lease rather than own their shops or aircraft companies which lease their planes. Under an
operating lease, the lessor may also provide services relating to the asset, such as maintenance, or operations.
In accounting terms, an operating lease is considered to be the same as renting an asset:
The lessee simply has to record the payments it makes under the lease agreement as an expense in the
P&L (and vice versa for the lessor) when they occur. There is no recognition of any asset or obligation to
make payments under the lease in the financial statements of the lessee
The lease payments are operating expenses which are tax deductible. Thus, although lease payments
reduce income, they also provide a tax benefit
The lessor continues to recognise the asset on its balance sheet and depreciate as normal. It does not
recognise any future cash to be received as a receivable, and simply records the income in the P&L as
it occurs
Multiple methodology
The simple technique to determine the operating lease liability is the application of a multiple to the current
operating lease charge. For example, if a company has an operating lease charge of 350 in 2008, this is
multiplied by, say, 7 to obtain the amount of liability and assets (2,450) that should be on the balance sheet.
Different multiples are appropriate for different sectors, as illustrated by Moody’s methodologies for their
ratings calculations below:
NPV methodology
A more sophisticated technique is to calculate the NPV of future operating leases payments. In order to
do this accurately, the future “normalised” level of lease payments is required, something that is not
always available.
2.3.1 Calendarisation
For the purpose of deriving trading multiples, estimates are often calenderised to a common year end. This is
done to ensure consistency and enhance comparability. We often calendarise to the year end of the company
being valued or the most common year end across the universe. In case of companies with different year
ends, forecasted estimates are “calendarised”. Calendarisation is the process of prorating estimates that are
available on fiscal year basis, to derive estimates on a calendar year basis.
Consider the following example
Fiscal year end of company XYZ 30 September
Forecasted revenues for FY 2008 US$1,200m
Forecasted revenues for FY 2009 US$1,440m
Revenues for calendar year 2008 shall be determined as under:
Forecasted revenues for FY 2008 pro rated for 9 months US$1200 x 9/12 = US$900m
Add Forecasted revenues for FY 2009 pro rated for 3 months US$1,440 x 3/12 = US$360m
Forecasted revenues for calendar year 2008 (Jan–Dec 06) US$900 + US$360 = US$1,260m
Data should always be calendarised for comparison purposes and to get LTM financials.
Please note that seasonality can affect the calendarisation and for the most accurate results, this needs to be
accounted for rather than assuming that earnings and cash flows are derived equally across the year.
Accounting standards require a disclosure reconciling the difference between reported income tax expense
and the amount based on the statutory income tax rate.
Permanent differences:
Differences between taxable profit and accounting profit which DO NOT reverse in subsequent periods.
For example, if the tax regulations only allow deductibility of part of a given expense, the disallowed
amount would result in permanent difference (e.g. employee stock options)
The impact: as this type of difference does not reverse in subsequent periods, their impact on the amount
of tax charged in the P&L of the current period is not measured and accounted for
Timing differences:
Differences between taxable profit and accounting profit which arise because the period in which some
items are included in taxable profit is different to the period in which they are included in accounting
profit (e.g. capital allowances versus depreciation for fixed assets)
Note that the total of these items in both accounting profit and taxable profit are ultimately the same, but
they occur in different periods
The impact: this type of item will reverse in subsequent periods, but will result in differences in the tax
paid in each year
Example:
Year 1 Year 2
€ Taxation Accounting Taxation Accounting
Profit before depreciation/tax allowance 1,000 1,000 1,000 1,000
Depreciation/tax allowance (400) (250) (100) (250)
Profit after depreciation/tax allowance 600 750 900 750
Tax rate (%) 30 30
Actual (cash) tax charge 180 180 270 270
Total reported tax charge 225 225
Deferred tax charge/(gain) 45 (45)
Effective tax rate (before deferred tax) (%) 24 36
Effective tax rate (after deferred tax) (%) 30 30
In year 1 the difference in tax charges relates to the additional tax capital allowances charges
(€150*30% = €45) whereas in year 2 the difference is due to the smaller tax capital allowances. Deferred tax
tries to ‘smooth’ these timing differences out: in year 1 a deferred tax liability would be made for
€45 to increase the actual tax charge up to the expected amount of €225. This reflects a liability on balance
sheet as the current favourable tax allowances upfront will be offset by more tax being payable in the future.
In year 2 this deferred tax liability is reversed as the timing difference reverses resulting in a reduction in the
actual tax charge from €270 to €225.
Accounting for deferred tax means that the reported tax charge reflects the tax expected to be payable
(albeit not maybe immediately) based on accounting profits. In the above example, without providing for
deferred tax, the effective tax rates for years 1 and 2 are 24% (€180/€750) and 36% (€270/€750)
respectively. Providing for deferred tax brings these to 30% for both years (€225/€750).
Example:
Total deferred Recognised deferred Unrecognised deferred
US$ million Gross amount tax assets tax assets tax assets
2006 9,019 3,079 2,234 845
2007 7,179 2,373 1,659 717
Source: ArcelorMittal (annual report 2007)
The valuation allowance is based on the company’s current view of the level of taxable income of the
different entities where the tax losses reside. If the likelihood of the company being able to realise the tax loss
carry forward improves, valuation allowance is reversed to reflect the improved likelihood. This reversal
increases the total amount of tax losses available to offset future taxable income. In interpreting the amount
of recognised deferred tax assets for the purpose of valuation, we recommend using the net number of
US$1,659 million for ArcelorMittal instead of the US$2,373 million of gross deferred tax assets.
For the purposes of calculating the EV, the value of the deferred tax asset is typically treated separately and
added to the EV as a non-core asset.
The practical problem is estimating the proper value for the deferred tax asset related to tax loss carry
forwards. It theoretically requires estimating the present value of the cash tax benefits as using the book
value would overestimate the value as it does not take into account the timing of the cash benefits. Although
company disclosure should help in assessing the timing of the tax benefits, it remains a challenging exercise.
In addition, it requires estimating the discount rate where opinions vary. Although some people argue that
the risk free rate should be used as the cash payment from the government should be seen as risk free, it is
accepted that the cost of equity is generally the appropriate discount rate for cash tax benefits, because
companies must generate profits after interest cost in order to benefit from tax loss carry forwards.
A similar methodology is used when evaluating a company from a transaction point of view. A company that
offers buyers significant tax savings later should be worth more than an identical business which does not.
Key issues to keep an eye out for are whether these deferred taxes are transferable to the new owners and
extent to which ownership changes may affect the realisation of tax deferrals.
Company with Assume a normal level of debt, and adjust interest, taxes and earnings
abnormally high debt for appropriately. Obtain a notional value on this basis and then make an
its sector (we can adjust appropriate deduction for the additional debt, including an adjustment
the process appropriately for additional debt, including an adjustment for additional
for abnormally low debt) risk/operational gearing.
Conglomerate or If the P/E of the different subsidiaries are likely to be very different
multi-business group from each other, it may be best to allocate debt (e.g. on the basis of
capital employed) attributable to each of these and value the resultant
“post interest” earnings by reference to the appropriate multiples,
rather than valuing each subsidiary on a debt free basis and then
making an overall deduction for debt.
2.6.2 Forecasts
UBS research
For financial forecasts UBS research forecasts can be used and these are available on Research web. For
European trading companies, you can request the analyst research model and you can also find most of them
on ras (type ras in your browser) and click on Launch Model Viewer (link can be found toward the bottom
right of the web page). You should benchmark the UBS research forecasts to consensus estimates (see
below) to understand whether our analysts are bullish or bearish relative to the other analysts covering the
stock in question.
Datastream/Factset (consensus estimates)
IBES estimates (a survey of all contributing analysts who cover the stock) can be sourced from DataStream
whereas both IBES and Reuters consensus estimates can be pulled from FactSet. More info on both of these
databases can be found in the WorkSmarter handbook.
Creating consensus estimates
Consensus estimates can also be created manually by building a spreadsheet comparing the forecasts of the
credible brokers. This can be more reliable than IBES which often includes forecasts from less well-known
research houses and/or forecasts which are out of date. Be careful, in case brokers report financials using
different reporting methodologies/accounting treatments, so in this case the numbers are not directly
comparable and your consensus will not be meaningful.
SECTION 3
Control premium percentages should be applied to equity values rather than enterprise values. This is
because they are derived from observations of the takeover prices of real companies, which usually have at
least an element of debt in their capital structure.
Another way of looking at the situation is to bear in mind that control is actually exercised by the holders of
voting equity rather than the holders of debt, and hence the control premium should only be applied to the
value of the formers’ holding.
3.5.1.2 Synergies
Synergies are the financial benefits that a company expects to realise from the integration of two businesses.
There are four main sources of synergies:
Cost synergies: result from efficiencies created through improved operating practices and greater
economies of scale, e.g. consolidated purchasing, SG&A reductions
Revenue synergies: result from ability to generate more revenues through combination of infrastructure or
distribution network. Usually very difficult to quantify
Capex synergies: lower investment required per unit of sales
Financial synergies: potentially lower cost of debt due to increased earnings power
Cost synergies are normally the simplest to quantify—they are usually announced for most transactions and
typically can be found in the press releases/investor presentations. It is key to consider the multiples on a
post-synergy basis to demonstrate how the acquiring company may have justified the acquisition price. It is
also important to benchmark the level of synergies across transactions (as a percentage of sales or costs) as
this can often account for variations.
3.6 Adjustments
Please see section 2 on comparable companies which shows how to factor in various EV adjustments.
Consistency is important with all adjustments to ensure that one has a meaningful set of data.
+
Transaction announcement / document
Company
Investor presentations
sources
Latest annual report and interim report of the target
Reliability
Confidential information (e.g. info memo, UBS models, documents sent by clients) should not be used for
sourcing financial information.
20-Feb-07 Vulcan Materials Florida Rock 44.9 45.4 38.0 3.8 10.3
Where relevant,
2-Mar-06 Hanson Civil & Marine na na 4.4 3.0 8.6 add columns with
21-Mar-03 CRH SE Johnson na na 0.0 na 7.9 operating metrics
SECTION 4
Where t is the time period in years of the cash flow you are discounting.
PV of enterprise
PV of equity cash flows
cash flows
4.2.1 Definition
A business’ free cash flow represents the cash returns available for distribution to all providers of capital (i.e.
debt and equity holders). Free cash flows are calculated as the net cash flow from a business, after capital
expenditure, changes in working capital and notional cash tax (but before interest):
EBIT
Less: Notional taxes/cash taxes 1
Earnings before interest, after tax
Add: Depreciation & amortisation
Less: Investment in working capital
Less: Capital expenditure
Unlevered Free Cash Flow
Alternatively,
Net income 2
Add: Deferred taxes & other non-cash charges
(e.g. depreciation, amortisation and deferred taxes) 3
Add: After-tax interest expense
Less: Investment in working capital
Less: Capital expenditure
Unlevered Free Cash Flow
Notes:
1 Notional tax/cash tax is the total tax charge less interest relief at the marginal tax rate. Alternatively you can apply the effective tax
rate to taxable income (roughly EBIT less tax losses carried forwards) to reflect the tax charge as if there were no debt
2 Net income before preferred dividends, equity income and minority interest
3 Goodwill amortisation is only deductible for tax purposes under limited circumstances in certain countries
As you can see from the above, tax on EBIT is adjusted for in the free cash flow calculations. It is important
that this reflects to the fullest extent possible the actual tax charge on earnings, including the appropriate
deductibility of amortisation and depreciation. This is discussed in more detail below.
Conventionally, a DCF valuation is undertaken pre-synergies. This theoretically values the whole company, as
if it were controlled, and so there is no need to add a control premium. In order to assess the total theoretical
value that an acquirer might extract from the business, it may also be appropriate to prepare a DCF including
synergies. A purchaser would not be prepared to pay this higher value, as it would be paying away all its
synergies, but might be prepared to pay a value incorporating, say, half the synergies assuming the
transaction meets a predefined return within an acceptable timeframe.
4.2.2.1 Turnover
Turnover should be broken down and modelled at an appropriate level of detail unless the mix is expected to
remain stable (e.g. by country, product group, channel of distribution).
In general, turnover can be projected by applying the assumed inflation rate and real growth rates, or
volumes and unit prices.
Research reports, client forecasts and industry surveys should be consulted to develop or confirm projections.
The relationships between turnover, market growth and market share should be considered carefully and, if
possible, modelled explicitly. It is critical to understand the basis for turnover and margin projections and to
assess their reasonableness.
Inflation rate assumptions in the market/turnover forecasts must also be checked for consistency with the
inflation rate assumptions in the DCF model and discount rate estimation (or make adjustments as appropriate).
It is particularly important that the cash flow projections be expressed in (or converted to) the same currency
for which the discount rate has been calculated. For example, if you are using a US$ risk free rate as the basis
for the WACC, the forecasts must be converted into US$ at appropriate rates (remember that the exchange
rate captures the inflation differential between currencies). Generally, it is recommended to use the currency
in which company’s cash flows are denominated.
Future values of plant and equipment on balance sheet can be projected by deducting depreciation and asset
disposals and adding capital expenditures on plant and equipment.
It should be noted that as the business’ markets mature and growth opportunities become more scarce,
depreciation and capital expenditure should converge to a 1:1 relationship, reflecting the fact that capital
expenditure is being spent to maintain, as opposed to expand, capacity.
Over the long term, a common rule of thumb is for capex to be equal to depreciation over the course of the
cycle in order to maintain returns. This effectively provides for a constant capital stock. Clearly this will be true
in aggregate for a mature industry, but care should be taken to examine the relative prospects of the
business being valued within that industry.
4.2.3 Dealing with affiliate income, minority interests, other income and
financial income
Equity income from associates can be problematic. Only dividend income is received—which is likely to be
less than the investing company’s share of profits, and the company’s pro-rata share of capital expenditure
and debt will not be included in the annual report or prospectus. If associates represent a large proportion of
income on value, they should be valued separately and excluded from the DCF analysis.
Minority interests should be valued separately as appropriate and deducted from the enterprise value when
estimating equity value if they have been added back to net income in calculating free cash flow.
Other income and financial income should be included in the firm’s cash flows to the extent that these
are core business activities. If this is not the case, or if there is significant variability in these items, they should
be excluded from the free cash flows and valued separately.
4.2.5 What to do with loss making or very fast growing subsidiaries and
where DCF valuation may be inappropriate
DCF valuations are only as reliable as the data on which they are based. In the case of loss-making or
fast-growing subsidiaries where there is a lesser degree of confidence regarding likely future performance
additional analysis should be undertaken.
Loss making companies which are not likely to achieve profitability in the future should be considered as if
they are being wound up; their cash flows excluded from the rest of the business and be valued on the basis
of their liquidation value (realisable proceeds net of closure and sale costs). For companies making temporary
losses, consider valuing them on the basis of their net assets, with an appropriate adjustment. Alternatively,
they may be valued on the basis of a normalised operating margin (based on the industry/sector) to derive a
theoretical profitability level, based on turnover/assets. Then amounts for risk and uncertainty should be
deducted in achieving those theoretical profitability levels (very subjective) and costs incurred in getting to
that stage including losses in the intervening period.
Fast growing subsidiaries should be valued independently of the rest of the business if possible in order to
allow analysis and sensitivity of the growth profile of that subsidiary. This should be benchmarked against
other growing companies (past and present) in that sector, and sense-checked in terms of costs of achieving
growth and winning market share.
4.3.1 Definitions
Terminal value is an estimate of the value of business at the end of the projection period, which is in turn
expected to be the present value of the future cash flows from that point. Conceptually, the firm is being
valued on the last day of the last year of the projection period. As with the cashflows during the projection
period, the terminal value needs to be discounted back to the valuation date.
Where “FCFt+1“ is the cash flow in year t+1 and “g” is the perpetual growth rate. This should be discounted
back t years to year zero.
It is important to show a sensitivity table with different assumptions for WACC and g, given their significant
impact on the terminal value, and hence overall value.
4.3.2.2 Multiple
This method assumes that the business trades in the public market or is sold at the end of the
projection period. It is often used as a cross-check to the other terminal value methods. For example, it is
helpful to know what EV/EBITDA multiple is implied by certain perpetuity assumptions and then to
cross-reference this against comparable company benchmarks to check that it is reasonable.
When using multiples it is imperative you apply the right one i.e. a current year sales multiple times year 10
sales will give the value at year 10, as will a one year forward multiple times year 11 sales. A current year
multiple times year 11 sales gives the value at year 11.
If free cash flows are being capitalised, we need to be sure that adequate long-term capex is being provided.
Where the operating statistic used can be sales, EBITDA, EBIT, net income, or another measure as appropriate
for the industry. We also need to bear in mind that, by the terminal value date, many of the special attributes
of a good business may well have been averaged down by competition implying a lower multiple than might
be used today.
NOPLATt 1 (1 g / ROCE)
Terminal value =
WACC g
Where
NOPLATt+1 = the normalised level of net operating profit less adjusted tax (NOPLAT) in the first year after
the explicit forecast period (see section 4.3.8 for detailed calculation of NOPLAT)
g = the expected growth rate in NOPLAT perpetuity
ROCE = the expected rate of return on net new investment
This formula is identical to the Gordon growth formula above in the case where ROCE is equal to WACC
(practically speaking when the return on new investments only equals the WACC), which could feasibly be
the case in mature, competitive markets where opportunities for value-creating investments are no longer
available. Hence the Gordon growth formula is used in most cases.
If you wish to assume that a company remains able to make incremental investments at above its cost of
capital in perpetuity, the above value driver formula can be used. This would be the case where a company is
assumed to have a natural advantage over its competition that will not be eroded over time.
4.3.6 Sanity checking the amount of value embedded in the terminal value?
How much is too much?
The amount of value embedded in the terminal value will be a result of a number of factors, including:
Length of the explicit projection period (longer period will lower proportion of value in terminal value);
and
Growth rate in projection period (higher rates will raise proportion of value in terminal value)
As such, it is not possible to be precise about the proportion of value in the terminal value, except to say that
for a normal business assumed to operate in perpetuity it is likely to be 50–70% depending on the
projection period. If it is higher than this, you should extend the projection period and explicitly model a
longer time period to try to capture a higher proportion of the projections explicitly and thus
improve accuracy.
4.3.7 Understand how to back calculate the implied long-term growth rate if
you use an EBITDA multiple for the terminal value
By rearranging the Gordon growth formula, it is possible to derive the implied long term growth rate. This is
useful to sanity check the EBITDA multiple which is being used to ensure it appropriately reflects the future
prospects of the business at the end of the forecast period. The formula is as follows:
Implied growth rate = WACC – (Steady state cash flow/Terminal value (multiple-based))
With a WACC of 10%, an assumed FCF growth rate of 2% and an assumed NOPLAT growth rate of 7%, the
terminal value (“TV”) would be as follows under the three methods:
1. Perpetual growth:
TV FCF
=
WACC g
96
=
0.10 0.02
= 1,200
= 150 X 7
= 1,050
= 1,000
4.4.1 Definition
The WACC is a measure of the weighted average after tax cost of all sources of capital to an entity. It can
also be thought of as the effective blended rate of return which an entity must pay to capital providers. It is
important to remember that in a typical valuation, the WACC is supposed to represent the appropriate
long term cost of capital.
WACC analysis
SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL
3
Risk free rate (%) WACC (%)
4.24 8.93
Levered company After tax
cost of debt (%) cost of debt (%)
5.74 4.13
15%
4
Cost Levered debt premium
150bp
of
debt
Notes:
1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices
2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure
3 10-year government benchmark bond yield (Source: Bloomberg, Datastream)
4 Company credit margin at chosen financing structure
D E
= (Cost of debt"Kd" ) (1- T) (Cost of equity "Ke")
D E DE
Where
D = Debt component of capital (at market value)
E = Equity component of capital (at market value)
t = Marginal tax rate
Kd = (R+m ) x (1– t)
(i.e. net of tax relief)
Ke = R + (p x ß)
Where
R = Risk free rate
m = Interest margin (i.e. the debt risk premium)
p = Equity risk premium
ß = Beta for the assumed long-term gearing
The risk-free rate (R) can be taken as the yield on the applicable 10-year government bonds. It is important
to take a 10 year bond as this captures longer-term WACC.
The “debt risk premium” (m) is the premium over the yield on long-term government bonds demanded by
the market on the company’s debt. It varies widely according to the credit rating of a company, or underlying
credit strength. DCM or GSF may be able to give an indication of the likely premium for individual companies.
Alternatively check the yield on recent long term (5 years +) financings of the company in question. You
should verify that the all-in cost of debt is correct (i.e. the consistent risk free rate and margin are used).
The “equity risk premium” (p) refers to the premium demanded by equity investors on shares that have an
“average” degree of market related risk and an “average” level of gearing. For equities on major stock
exchanges, it is likely to fall between 4 and 8%.
Beta (ß) reflects the sensitivity of the stock to movements in the market. Betas are dependent upon
the gearing of a company, and when obtained from Barra, Datastream, Bloomberg and most other sources
are “geared betas” which reflect the actual level of gearing for the company concerned (i.e. reflects actual
measured co-variance between movement in the stock and the relevant index). Within normal gearing
ranges, beta can be adjusted to reflect assumed gearing levels different from the actual gearing level using
the following formula:
D
ß geared = ß ungeared x 1 + ( x (1 – t))
E
Betas and equity risk premium data are normally available only for major stock markets. It may still be
possible to use this data when the target business is in a different country, although the equity risk premium
might be higher for a developing economy or an emerging stock market than for, say, the NYSE or London
Stock Exchange (see 4.4.5.2).
Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is
important. The following points should be considered:
The risk-free rate should normally be 2 to 6% above the assumed general long-term rate of inflation
The currency used for projections should be the same as the currency on which WACC is based
The assumptions about capital structure (i.e. proportions of debt and equity) and tax rates should be
reviewed carefully if the company will pay little or no tax under those assumptions
If management provide a discount rate, the underlying assumptions should be checked. Is it after-tax? Is it
a return on equity or a return on capital? For what currency is it calculated? Is it a hurdle rate?
An after-tax discount rate should be used with after-tax cash flows
Turnover and costs are generally projected as nominal values (i.e. they include inflation). There are some
situations in which it is acceptable to discount real cash flows using a “real” discount rate, but using
nominal figures (i.e. which include inflation) is usually more accurate, reduces the possibility of confusion
and is often simpler
The cost of preference shares is defined as the yield to maturity (based on the net dividend) on the
company’s preference shares, with no deduction for corporate tax
The cost of common equity can be calculated based on the CAPM as calculated above, which can be cross-
checked by calculating the implied cost of equity from a dividend discount model (see below).
There may be circumstances where it makes sense to use a different WACC in different years, for example, if
a tax regime is expected to change.
UBS Equity Research calculates a measure of the forward-looking risk premium, which attempts to capture
investor expectations. This implied equity risk premium is derived from a discounted cash flow model, which
equates discounted future streams of earnings (cash flows) to prevailing market valuations and is primarily
used to assess risk appetite. The equilibrating factor is the discount rate, which is the sum of the risk-free rate
and the equity risk premium. Subtracting the long-term bond yield from the discount rate yields the implied
equity risk premium. This methodology has drawbacks arising from the fact that consensus forecasts are
often incomplete and/or date quickly, particularly in volatile markets, potentially giving rise to
anomalous results.
As the wide range of estimates suggests, “p” is difficult to estimate, since it is in theory a measure of the
Ievel of required—rather than actual—equity returns. Because required returns from equities cannot be easily
measured, "p" is often estimated by considering actual stock market returns over a very long period of time,
relative to either short-term or long-term government bond yields. Equity returns can be measured either as a
geometric mean (i.e. the compound average return over the period) or as an arithmetic mean of the annual
returns. There are arguments for both measurement approaches. Similarly, there are arguments both for
using short-term and for using long-term rates as the risk-free rate in this calculation; for our purposes,
long-term rates are preferable since we are attempting to measure the cost of long-term capital, and as such
will be the same as the rate used in calculating the cost of equity.
4.4.5 Beta
Betas are calculated using the following formula:
Beta (Stock) = Covariance (Expected stock return, Expected market return) / Standard deviation (Expected market return)
Forward looking betas are estimated by Barra, but in the absence of reliable data on expected returns,
historic data may be used. This can be downloaded into Excel from information services such as Datastream,
and calculated using standard Excel formulae.
The betas acquired from most public sources reflect the specific debt/(debt—equity) ratio at the time of
measurement. For comparability purposes (e.g. in WACC calculations), we may wish to make use of a beta
with a different capital structure. Note that for companies that have some level of debt, levered betas are
higher than unlevered betas because leverage amplifies the ups and downs of returns for shareholders for
any given level of business risk. Business risk with no leverage is measured by the unlevered beta or asset
beta. The equation overleaf sets out how to adjust the beta for leverage:
Example:
25 = D0 = original debt component of capital (at market value)
D
ß geared = ß ungeared x 1 + ( x (1 – t))
E
40
= 0.90 x 1 + ( x (1 – 33%))
60
= 1.30
To calculate the cost of equity from a dividend discount model, you will need to model the expected future
dividends of the business. Then, taking the current share price of the company, you can calculate the IRR that
is implied by this price and the future cash flows. This IRR is the implied cost of equity. This method does
however rely on dividend estimates being in line with market expectations and as a result can produce
inaccurate results.
FVt= PV x (1+r) t
Where r is the WACC and t is the time period of the cash flow being discounted (i.e. year 1, year 2 etc)
Rearranging, the formula to discount a future value is:
PV = FVt / (1+r) t
10.50
10.25
10.00
WACC (%)
9.75
9.50
9.25
9.00
1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5
Perpetual growth rate (%)
Value @ 50p Value @ 45p
Rate Source
US risk free rate 2.7% 10 year US treasury (Datastream)
Country risk premium 7.2% Difference between 10Yr US$ denominated
Indonesian and US Govt Bonds (Datastream)
Risk free rate 9.9%
Market risk premium 5.8% Deutsche Bank Research report
Levered beta 0.60 Average unlevered beta of peers from Barra,
adjusted for leverage
Cost of equity 13.4%
Parent cost of debt 7.4% 250bps above 10 yr US treasuries (DCM)
Country risk premium 7.2% Difference between 10Yr US$ denominated
Indonesian and US Govt Bonds (Datastream)
Pre-tax cost of debt 14.6%
Marginal tax rate 28.0% KPMG Tax Rate Survey 2008
Post-tax cost of debt 10.5%
Debt/(debt + equity) 30% Assumed long term leverage
WACC 11.2%
There is some debate around whether to include an additional country equity risk premium in the cost of
equity. As in the example above, it can be argued that this is already captured in the risk free rate and that
there is no fundamental reason why an investor in emerging market equities requires a greater spread over
the relevant risk free rate than an investor in, say, Western Europe.
If local data is not available, it is possible to add a country risk premium on top of an established (e.g. UK/US)
risk free rate and market risk premium for a benchmark country. Estimates for this are relatively scarce, but
estimates from Aswath Damodaran, a recognised finance professor are often used (see:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html), as are Bloomberg estimates
(type “CRP”). In the event that a country risk premium is not available either, you should estimate the equity
risk premium by benchmarking against other countries for which data is available based on economic
characteristics.
4.8.2 Betas
Barra betas are commonly used. The latest Barra betas are continuously updated and can be found on the
UBS shared drive, under: \\ldnroot\data\IBD\APPLICATIONS\APPS\Barra\. Barra betas are the preferred source
for betas as they are based on forward looking information from Barra’s equity model and are unlevered.
Alternatively, betas are available from Bloomberg under the security description for equity instruments, or by
typing BETA. Two types are available—the raw beta, based on historical prices, not adjusted for dividends,
etc, or the adjusted beta, calculated as (0.67 x raw beta) + (0.33 x 1). This calculation is intended to give an
estimation of future expected beta. Bloomberg betas are levered betas and hence should be unlevered based
on current leverage and relevered using the assumed long term capital structure.
Betas are also available from Datastream (data type: BETA), based on historic stock price data over the
previous 2.5 years and adjusted for outlying data. These are levered betas and hence should also be adjusted
as per the above.
Consider reviewing the R2 values for your betas. Low R2 values indicate little correlation and hence near
meaningless beta results. These are available on the Beta screen in Bloomberg, or can be calculated in Excel if
using a manual regression of historic market and share price data.
Cash flow weighting 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Years to discount (0.1) 0.2 1.2 2.2 3.2 4.2 5.2 6.2 7.2 8.2
Discount factor 101.2% 98.2% 90.2% 82.8% 76.0% 69.7% 64.0% 58.8% 53.9% 49.5%
PV of FCF (80) 219 249 271 264 247 238 226 216 205
Sum of PV of FCFs 2,054
4
Enterprise value to equity value bridge IMPLIED ENTRY AND EXIT MULTIPLES
Associates 0 0 Perpetual EBITDA
Net non-core assets 0 0 growth multiple
Net (debt)/cash (500) (500) EV/EBITDA (x)
Minority interest 0 0 2009E 9.9x 9.8x
Pension deficit 0 0 2010E 9.5x 9.4x
Equity value 4,581 4,523
Equity value per share (GBP) 15.27 15.08 EV/EBIT (x)
Upside/(downside) to current (%) 53% 51% 2009E 13.0x 12.8x
2010E 12.4x 12.2x
KEY ASSUMPTIONS
WACC (%) 8.9% Implied exit multiples (x)
Perpetual growth rate (%) 2.0% 2018E EBITDA 8.2x 8.0x
Exit EBITDA multiple (based on 2018E EBITDA) (x) 8.0x 2018E EBIT 10.3x 10.1x
5
WACC (%)
WACC (%)
8.4 4,998 5,223 5,483 5,787 6,147 8.4 14.99 15.74 16.61 17.62 18.82
8.9 4,673 4,863 5,081 5,332 5,626 8.9 13.91 14.54 15.27 16.11 17.09
9.4 4,387 4,549 4,733 4,944 5,187 9.4 12.96 13.50 14.11 14.81 15.62
9.9 4,134 4,273 4,430 4,608 4,812 9.9 12.11 12.58 13.10 13.69 14.37
SENSITIVITY TO SALES GROWTH RATE AND WACC
Change in Sales growth (%) Change in Sales growth (%)
5,081.0 (2.0) (1.0) 0.0 1.0 2.0 5,081.0 (2.0) (1.0) 0.0 1.0 2.0
WACC (%) 7.9 4,922 5,417 5,953 6,532 7,157 7.9 14.74 16.39 18.18 20.11 22.19
WACC (%)
8.4 4,551 4,999 5,483 6,006 6,571 8.4 13.50 15.00 16.61 18.35 20.24
8.9 4,233 4,641 5,081 5,557 6,070 8.9 12.44 13.80 15.27 16.86 18.57
9.4 3,957 4,331 4,733 5,169 5,638 9.4 11.52 12.77 14.11 15.56 17.13
9.9 3,716 4,060 4,430 4,830 5,261 9.9 10.72 11.87 13.10 14.43 15.87
SENSITIVITY TO EBITDA MARGIN AND WACC
Change in EBITDA margin (%) Change in EBITDA margin (%)
5,081.0 (2.0) (1.0) 0.0 1.0 2.0 5,081.0 (2.0) (1.0) 0.0 1.0 2.0
7.9 5,429 5,691 5,953 6,215 6,477 7.9 16.43 17.30 18.18 19.05 19.92
WACC (%)
WACC (%)
8.4 4,999 5,241 5,483 5,725 5,966 8.4 15.00 15.80 16.61 17.42 18.22
8.9 4,632 4,857 5,081 5,305 5,530 8.9 13.77 14.52 15.27 16.02 16.77
9.4 4,315 4,524 4,733 4,943 5,152 9.4 12.72 13.41 14.11 14.81 15.51
9.9 4,037 4,234 4,430 4,626 4,823 9.9 11.79 12.45 13.10 13.75 14.41
SENSITIVITY TO NET WORKING CAPITAL AND WACC
Change in NWC as % of sales (%) Change in NWC as % of sales (%)
5,081.0 (5.0) (2.5) 0.0 2.5 5.0 5,081.0 (5.0) (2.5) 0.0 2.5 5.0
7.9 5,987 5,970 5,953 5,936 5,919 7.9 18.29 18.23 18.18 18.12 18.06
WACC (%)
WACC (%)
8.4 5,512 5,498 5,483 5,468 5,453 8.4 16.71 16.66 16.61 16.56 16.51
8.9 5,107 5,094 5,081 5,068 5,055 8.9 15.36 15.31 15.27 15.23 15.18
9.4 4,756 4,745 4,733 4,722 4,711 9.4 14.19 14.15 14.11 14.07 14.04
9.9 4,450 4,440 4,430 4,420 4,410 9.9 13.17 13.13 13.10 13.07 13.03
SENSITIVITY TO CAPEX AND WACC
Change in Capex as % of sales (%) Change in Capex as % of sales (%)
5,081.0 (1.0) (0.5) 0.0 0.5 1.0 5,081.0 (1.0) (0.5) 0.0 0.5 1.0
7.9 6,091 6,022 5,953 5,884 5,815 7.9 18.64 18.41 18.18 17.95 17.72
WACC (%)
WACC (%)
8.4 5,618 5,551 5,483 5,415 5,348 8.4 17.06 16.84 16.61 16.38 16.16
8.9 5,214 5,147 5,081 5,015 4,948 8.9 15.71 15.49 15.27 15.05 14.83
9.4 4,864 4,799 4,733 4,668 4,603 9.4 14.55 14.33 14.11 13.89 13.68
9.9 4,558 4,494 4,430 4,366 4,302 9.9 13.53 13.31 13.10 12.89 12.67
6
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00
WACC analysis
SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL
3
Risk free rate (%) WACC (%)
4.24 8.93
Levered company After tax
cost of debt (%) cost of debt (%)
5.74 4.13
15%
4
Cost Levered debt premium
150bp
of
debt
Notes:
1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices
2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure
3 10-year government benchmark bond yield (Source: Bloomberg, Datastream)
4 Company credit margin at chosen financing structure
Beta analysis
Beta methodology Company data 1.0
WACC—SENSITIVITY ANALYSIS
Capital structure Relevered Cost of debt
D/E D/(D+E) beta Cost of equity Pre-tax Post-tax Cost of capital
(%) (%) (x) (%) (%) (%) (%)
Notes:
1 Market cap as of [•]
2 Latest reported net debt as of [•]
17
SECTION 5
Minimal future capital requirements: The priority of a company that has been acquired through a LBO
is the payment of interest and principal payments on the new debt. All other things being equal,
companies with lower maintenance capital expenditure requirements can dedicate more cash to servicing
their debt
Divestible assets: Unrelated or potentially non-core divisions can greatly enhance the attractiveness of a
target company, since they may be sold to raise funds for repayment of debt if required
Strong, incentivised management team: Good management is often thought of as the single most
important factor in any LBO. A motivated and competent management group is needed to run the
company after the buy-out. In most cases, the best choice is for existing management to take an equity
interest in the company. However, new management is sometimes brought in by investors. The LBO
structure typically provides strong incentives/rewards for successful management teams which is a key
differentiator versus traditional strategic bidders
Viable exit strategy: The private equity firm should have a strategy for exiting the business within an
appropriate timeframe, either by selling the business to a strategic buyer or by selling equity to the public
through an initial public offering. Over the past years, secondary buy-outs (i.e. a sale to another financial
investor) have been offered as viable exit strategies, however these do rely on the availability of debt
Potential for restructuring: Significant value in a LBO can often be created through restructuring the
operations of the business (i.e. cost cutting, process efficiencies). Often divisions of large corporates have
never had a true focus on the efficiency of operations and this represents a significant opportunity to
create value for the equity investors in a LBO
Technology: State-of-the-art technology helps ensure maximum efficiency and profitability. The nature
and requirements of the technology platform should be considered, particularly in relation to capital
expenditure requirements
Skeletons: Any litigation problems, environmental concerns or other unresolved contingent liabilities can
be “deal-breakers” since these problems can make financing difficult to attain given the risk implied
The interplay between the fixed and variable financing ("leverage") and its effects can be illustrated with
an example.
yr 1 (m) yr 5 (m) CAGR (%)
EBITDA 100 150 10.7
EBITDA multiple 6x 6x
Enterprise value 600 900 10.7
Debt outstanding (300) (150)
Equity value 300 750 25.7
Though the percentage growth in firm value is relatively modest (under 11%), the investors in the equity
would have achieved 26% per annum return on their investment. Of course, the effects of leverage can work
equally dramatically in the opposite direction if the firm value decreases even modestly. The impact is
accentuated if the fall in value stems from a fall in earnings as the debt will be paid off less rapidly. As a rule
of thumb, many assume that entry multiple = exit multiple. However, financial investors are increasingly
factoring in market, sector and company specific factors when determining assumptions and further analysis
should be undertaken to support exit multiple assumptions (i.e. trading of multiples through the cycle).
1
Senior debt Generally secured on the assets of Banks, institutional buyers,
the business and ranking ahead of CLOs
all other claims on the business in
the event of a liquidation
(exceptions apply)
2
Subordinated debt (high Subordinate to the senior debt but Institutional bond investors,
yield bonds or mezzanine ranking ahead of other claims on mezzanine funds, banks
debt) the business.
3
Equity Ordinary shares or preference LBO funds, venture
shares or subordinated loan stock capitalists, management
groups etc
3 Equity 3 Equity/
shareholder
loan
3 New Co (equity)
Existing debt
Target Co
(normally refinanced)
The multiple of total net debt to EBITDA is often used as the key determinant of debt capacity, indeed this
ratio is often put forward as a benchmark indicator. However, as stated above, it should not be used to the
exclusion of the other drivers. The total debt to EBITDA ratio uses EBITDA as a proxy for cash flow and shows
the number of years of such cash flow that would be required to repay all debt. Total net debt would
normally exclude trapped cash which is either required for operations or “trapped” in a foreign jurisdiction.
Free Cash Flow
The ability of a company to repay debt out of free cash flow (after interest) is critical. Most LBO transactions
are structured with an element of amortising senior debt which is repaid over a given number of years from
cash flow. Limited free cash flow results in limited senior debt capacity.
Interest coverage
EBITDA
Cash interest
A more comprehensive measure of a firm’s ability to meet its fixed-charge obligations. Although banks
normally only consider cash interest, they might also look at the coverage including PIK interest.
Equity Gearing
Equity
Debt + Equity
The amount of equity required in a transaction is governed both by debt capacity but also by the extent to
which the industry and development story of the company is determined to be “equity risk”.
1 Model the cash flows of the business for a forecast period of 10 years. The key components for
cash flows are Revenue, EBITDA, Depreciation, Capex and Change in Net working capital. A guide
to building up projections is set out in Section 4. In addition, we should consider whether there are
any ways of generating further cash such as reducing working capital requirements or capital
expenditure (although take account of any impact this may have on growth) and model these into
the business
You should also consider disposals of surplus assets. However, little reliance should be put on
disposals in order to make the financing ”work“ as there is often significant execution risk around
disposals. The projections should generally be for the business on a stand alone basis and this may
necessitate adjustment of the numbers available to reflect the costs of provision of certain
central functions
2 When modelling a LBO, the base interest rate for senior debt tranches should be taken as the
blended rate between the three-year swap rate and the three-months LIBOR rate in the currency of
borrowing to reflect the cost of interest rate hedging (normally LBOs are required to fix at least
50% of their variable borrowing cost to reduce risk). If the debt is to be multi-currency, then a
weighted average rate should be estimated given the relative proportions of the regional revenues
or assumed currencies through which the borrowing take place
In addition to the base rate, the interest rate margins applicable to senior debt vary according to
tenor, amortisation schedule, market conditions and deal structure. In general, a shorter term
amortising tranche (Term Loan A) will have lower margins than a longer bullet repayment tranche
(Term Loan B and C). The price of senior debt, as with other debt tranches, is ultimately market
driven as LBO debt is usually syndicated. As such, the GSF team should always be consulted in
determining appropriate margins and the overall level of debt
Purely for illustrative purposes, a seven year amortising tranche may price at a margin of
approximately 325 basis points above the base rate while an eight year bullet repayment tranche
may price at around 400 basis points above base rate
3 In practice, capital structures vary significantly according to the nature of the business and market
conditions. Normal European structures would have Term Loan A, B and C as well as a Mezzanine
tranche. Previously, there have been second lien and high yield tranches in some deals as well. In
2007-2008, many deals were executed without a Term Loan C
For example, a buy-out in March 2008 of a European based telecoms company with an EV of
€2,000m and EBITDA of €200m could have had approximately 5.0x total debt as of the transaction.
The capital structure might have looked as follows:
4 Based on a typical scenario, assume an exit in year 3 at an EBITDA multiple equivalent to the multiple
at which the business is assumed to be purchased. However, as referenced earlier, more
sophisticated assumptions are normally required
5 The iterative process now begins. The first step would be to check if fixed charge cover, leverage
(i.e. the gross and net debt/EBITDA ratio), debt repayment and investor returns are adequate. If they
are, then a higher total valuation may be possible. If not then an iterative process begins of flexing
the proportions of debt, equity and total value so as to reach a position when all investors'
requirements are satisfied. If they cannot be, then the total value may need to be reduced
6 The outcome of a LBO will be sensitive to a number of assumptions, in particular the rate of growth
of the business, the exit multiple and the year of exit. The modeller should sensitize the assumptions.
Basic sensitivity tables have been incorporated into the standard LBO model
Given these multiple effects, it is normal to show a range of sensitivities when presenting LBO valuation
outputs, typical tables may be as follows
A yr 3 IRR
Purchase EV (£m)
120.0 125.0 130.0 135.0
Entry LTM EBITDA (x)
9.3 9.7 10.1 10.5
Offer premium (%)
20.0 25.7 31.4 37.1
Offer price (£)
1.20 1.26 1.31 1.37
7.5 26.7 21.3 17.1 13.6
Exit LTM EBITDA (x)
12
A LBO critically relies on the ability of a company to generate cash to service its debt. In the example
below, cash flows in excess of servicing fixed charges are relatively modest in the stub year. Thereafter,
significant cash becomes available to pay down some of the outstanding debt
13
It is essential that the use of excess cash is properly modelled. Below is an extract from the debt
schedule, from which the sequential order in which the debt tranches are paid down is evident
Outstanding debt balances (Capital Structure I)
(March y/e GBPm) Stub 09 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
RCF
RCF available 200 200 200 200 200 200 200 200 200 200
RCF, BoP 0 0 0 0 0 0 0 0 0 0
Drawdown/(repayment) 0 0 0 0 0 0 0 0 0 0
RCF, EoP 0 0 0 0 0 0 0 0 0 0 0
Average drawn RCF 0 0 0 0 0 0 0 0 0 0
Average undrawn RCF 0.5% 200 200 200 200 200 200 200 200 200 200
Interest on RCF 7.3% (0) (1) (1) (1) (1) (1) (1) (1) (1) (1)
Cash flow available post repayment of RCF 10 110 150 189 215 224 233 236 243 246
Term Loan A
Term loan A, BoP 234 224 115 0 0 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment (10) (110) (115) 0 0 0 0 0 0 0
Term loan A, EoP 234 224 115 0 0 0 0 0 0 0 0
Interest on Term loan A 7.3% (3) (12) (4) 0 0 0 0 0 0 0
Cash flow available post repayment of Term loan A 0 0 35 189 215 224 233 236 243 246
Term Loan B
Term loan B, BoP 234 234 234 199 10 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 (35) (189) (10) 0 0 0 0 0
Term loan B, EoP 234 234 234 199 10 0 0 0 0 0 0
Interest on Term loan B 7.8% (3) (18) (17) (8) (0) 0 0 0 0 0
Cash flow available post repayment of Term loan B 0 0 0 0 205 224 233 236 243 246
Term Loan C
Term loan C, BoP 234 234 234 234 234 29 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 0 0 (205) (29) 0 0 0 0
Term loan C, EoP 234 234 234 234 234 29 0 0 0 0 0
Interest on Term loan C 8.3% (3) (19) (19) (19) (11) (1) 0 0 0 0
Cash flow available post repayment of Term loan C 0 0 0 0 0 195 233 236 243 246
Second Lien
Second Lien, BoP 0 0 0 0 0 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 0 0 0 0 0 0 0 0
Second Lien, EoP 0 0 0 0 0 0 0 0 0 0 0
Interest on Second Lien 7.3% 0 0 0 0 0 0 0 0 0 0
Cash flow available post repayment of Second Lien 0 0 0 0 0 195 233 236 243 246
Below is the key valuation output for the LBO. IRRs on the equity investment are calculated based upon
set exit years and exit multiples. This table should also be accompanied in any presentation by the
sensitivity tables outlined above (see section 5.7.3)
LTM Exit Net Loan Equity Money Inv. Cost Year 1 Year 2 Year 3 Year 4 Year 5
EBITDA multiple EV debt note value IRR multiple (GBPm) 2009E 2010E 2011E 2012E 2013E
(GBPm) (x) (GBPm) (GBPm) (GBPm) (GBPm) (%) (x) Jan 09 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13
2010E 493 5.0x 2,464 796 922 745 1% 1.0x (1,574) -- 1,593
493 5.5x 2,710 796 922 992 13% 1.2x (1,574) -- 1,814
493 6.0x 2,956 796 922 1,238 25% 1.3x (1,574) -- 2,036
493 6.5x 3,203 796 922 1,485 36% 1.4x (1,574) -- 2,258
493 7.0x 3,449 796 922 1,731 48% 1.6x (1,574) -- 2,480
2011E 519 5.0x 2,594 621 1,014 959 8% 1.2x (1,574) -- -- 1,877
519 5.5x 2,853 621 1,014 1,218 15% 1.3x (1,574) -- -- 2,110
519 6.0x 3,113 621 1,014 1,478 20% 1.5x (1,574) -- -- 2,344
519 6.5x 3,372 621 1,014 1,737 26% 1.6x (1,574) -- -- 2,577
519 7.0x 3,631 621 1,014 1,996 31% 1.8x (1,574) -- -- 2,811
2012E 544 5.0x 2,720 401 1,115 1,203 11% 1.4x (1,574) -- -- -- 2,198
544 5.5x 2,992 401 1,115 1,475 15% 1.6x (1,574) -- -- -- 2,443
544 6.0x 3,264 401 1,115 1,747 18% 1.7x (1,574) -- -- -- 2,687
544 6.5x 3,535 401 1,115 2,019 22% 1.9x (1,574) -- -- -- 2,932
544 7.0x 3,807 401 1,115 2,291 25% 2.0x (1,574) -- -- -- 3,177
2013E 566 5.0x 2,828 153 1,227 1,449 12% 1.6x (1,574) -- -- -- -- 2,531
566 5.5x 3,111 153 1,227 1,731 15% 1.8x (1,574) -- -- -- -- 2,785
566 6.0x 3,394 153 1,227 2,014 17% 1.9x (1,574) -- -- -- -- 3,040
566 6.5x 3,677 153 1,227 2,297 19% 2.1x (1,574) -- -- -- -- 3,294
566 7.0x 3,960 153 1,227 2,580 22% 2.3x (1,574) -- -- -- -- 3,549
Note: 1. Assumes offer price of GBP7.50, EV purchase price of GBP2,586m, and an entry leverage of 2.0x LTM EBITDA
SECTION 6
6.1.1 Definition
The sum-of-the-part (“SoTP”) methodology values a company by applying different valuation techniques to
its separate units. The sum of these values makes up the total enterprise value (“EV”) of the company.
6.1.2 Application
This methodology is used to value holding companies or conglomerates where the constituent businesses
require different valuation techniques. It is well-suited to valuations involving restructuring and where a
client is considering a strategic review or sale of one of its businesses. It is quite common for UBS or other
equity research to include a SOTP valuation in their reports
The individual businesses can be valued on a (1) trading, (2) break-up or (3) fundamental basis
– (1 & 3) a group conducting a full de-merger of its businesses in two separately quoted entities
– (2 & 3) a group selling one of its subsidiaries to a trade buyer
– (1, 2 & 3) an acquirer disposing unwanted parts of its recently acquired target via a combination of
flotation and a trade sale
Helps to understand whether the company is more valuable as a whole or in parts
Helps to identify value-driving business units
Care needs to be taken to account for synergies and dissynergies
6.1.5.1 Calculations
Multiple (x) Value
(€m) Methodology Low-high Reference Share held (%) Low-high
Listed portfolio
Subsidiary 1 Market cap na 2,526 68.3 1,725
Subsidiary 2 Market cap na 1,236 43.4 536
Non-listed portfolio
Subsidiary 3 P/E 8–10 10 88.0 70–88
Subsidiary 4 P/TBV 1.0–1.5 600 95.3 572–858
Subsidiary 5 EV/EBITDA less 5–7 254 63.7 809–1,133
net debt¹
Operating units 3,713–4,340
Corporate function P/E 8 (8) (64)
Net debt P/BV 1 (150) (150)
Total 3,499–4,126
Note:
1 Assumed net debt at the subsidiary is zero
Sum-of-the-parts valuation
4,500 4,340
1,133 4,126
4,000
809 3,713
3,500 3,499
858 ( 64 )
( 150 )
3,123
3,000 572
(€m)
2,500 536 88
70
2,000
1,725
1,500
1,000
500
Sub 1 Sub 2 Sub 3 Sub 4 Sub 5 Operating Corporate Debt Total Market
units cap
Consistency Ensure the values for all parts are either EVs or equity values
NOPLAT = Normal operating profit less adjusted taxes. Essentially EBIT adjusted to exclude income from
non-core assets and remove any implied interest cost in respect of unfunded pensions less tax related to
this core EBIT
Capital employed = the total capital utilised in the generation of operating profit (essentially shareholders
funds plus net debt and the value of other sources of finance). This should capture shareholders' funds
plus minority interests, net debt, unfunded pension provisions and any other source of finance less the
value of non-core assets
WACC = Weighted average cost of capital. This should capture the average post tax cost of all sources of
finance weighted according to market values
ROCE = A post tax rate of return on invested capital = NOPLAT / Capital employed (either average or
opening capital is used)
Assumptions
WACC 10.0%
Terminal growth (g) 6.0%
Return on new investments (ROCE) 20.0%
Tax rate 25%
% D&A of Sales 6.0%
% Capex of D&A 120.0%
% of change in WC 7.5%
1 2 3 4 5 TV
Capital employed
Opening balance 1,000 1,020 1,040 1,063 1,088 1,109
D&A (60) (66) (73) (80) (83)
Capex 72 79 87 96 100
Change in WC 8 8 8 9 4
Closing balance 1020 1040 1063 1088 1109
1 2 3 4 5 TV
EBIT 250 275 303 333 346 367
Tax (63) (69) (76) (83) (87) (92)
NOPLAT (A) 188 206 227 250 260 275
Opening capital * WACC (B) (100) (102) (104) (106) (109) (111)
EVA (A-B) 88 104 123 143 151 164
NPV of EVA 80 86 92 98 94
Sum of NPV of EVA (C) 449
Terminal values in A constant terminal growth of cash flows does not imply the same
EVA… constant terminal growth of the EVA!
The growth rate you use to estimate after-tax operating income in future
periods should be estimated from fundamentals when doing discounted
cash flow valuation.
– Set growth rate = Reinvestment rate x Return on capital
– if the above relationship does not hold, different values will obtained
from the DCF and EVA valuations
The APV valuation method is considered effective in situations which have a changing capital structure of the
company over time (as opposed to DCF valuation which assumes a long-term, constant capital structure).
A key advantage of the APV approach is the flexibility it gives. Essentially it allows the separation of the
effects of debt into different components and allows the use of different discount rates for each component.
APV and the standard DCF approaches should give the identical result if the capital structure remains stable.
APV analyses financing effects separately and then adds their value to that of the business. APV allows the
manager to more easily identify the sources of value in a project, providing a better understanding of
the project.
– where βu = non-levered beta; βe = Levered beta; βd = beta of debt; E = Market Value of Equity; D =
Market Value of Debt; t= tax Rate
– discount the non-levered annual FCF and terminal values using Ku
– this results in the NPV assuming the business were financed entirely by equity
2. The value of the tax benefits associated with debt financing:
– calculate the interest tax shield by multiplying the annual interest expenses with the marginal tax rate
on a year-by-year basis
– calculate Terminal value of interest tax shields (based on long term capital structure assumptions)
Terminal value = interest tax shieldN+1 / (cost of debt – perpetual growth rate)
– discount the tax savings at the estimated cost of debt. The cost of debt should be pre-tax
Assumptions
Tax rate 35.0%
Cost of debt 6.0%
Cost of equity 12.4%
Debt ratio (D/V) 40%
Long-term growth forecast 3.0%
Calculation of TV
FCFTV / (WACC – long term growth forecast) 242.2
= 14.5 / (9% -3%)
NPV of Terminal value 144.4
Terminal value / (1+WACC)^(1 / terminal year)
= 242.2 / (1+ 9.84%)^(1/6)
3. Total APV
The aim of an EV is to recognise the profit as it is earned over the life of the insurance policy (i.e.: when it is
earned, not when it is released to shareholders). EV is the value of the product sold, estimated at time of sale
and booked in P&L. The future profits are discounted at a risk discount rate, typically calculated as risk free
rate plus a risk premium and often different for different products.
The goodwill can be calculated as a multiple of the VNB, usually in the order of 4–8 times. Do not mistake
this goodwill with the accounting term—this is the terminology used for the franchise value in life insurance.
For an in-depth calculation of AV, please refer to the UBS Valuation Guide Book, Life and Pensions Insurers,
prepared by FIG.
APPENDIX A
A.1. Adjustments
It is difficult to make a list of all possible EV adjustments. In practice, adjustments will be decided within each
team. Focus should be on adjustments that are likely to have a material impact on the enterprise value
calculation. The key is being consistent with all adjustments.
Impact on NOSH Equity value = (“A” shares x “A” price) + (“B” shares x “B” price)
A.1.2.1. Options
Comments
Principle Only include “in the money” options in number of shares outstanding
– typically all options vest on “change of control” event
Treasury method is the most common
– proceeds from conversion of options are used to buy back shares at
offer price
In theory, “out of the money” options will also have value and should be
included in equity value – in practice this value is not available from
public documents and requires specialist option valuation
A.1.2.2. Convertibles
Comments
Principle “In the money” when the conversion price < offer price
– increases diluted NOSH
– adjust Net income for the interest expense (post tax)
– convertible bond should be EXCLUDED from the net debt
“Out of the money” when the conversion price > offer price
– convertible bond should be INCLUDED in the net debt
– use aggregate amount of the debt and option components
Impact on NOSH New shares issued = face value of convertibles ÷ conversion price
Impact on The convertible interest charge (post tax) is added back to get the
income earnings figure as if the convertible did not exist
Impact on Either: “out of money” in which case treat convertible as part of net
debt debt
Or: “in the money” in which case include as part of net debt as market
value (and do not make the other adjustments above)
A.1.2.3. Pensions
Comments
Principle Pension liabilities are effectively long-term debt used to fund employee
compensation and as a result have an impact on EV
Pension deficit (post tax) needs to be added to the EV
– = (value of plan assets) – (value of plan liabilities)
Other pension employment benefits (OPEBs) is not usually funded
– OPEBs deficit treated as debt equivalent in EV on a post tax basis
Normally pension expense treated as operating item and included in EBIT
– in reality, only service is truly the operating item
A.1.2.6. Exceptionals
Comments
Principle All line items should be adjusted for exceptionals and exclude
discontinued operations where relevant
Common exceptionals include:
– restructuring charges
– impairment of fixed and intangible assets
– large loss/gain on disposals
Goodwill amortisation has disappeared (US GAAP + IFRS)
– but replaced by impairment—to be treated as an exceptional
APPENDIX B
Glossary
8.
Glossary
Term Meaning
Adjusted present value A variant of the DCF used to calculate the net present value of a company or
(“APV”) project assuming it were financed entirely by equity plus the net present value
of the tax shield created by using debt in the capital structure
Appraisal value (“AV”) Appraisal Value is the key methodology for the valuation of life insurance and
pensions companies. It is an intrinsic valuation methodology similar to a DCF
or DDM but made simpler by the use of Embedded Value (“EV”) and Value of
New Business (“VNB”)
Beta A measure of the sensitivity of the stock to movements in the market
Covariance (historical stock return, historical market return)/
Variance (historical market return)
Break-up value Break-up value is the total value of the company if its operations are sold
separately, as such this is a transaction valuation
Call Option Right, but not the obligation, to buy a security at a specified price
Capex Capital expenditures
Capital Asset Pricing Model Theoretical model used to estimate expected cost of equity based on
(“CAPM”) correlation with the overall market
Capital lease See Finance Lease
Compound annual Equivalent annual growth for a given period CAGR
growth rate (“CAGR”) (Year “n” value ÷ Year 1 value) ^ (1 / (n-1)) – 1
Conglomerate Conglomerate is a group of different businesses whose operations are not
integrated with each other
Conglomerate/holding Conglomerate/holding company discount is the discount to underlying net
company discount asset value (“NAV”) at which conglomerates are valued
Contingent liability A liability for which its value depends on certain other values or events
(e.g. Lawsuits)
Control premium Incremental price required to obtain control
Conversion price Price at which a convertible security converts
Convertible security Security that is convertible into another security at a prestated price
Creditor days Creditors/Cost of Goods Sold x 365
Debt risk premium The premium over the yield on long-term government bonds demanded by
the market on the company’s debt
Debtor days Debtors/Sales x 365
Deferred tax Deferred tax is an accounting item that effectively smoothes the difference
between the tax charge expected in the accounts and what is actually payable
Defined benefit pension A plan where the retirement benefits are defined by a company,
who are obligated to meet payments at a set level, regardless of
investment performance
Defined A plan providing an individual account for each participant, who will reveive
contribution pension benefits based solely on the amount contributed to the plan and the returns
on assets in which the plan invests
Discounted cash flow Present value of cashflow. Cashflow/(1+Discount rate)t
(“DCF”)
Dividend discount model Valuation method to derive equity value by discounting future dividends
(“DDM”)
Term Meaning
EBITA Earnings before interest, tax and amortisation
EBITDA Earnings before interest, tax, depreciation and amortisation
EBITDA Debt Leverage Total net debt
EBITDA
EBITDAR Earnings before interest, tax, depreciation, amortisations and rents/leases
Economic value added Valuation methodology comparing the returns a company generates with cost
(“EVA”) of capital
NOPLAT – opening capital employed x WACC OR
Capital employed x (ROCE – WACC)
Effective tax rate Income tax expense/taxable income
Enterprise value (“EV”) Represents the total value of a business/enterprise to all providers of capital
(debt, minorities, preference, equity)
Equity value + net debt + minority interests + pension deficit + off-balance
sheet items + other debt-like items
Equity Gearing Equity
Debt + Equity
Equity risk premium The premium demanded by equity investors on shares which have an
“average” degree of market related risk and an “average” level of gearing
Equity value Represents the value to the providers of equity, after net debt, minorities and
preference shares have been deducted from enterprise value
EURIBOR European Interbank Offer Rate
Exercise price Price at which an option holder may buy or sell a security
Finance lease A finance or capital lease generally lasts for the life of the asset, with the
present value of lease payments almost equivalent to the price of the asset
Fixed Charge Coverage Cash flow available for debt service
Interest plus scheduled repayment
Free cash flow (“FCF”) Cash flow available to service capital (cash flow from operations less capex)
Fundamental valuation Reflects the net present value of the cash flows of the business
Holding company Holding company is a company whose single raison d’être is to hold shares
in other companies (usually the company does not produce goods or
services itself)
Internal rate of return Equivalent annual return CAGR on an investment
(“IRR”) Corresponds to discount rate at which NPV=0
Lease A lease is a contract between two parties: one party (lessee) has right to use
an asset which is owned by another (lessor) for a fixed or indefinite period of
time, whereby the lessee obtains exclusive possession of the property in return
for paying the lessor a fixed or determinable payment. The lessor retains the
legal ownership of the asset
Leveraged buy-out (“LBO”) Purchase of a company through use of a high proportion of debt financing
LIBOR London Interbank Offer Rate
Marginal tax rate Statutory tax rate in specified jurisdiction
Minority interest Third party ownership in a parent company’s subsidiary
Money multiple Cash exit value as a multiple of cash entry value of a given investment
Net debt Short-term + long-term interest-bearing liabilities—cash and cash equivalents
(marketable securities)
Net present value (“NPV”) See discounted cash flow
Term Meaning
NOPLAT Net operating profit less adjusted taxes (practically speaking, taxed EBIT
adjusting for non-deductible items)
Off-balance sheet liability Liability of a company which does not appear on its balance sheet
Operating lease An operating lease is usually signed for a period considerably shorter than the
useful life of the asset and the present value of lease payments are generally
much lower than the actual price of the asset
Option Right to buy or sell a security. See Call Option and Put Option
Perpetual growth Method for calculating terminal value based on a single future growth rate
FCFt 1
WACC g
Preference shares Shares paying a fixed return. May be supplied with warrants attached
Put Option Right, but not the obligation, to sell a security at a specified price
Return on Return a business generates on its total capital
capital employed (“ROCE”) ROCE = EBIT / (average shareholders funds + net debt)
Return on equity (“ROE”) Return a business generates on its equity
ROE = Net income / average shareholders funds
Return on invested capital See return on capital employed
(“ROIC”)
Stock days Stock / Cost of Goods Sold x 365
Sum of the parts (“SOTP”) Valuation method involving the separate valuation of different parts of a
business to determine aggregate value
Synergies The financial benefits that a company expects to realise from the integration
of two businesses
Terminal value An estimate of the value of business at the end of the projection period
Trading valuation Reflects the theoretical value of one share as part of a listed entity
Transaction valuation Reflects the value an acquirer can derive from controlling a company
Unaffected market value Market capitalisation of a listed company implied by the closing price on the
day prior to rumour or speculation of impending corporate transactions (e.g.
takeover speculation)
Volume weighted Average share price over a period where each day’s closing price is weighted
average price (“VWAP”) by volume traded that day
Warrant Entitlement to buy an amount of a security (usually common stock) at a
specified price
Weighted average cost Weighted cost of debt + weighted cost of equity =
of capital (“WACC”)
D E
(Cost of debt"Kd" ) (1 T) (Cost of equity"Ke")
D E D E
APPENDIX C
Further reading
9.
Further reading
Valuation & Accounting
Damodaran on Valuation: Security Analysis for Investment and Corporate Finance
Equity Valuation: Models from Leading Investment Banks by Jan Viebig, Thorsten Poddig and
Armin Varmaz
Applied Mergers And Acquisitions by Joseph R. Perella, Robert F. Bruner
Accounting For M & A, Equity, And Credit Analysts by James E. Morris
Valuation: Measuring And Managing The Value Of Companies by Tim Koller, Marc Goedhart &
David Wessels
Security Analysis: Principles And Techniques by Benjamin Graham and David Dodd
Corporate Finance: Theory And Practice by Pierre Vernimmen and Pascal Quiry
Business Analysis And Valuation: Using Financial Statements by Krishna G. Palepu and Paul M. Healy
The Quest for Value by G. Bennett Stewart
Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing by
Hersh Shefrin