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Valuation Manual
January 2018
Valuation Manual
This manual has been prepared to provide students of the EDHEC Advanced Corporate
Finance module with an overview of standard valuation techniques and discussion of key
issues. It should not be relied upon in a professional setting and should not be distributed
without consent.
Valuation Manual
Contents
1. Summary of valuation methodology 4
1.1 Summary of valuation methodology 4
2. Forecasting a business plan 5
2.1 Introduction 5
2.2 Check notes to accounts & read MD&A 5
2.3 Key operating data 5
2.4 Key financing data 8
2.5 Other profit & loss items 8
2.6 Other balance sheet items 9
2.7 Net debt 9
3. DCF analysis 10
3.1 Introduction 10
3.2 Why do we use DCF? 10
3.3 Which cash flows do we value? 10
3.4 Explicit cash flow forecasts and the terminal value 12
3.5 The valuation exercise 12
3.6 Terminal Value 13
3.7 Discounting free cash flows and continuing value 15
3.8 From present value of FCF to equity value 16
3.9 Sensitivity analyses 19
4. Weighted Average Cost of Capital 20
4.1 Cost of Capital 20
4.2 The cost of equity 20
4.3 The cost of debt 2
4.4 The effect of tax on the cost of debt and equity returns 4
4.5 Capital structure and weightings 4
5. Multiple valuation 5
5.1 Introduction 5
5.2 Enterprise value vs market capitalisation 5
5.3 Accounting for subsidiaries, associates and investments 5
5.4 Treatment of minority interests and income from associates in multiples 6
5.5 General procedural rules 7
5.6 Accounting inputs 7
5.7 Control premiums 7
5.8 Comparable transactions 7
Valuation Manual
Comparable • Analysis based on market value • Simple widely-used valuation tool • Static-priced
Companies (“CoCo”) of comparable companies
also known as • Useful for comparisons of relative • Difficult to value unprofitable
Trading multiples • Relative valuation rather than value businesses
absolute
• All value drivers incorporated into • Takes no account of long-term
• Equity market multiples applied one statistic value drivers – growth, margin
to forecasted normalised improvement etc.
operating results • Most suitable for mature
companies • Historic multiples take no
account of future fortunes
• Market inefficiencies (e.g. small
cap. effect)
Comparable • Analysis based on pricing of • Simple widely-used valuation tool • Difficult to value unprofitable
Transactions comparable transactions businesses
(“CoTrans”) also • All value drivers incorporated into
known as • Relative rather than absolute one statistic • Difficult to split out level of
Transaction valuation synergistic benefits
• Includes premium for control
multiples • Applied to historical LTM (‘takeout’ valuation) • Private vs public company
operating results control premium
• Quality of data
LBO analysis • Valuation driven by debt capacity • Estimates the price level a • Difficult to forecast out accurately
and IRR target of sponsor financial buyer is prepared to pay
on basis of IRR requirements • Exit value/multiple is critical
• Fundamental analysis of future
cash flows and standalone debt • Efficient/aggressive capital • More focussed on price rather
capacity structure than fundamental value
Net asset value • Balance sheet based valuation • Can be used to approximate • Ignores future profitability / cash
(NAV) approach liquidation / break-up value flows
• Used primarily in asset heavy • Balance sheet items can be
industries and in particular real historical and cost based
estate
• Assets can only marked to
• Balance sheet items can be market where reliable valuation
individually ‘marked to market’ benchmarks exist
where possible
Valuation Manual
2.1 Introduction
When conducting a company valuation it is important to understand its historical performance. By analysing a
company’s historical performance one should:
Identify all key BS, P&L as well as CF line items
Perform ratio analyses and identify the key trends of these ratios
Benchmark historical ratios with comparable companies or sector averages
Furthermore, it is equally important to understand the business, industry dynamics and firms’ strategy. The
following steps should be taken into account:
Acquire basic understanding of the business
Conduct analysis on key industry trends
Develop a view on the companies’
- competitive environment
- opportunities & threats
- strengths & weaknesses
- strategy going forward
Identify the key value drivers of the industry and firm
Construct a plausible storyline for forecasting
A business plan is an important tool for analysing a company's prospective financial performance/position. The
derivation of the assumptions underpinning a business plan provides a useful framework for bankers to discuss
the company's prospects/operating environment with company management. As well as highlighting a company's
principal value drivers, the business plan will form the foundation for among others a DCF analysis, an LBO
analysis and a merger analysis.
Work in progress
1
Technically the nominal price increase n is given by (1+n) =(1 +i) x (1+r), where i is the rate of the inflation and r is the real
price increase. However, at most projected growth rates and inflation levels there will not be a large error introduced by
simplifying this to n = i + r.
Valuation Manual
The source of work in progress related sales should be analysed and included in a separate line item in the model.
On the long term work in progress should trend towards zero as you may assume that on the long term production
volume is equal to sales volume.
Operating costs
Operating costs comprise all costs with a fixed as well as a variable nature, including personnel expenses (wages
and salaries, social security charges, pension charges), selling and marketing expenses, IT expenses, R&D
expenses etc. To the extent that operating costs are separately identifiable it is best practice to model them
separately according to the driver of that cost rather than as a simple percentage of sales. This is especially the
case with personnel expenses. Information regarding FTEs is available for most companies. If possible, wages
and salaries forecasts should be based on number of FTEs multiplied by cost per FTE. As mentioned earlier,
using a P * Q approach is the preferred option as it reflects in a better way the effect of economies of scale. Other
personnel expenses such as social security and pension charges are usually forecast as a percentage of total
wages as this is the driver of these costs.
All other operating costs in can be modelled as a percentage of sales, and as such one should model costs on a
separate sheet if another driver is more applicable. With regard to R&D and IT costs one could choose to
forecasts these costs with a growth rate for the first years (for example 3 – 5 years) of the business plan and once
sales have ended up in steady state switch the driver as a percentage of sales.
Exceptional items
To be able to forecast the underlying business accurately, exceptional items such as restructuring charges should
be excluded from historical reported figures and modelled separately going forward. By definition exceptional
items should be non-recurring. However, based on e.g. expected restructuring costs in the business plan period
exceptional costs may occur in the near future. Always analyse whether these costs are actual cash outs and if so,
do take them into account in the free cash flow calculation of the valuation.
2.3.3 Depreciation
There are a number of ways to forecast depreciation of tangible fixed assets. A standard approach is to forecast
as a percentage of average tangible fixed assets. Effects of disposals/acquisitions and the timing thereof during
the year should be taken into account when analysing historical figures.
From a valuation/cash perspective please bear in mind depreciation has only an effect on taxes paid.
Depreciation could also be modelled using a useful economic life concept. In this more detailed approach existing
fixed assets and future capital expenditures are depreciated based on their respective useful life.
Valuation Manual
2.3.4 Amortisation
Amortisation involves depreciation of intangible assets such as intellectual property i.e. licences, rights to royalties,
brands, broadcasting rights etc. and goodwill. Please note that in most accounting regimes goodwill on
acquisitions is no longer amortised but impaired, if deemed necessary, based on reduced expected future
profitability of the assets to which the goodwill relates. Amortisation (not related to goodwill) is forecasted as a
percentage of average intangible fixed assets.
2.3.7 Provisions
Projecting provision movements starts with an analysis of the historic use of provisions in order to ascertain the
true cash flow impact on the business. However, it is possible that provisions made historically will represent
necessary cash expenditure occurring in the future. For example, some companies consistently have to make
provisions for ongoing bad debts or companies might estimate certain costs to restructure its business (closing
factories, redundancies etc.) and to avoid ongoing ‘damage’ to the profit and loss account it will provide for this in
a particular year.
Movements in provisions consist of i) non-cash additions which are included in EBITDA as a cost, ii) non-cash
releases which are also included in EBITDA as a one-off gain, and iii) the actual usage of the provision that has a
cash flow effect and therefore will flow through the cash flow statement. When analysing the cash flows of the
business, EBITDA has to be adjusted for the non-cash movements included in EBITDA.
Valuation Manual
Another and easier approach, which is applied in calculation of the cash flows in most standard models, includes
the net movement in the balance sheet position which incorporates the non-cash adjustment for EBITDA as well
as the cash uses. Furthermore, provisions can be split into operating and non-operating provisions for modelling.
Operating provisions are included in the DCF valuation via the free cash flow calculation and include a.o.
guarantees, recurring employee related provisions, restructuring provisions and deferred tax liabilities. Non-
operating provisions relate to a.o. pension provisions, which should be evaluated separately and treated as a debt
like item in the Equity Value calculation.
2.4.1 Interest
Interest income can be modelled as an interest percentage on the average cash position throughout the year. The
interest rate on cash should be based on deposit rate. Interest expenses are forecast by an interest percentage on
the average debt position throughout the year. The interest rate on borrowings at any point in time should be
based on the credit terms which often can be found in the notes of the annual report.
2.4.2 Dividends
Companies generally aim to pay a dividend per share which grows moderately each year, providing a stable and
increasing income to the shareholders. As a rule, they do not try to maximise payout in one year, only to have to
reduce the payout when profits are disappointing. Hence, dividend forecasts are based on the number of shares
outstanding multiplied by a dividend per share. The pay out could, alternatively, be calculated in relation to the
dividend cover (earnings/dividends). Fast growing companies will generally show a low dividend pay out ratio, as
these companies require the cash to finance business growth. Mature, less growing stable businesses will have in
general higher dividend payout ratio’s. In most continental European countries, only a final dividend is paid, unlike
for example UK public companies, where interim dividend as well as final dividend are more common (split is most
commonly 1/3:2/3).
2.4.3 Tax
Tax should be calculated in accordance with the requirements of the countries of operation of the business
concerned. Generally this will involve adjustments to the accounting profit by adding back cost items that the
taxation authority does not recognise, or deducting items which are not recognised in the accounting policies but
eligible for tax allowances. In a standard model taxes can be forecast by multiplying the statutory tax rate by
taxable income. Taxable income refers to Profit Before Taxes (PBT) adjusted for all non-tax deductible items such
as goodwill amortisation and tax credits not recognised in the PBT. Statutory tax rates for all major countries can
be found in an annually published KPMG Tax Survey report. When the company incurs taxation in different
countries, try to estimate the country average statutory tax rate based on a weighted average of the profits and
applicable statutory rates in the applicable countries in order to forecast taxes.
item and will increase the balance sheet position. Cash movements are the result of actual dividends paid to the
minority shareholders that has to be reflected as a cash out in the cash flow statement. Do not forget to make a
negative adjustment for the value of the third party stake in the minority company as an adjustment to be included
in the bridge from Enterprise Value to Equity Value.
2.6.2 Debt
Debt can be forecast in detail, per debt component or on an aggregate level. In an LBO analysis detailed debt
forecasting is key, however in a DCF valuation aggregate forecasting is sufficient. In a standard DCF model
aggregate forecasting of debt can be applied, while a standard LBO model provides a detailed breakdown of all
debt items.
3. DCF analysis
3.1 Introduction
The discounting cash flow (DCF) analysis is a valuation method to calculate the present value of the expected
future cash flows from the company or project (adjusted for risk and timing). The DCF method is, theoretically, the
best estimate for the fundamental value of a company or project. However, certain elements of the theory are
subject to debate, and in practice the value based on DCF heavily depends on underlying assumptions being used
for forecasting the cash flows and the discount rate. DCF’s should certainly never be treated as a black box, or as
truly being the ‘perfect’ value.
Operating Equity
Fixed
Assets
Operating assets of the firm
Distribution of cash flows between debt
that generate free
and equity holders.
cash flows (FCF)
PV (FCF) during PV Continuing Operating Excess cash Value non Value non Adjusted Value interest Equity value Value preferred Employee stock Value ordinary
PP Value enterprise value operating assets operating enterprise value bearing debt equity options shares
liabilities
WACC
EV
Cont.
FCF Value
FCF FCF
FCF FCF
time
Exit PLANNINGPERIOD PERPETUITY
Date
In order to generate the cash flow inputs for our DCF analysis we need to forecast the expected values for the
profit and loss account items as set out in Chapter 2, and then adjust them to reflect the cash flows expected to
derive from those items.
The most common methodology is to value the ‘unlevered’ or ‘ungeared’ free cash flow of the project – i.e. the
cash flows available for distribution to investors (both debt and equity providers) of any class after all other
expenditure and claims have been paid (‘free cash flow to the firm’). We can then adjust the valuation separately
for the mix of financing using WACC (described below). Cash flows of any frequency may be valued (e.g. monthly,
quarterly or annual) but for most purposes annual cash flows are adequate. Free cash flow to the firm is defined
as cash flows generated by the operating assets of the firm taking into account all investments in operating capital.
The figure below provides the basic calculation of the FCF according to most standard models.
FREE CASH FLOW = GROSS CASH FLOW - CASH FLOW FROM INVESTING
Note: (1) If a company generates results in multiple countries one should calculate a blended statutory tax rate
Valuation Manual
Cycle
Average
Growth
Rate
The theory
Having derived the free cash flows we must discount them at rates which reflect risk and the time value of money.
This is achieved by discounting at the Weighed Average Cost of Capital (‘WACC’). The WACC is calculated by
weighting the cost of equity and debt in the company’s financial structure according to their target market values
(note the circularity of using the value to calculate the WACC to calculate the value). In the WACC, the cost of
equity is the appropriate cost at the leverage assumed in the weighting process (i.e. if it is assumed that 30% of
the total capital structure is debt then the cost of equity should reflect 30% gearing).
where
ke is the geared (levered) cost of equity
kd is the cost (to the firm) of debt
khs is the cost of hybrid security (such as convertible)
E is the value of equity in the capital structure
D is the value of debt in the capital structure
H is the value of hybrids in the capital structure
Td is the marginal tax rate
Due to the circularity noted above, the values of D and E are often set as targets, rather than as the market
values. These targets represent a supposed ‘optimum’ capital structure for the business, estimated by peer group
analysis or alternatively based on an estimate of the Debt to EBITDA multiple versus the average rolling
EV/EBITDA multiple (preferably over a few business cycles). Note that a business may contain additional sources
of capital to the equity and debt outlined above; any hybrid instruments, such as convertible debt and preferred
shares, would require adjustment to the WACC calculation as indicated in the formula. It is entirely acceptable to
model a changing WACC over time (due to changes in one or more of the elements). The WACC is discussed in
more detail in the Chapter 4.
Calculation of the Terminal Value using Perpetuity Method / Gordon Growth Model
If the cash flows are expected to grow in perpetuity at a constant rate (which may be negative) then this effect can
be replicated by use of a standard perpetuity formula with an infinite nominal growth rate in FCF of GCV:
FCFCV
CV =
WACC − G CV
where,
CV = Continuing value
FCFCV = Free cash flow in the first year of the continuing value period
GCV = Nominal growth of the free cash flows in the continuing value period
WACC = Weighted Average Cost of Capital
Whilst majority of DCF valuations use perpetuity method in some form, one should be careful using this
formula.
By adjusting the growth rate in the continuing value period, the capital expenditures that must accommodate this
growth rate, meaning the FCFCV, should change as well (higher capex, lower cash flows). The nominal growth rate
in the continuing value period equals inflation plus real growth where real growth depends on the level of capex for
growth (measured with RI) and the real return being generated on these new assets (driven by RONIC and
Inflation). In formula:
G CV = π + RI CV [RONICCV − π ] = RI CV × RONICCV + [1 − RI CV ]× π
where,
GCV = Infinite nominal growth rate in free cash flows in the continuing value
π = Long term inflation in the currency of the FCF
Valuation Manual
In order to validate your steady state assumptions one should compare the reinvestment ratio in the explicit
forecast period with the continuing value assumption.
RICV RICV
Explicit forecast period Continuing value period Explicit forecast period Continuing value period
The RONICCV reflects the nominal return being generated on new investments in the continuing value period,
ROIC will migrate to the RONIC in the continuing value period. In competitive industries the RONICCV should be
equal to the WACC as it is not possible to generate excess returns into perpetuity in these industries. In other
words, the company will make only zero NPV projects in the continuing value period. This will drive the ROIC to
the WACC in the continuing value period. When a firm has a sustainable competitive advantage till infinity (e.g., a
monopoly due to access to unique resources) it is possible to have a RONICCV above the WACC. This implies that
the company will sustain to create value after the planning period (NPV > 0).
RONIC
RONIC
ROIC
ROIC
SPREAD
WACC
WACC
Explicit forecast period Continuing value period Explicit forecast period Continuing value period
Assuming that most companies operate in competitive industries and excess returns will diminish on the long term,
you would expect that the RONIC during the explicit forecast period will migrate to the WACC. Similar to the
reinvestment ratio, try to achieve smooth patterns of RONIC in the steady state phase of your explicit forecast
period. The RONIC during the explicit forecast period can be derived implicitly from your forecast. In formula:
NOPLATt +1
- 1- π
Gt,t +1 - π NOPLATt
RONICt = +π= +π
RIt RIt
The CV formula as stated earlier FCFCV / (WACC - GCV) could be rewritten as we have derived the following
formulas for free cash flow and growth rate in the continuing value period:
Valuation Manual
FCFCV = NOPLATCV x [ 1 − RI CV ]
G CV = RI CV × RONIC CV + [1 − RI CV ]× π
Where in case of no value creation in the continuing value period, i.e. RONICCV equals WACC, the CV formula is:
NOPLATCV
CV =
WACC − π
Q1 30% 30 32 33 35 36 38 40
Q2 40% 40 42 44 46 49 51 54
Q3 20% 20 21 22 23 24 26 27
Q4 10% 10 11 11 12 12 13 13
PV (FCF) during PV Continuing Operating Excess cash Value non Value non Adjusted Value interest Equity value Value preferred Employee stock Value ordinary
PP Value enterprise value operating assets operating enterprise value bearing debt equity options shares
liabilities
Be careful using the book values for these assets as these may significantly differ from the fair/ market value.
Valuation Manual
The adjustment on the DCF derived EV for funded pension plans is as follows 2:
Plus: [Fair value of the pension assets – Fair value of the pension benefit obligation][1-Tc]
Where the adjustment for [1-Tc] reflects the related deferred tax asset/liability in case of a pension deficit or
surplus.
If significant, the negative adjustments made for the pensions in the valuation could be treated as a debt
component in the WACC.
2
If the differences between (un)recognised under/overfunding are already reflected in the forecasted service costs (e.g.
higher forecasted service costs due to large deficits), these adjustments are not necessary as they are already reflected in the
FCF hence valuation
Valuation Manual
ESOP to be granted in the future: include the projected cost of ESO to be granted in the future in the FCF and
treat it as if it is comparable to a cash bonus although in reality it is not. For valuation purposes, assuming the
cost of future ESO is a cash out, will then properly reflect the value transfer to it’s employees
Inventory days
Enterprise value most
sensitive to changes in
Capex market share, long term
FCF growth and WACC
Revenues/FTE
Production
cost/unit
Tax rate
WACC
CV grow th
Market share
Through the table function in Excel sensitivity analyses can easily be performed.
Valuation Manual
CAPM theory
The portfolio theory underlying the CAPM holds that investors only require a return for the non-diversifiable risk of
the market. This risk will vary according to both (i) the nature of the business' operations and (ii) the financial risk
introduced by gearing (leverage). This variability is captured by a factor termed ‘beta’ (βe). The returns equity
investors require to compensate for this non-diversifiable risk may be expressed mathematically as:
Where:
re = required return to investor (pre-tax), which is therefore cost of equity to the business;
rf = risk free rate;
βe = the geared equity beta;
(rm - rf) = the market risk premium (“MRP”)
SFP = small firm premium
ILP = illiquidity premium
Beta
Beta is a measure of covariance; the degree to which the returns of an asset move with the market return and thus
reflects market risk. The beta shows whether a company is more or less risky than the market:
Beta = 1.0; implies that when the market went up (down) 10% on average the stock also went up (down) 10%
Beta = 0.8; implies that when the market went up (down) 10% on average the stock also went up (down) 8%
Beta = 1.2; implies that when the market went up (down) 10% on average the stock also went up (down) 12%
The standard procedure for estimating historical betas is to regress stock returns against market returns. The
slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
Ri = a × β + Rm
where,
a = intercept
β = slope of the regression, cov(Rj,Rm)/Var(Rm)
Ri = (Div.+Pt=1-Pt=0)/Pt=0
Rm = Div. Yieldm+(Indext=1-Indext=0)/Indext=0
The selection of the time horizon and the sampling interval also have an impact on the value of the measured
beta. In practice often monthly return intervals are used as this mitigates some of the effects of thinly traded stock.
One can determine the raw beta by regressing the total returns of the company’s shares in Euro with the MSCI
World Index also in Euro. If the marginal investor is a local investor one could better use a local index however we
assume that the price setting investor tends to be a global investor. A three year time frame will result in sufficient
data points and should better reflect the current systematic risk profile of the business. Through the built-in
regression function in Excel one can easily calculate the beta of a particular stock (Tools > Data analysis > select
Regression or via the slope function).
In order to sanity check the beta’s derived from your regression analysis the following sources for beta’s can be
checked: Value Line, Datastream, Thomson, Bloomberg and Barra. Please keep in mind that in the default beta
estimation these sources use the local index as market portfolio.
If a share is thinly traded one should use monthly/weekly returns over a 5 years historical period. To determine
whether a share is thinly traded one could analyse:
Daily/weekly volume vs outstanding shares
Daily/weekly volume vs free float
Free float vs outstanding shares
Bid/ask spread
Please keep in mind that analysing historical beta’s will only work for traded firms that did not significantly changed
their activities, operating leverage and financial leverage over the historical period. The beta calculated or
observed, whatever its source, will be the equity beta, i.e. it combines the effect of both financial risk and operating
risk. For the purposes of comparison we are interested in operating risk, therefore it is necessary to adjust the beta
for the effect of financial risk to derive the asset-, unlevered- or ungeared beta.
3
These findings are however still debated. Other researcher found the following MRP for developed countries. Damodaran
(2000): 5-6%; Copeland, Koller and Murrin (2000): 5.0%; Brealey and Myers (2000): 6-8%; Harvard Business Review (1995):
5-7%; Copeland: 5.5%; Stern Stewart: 6.0%
Valuation Manual
The principal formula employed in this process is the relationship between a company's betas, as follows:
Asset beta = (proportion of debt x debt beta) + (proportion of equity x equity beta)
or:
D E
βA = × βD + × βE
D+E D+E
Where:
βA = the asset or business beta;
βE = the geared equity beta;
D = value of net debt; and
E = value of equity
Betas, as mentioned earlier, give an indication of risk and the asset beta calculated from the formula above gives
an indication of the risk of the assets. The risk of the assets in an ungeared state can be determined by calculating
the equity contribution to βA. In the presence of corporate taxes, the final formula (Hamada-formula
6
) is thus:
β A = β E /[1 + (1 − Tc ) × D/E]
where:
Tc = tax shield on debt
Using this equation we can restate observed betas for different comparable companies, unlever those betas (from
the financial structure in their companies with the debt defined as net debt) and relever them (at the target’s
financial structure with the debt defined as gross debt) to give an estimated appropriate equity beta (see formula
below). The tax rate should be defined on a marginal basis, hence should reflect the level of tax deductibility that
can be realized on the interest costs going forward.
The target debt ratio
The debt ratio chosen for the company to be valued is inevitably subjective. In the first instance peer group
analysis of both debt ratios and asset betas will suggest whether the business risk is low or high. Supportable
financial risk will be an inverse function of the business risk. It is possible that due to business cycles or other one-
off events gearing at the balance sheet dates for otherwise comparable companies will be unrepresentative. The
data should always be reviewed critically with this in mind.
The following rules for determining unlevered betas should be used. First identify proper peers to be used for
ungearing betas and determine the historical equity betas of these companies. The average of betas derived from
3 year weekly and monthly returns can be used. Secondly determine the average market based net debt/equity-
ratio of peers corresponding with the timeframe of calculation of historical equity betas. The net debt/equity ratio
can be derived from Thomson/Bloomberg. Thirdly one should determine the average marginal tax rate of peers
corresponding with the timeframe of calculation of the historical equity betas. As the marginal tax rate on debt
often matches the statutory tax rate, it is recommended to use the statutory tax rate and not the effective tax rate.
The statutory tax rate can be sourced from the KPMG Tax Survey report. The final step is to calculate the
unlevered betas of the individual peers, remove any outliers and take the median of the peer group.
Regearing the beta
The asset beta formula referred to the above can be re-arranged to give4:
β E = β A [1 + (1 − Tc ) × D/E]
βE can now be calculated since the variables βA, D, E and Tc for the company in question are known. Please note
one should determine the gross debt/equity-ratio based on market values of the company one is analysing. Gross
debt should be taken as excess cash going forward will probably be paid out as dividend or used for share
buybacks. In addition one should determine the average statutory tax rate the company will incur going forward.
However, often the current tax rate is used unless there will be a change in statutory tax rates that is already
known.
4
Hamada assumes the beta of tax shields equals zero
Valuation Manual
The small firm effect stems from the fact that regression betas do not capture all systematic risk characteristics of
small firms; operational leverage tends to be higher for small firms and distress premiums tend to be larger for
small firms representing a shadow cost, hence a value discount. A small firm premium (SFP) in the cost of equity
results in a valuation discount as expected cash flows will be discounted at a higher rate. The figure below
provides an overview made in a study by Ibbotson of small firm premiums in relation to the Equity Value of a
company (rounded figures used).
5.0
4.0
4.0
3.0
(%)
1.8
2.0
1.0
1.0
0.0
0.0
<370 370 - 1,185 1,185 - 4,593 >4,593
Equity Value (€m)
Illiquidity premium
The illiquidity discount stems from the fact that shares of listed companies can be traded easily, rapidly, with price
certainty and with a minimum of transaction costs whereas for illiquid equity stakes it can be restricted or a lengthy
and costly process. The illiquidity discount depends on the type of illiquidity; whether the asset is privately held or
publicly traded, whether there are restrictions on the sale of the instrument and whether the market for the
investment is thin or active. In general two approaches are used for coping with illiquidity:
Discrete percentage: subtract 10-30% from the equity valuation no adjustments for illiquidity in the discount
rate (Courts often use 10-25% as an illiquidity discount)
Discount percentage: add 2-4% to the CAPM cost of equity and make no further illiquidity adjustments in the
valuation (Mercers model (1997))
Introduction
In general the cost of debt is influenced by the following five risk factors:
real interest rate risk: the risk that real interest rates will increase
inflation risk: the risk that inflation will increase
market risk: sensitivity of debt returns to the market
default risk: the risk that the debt issuer will default
liquidity risk: the risk that the debt holder will not be able to liquidate their investment in a timely manner
Valuation Manual
Risk premium
Uncertainty FCF,
Capital structure
To determine the appropriate cost of debt one should follow the following steps. In case the debt of a company is
publicly traded, use the expected yield to maturity of the publicly traded debt. In case you can estimate the
(synthetic) bond rating, use the expected yields on traded bonds with similar ratings. If you can not estimate this
one should ask the banker involved or review recent borrowing spreads being paid.
n
E(Coupon t ) + E(Redemption t )
MV(debt) = ∑
t =1 (1 + expected yield)t
where,
E(Coupon) = (1 − p) × Coupon + p × (1 − LGD) × Coupon
E(Redemptions) = (1 − p) × Redemption + p × (1 − LGD) × Redemption
p = default probability
LGD = loss given default
Estimating the default probability (p) and loss given default (LGD) for below investment grade debt can however
be quite difficult. Therefore to estimate the cost of below investment grade debt one can use the following
approximation based on “Valuation” of McKinsey:
Where βdistress equals the difference of the beta of above investment grade debt vis-a-vis below investment grade
debt (estimated to be around 0.1). Therefore assuming an average midcycle MRP of around 5.5% the cost of
below investment grade debt equals:
where, the risk free rate is approximately equal to the yield on a 10 year government bond. The cost of debt for
above investment grade companies should be equal to the yield on a 10 year government bond plus the credit
spread. The relevant rating of a company can be found in Bloomberg (code CRPR).
Non-traded debt
Valuation Manual
In case debt is not traded one could estimate the cost of debt by determining a synthetic rating and derive the
accompanying credit spread. Based on a number of ratios as being used by rating agencies (e.g., Net
debt/EBITDA, EBITDA over cash interest etc.) rating tables for different sectors can be made and these can be
compared with the ratios of the specific company to determine the (synthetic) rating. Please note the credit ratio
differs significantly per sector so sector differentiation is advised.
In case it is impossible to determine a synthetic rating one could use the credit rating of a comparable peer (similar
in terms of size, profit and leverage) or use an industry rating.
If a company has more than one debt instrument, theoretically the average cost of debt should be based on a
bottom up approach by finding or calculating the expected yield to maturity for each individual instrument and use
market values of each instrument to weigh each instrument’s yield and produce an average. In most instances
however the cost of debt will be based on the companies rating and no bottom up approach is used.
4.4 The effect of tax on the cost of debt and equity returns
where Tdt is the tax shield, it is the interest expense and tt is the marginal rate of tax at time t.
Whilst this is comparatively simple, it is worth noting that the marginal tax rate should in fact be the tax rate to
which the tax shields on interest are realised. Often the statutory tax rate is used as a proxy for the marginal rate
however as studied by Graham it is estimated that the marginal tax rate is on average 0-5% points below the
statutory tax rate as a consequence of not fully utilising the tax shields on interest . If the firm does not pay taxes
over some period of time (e.g., because the firm has large tax loss carry forwards), there is a delayed tax
advantage on debt financing. In such a situation it may be better to use the APV-method and separately value the
tax shields on interest.
Weightings in the WACC should be based on market values, because these represent the true economic claims
the investors have on the company and would like to receive a return over. The target debt level should be stated
on a gross debt level basis and not on a net debt basis as it is very likely that excess cash going forward will be
used for dividend payout or share buybacks. However, if you know with quite some certainty that the company will
sustain substantial levels of excess cash going forward it is allowed to use net debt.
In case the current capital structure differs significantly from the target capital structure you may take the migration
of the capital structure into account, resulting in a time varying WACC.
One could determine the market value based target capital structure by analysing statements made by
management on their policy for the company’s capital structure or use the average capital structure of the peer
group or industry.
Management policy on capital structure
In case management has stated a target leverage multiple, for example Debt/EBITDA of 3.0x going forward, then
one could take a view on the long term Enterprise Value/ EBITDA, say for example 10.0x and subsequently derive
the target capital structure (i.e. D/TV = 30% and E/TV = 70%). Another way to determine the target capital
structure based on management policy could be done if management has stated targets in book value. For
example management targets a debt / [ debt + equity ] ratio of 40%. If you take a view on the long term expected
MTB ratio of for example 2.0x, the derived capital structure will be D/TV = 25% and E/TV = 75%.
Average capital structure of the industry/ peer group
If management did not give clear indication on their capital structure going forward one could always determine the
target structure based on the peer group/industry (historical or average). Alternatively, one could use the multiple
approach as discussed above for the peer group/industry instead of one individual company.
Valuation Manual
5. Multiple valuation
5.1 Introduction
The analyses of the trading values of comparable companies (CoCo) and the values paid for the whole
businesses in transactions (CoTrans) are essential valuation tools.
Multiples, essentially a ratio measuring value against some objective criteria, such as sales, are calculated and are
then applied to some criteria for another company, whether quoted or unquoted, to derive an implied value. As
well as referring to standard financial criteria such as sales and operating profit, multiples can also be calculated
with reference to various industry specific criteria – e.g. EV/subscriber in telecoms, sector or EV/funds under
management in financial services industry. Recognising the subjectivity and inherent errors of the approach,
multiples are usually stated as ranges rather than as absolute figures.
The use of multiples provides you with a quick and dirty methodology to get a first idea of the company’s value. In
addition one should use multiples as a control methodology, to assess whether the DCF is in line with market
comparables or comparable transactions.
There are essentially two different sources for multiples:
(a) Comparable companies – multiples are calculated by reference to the market valuation of quoted companies
which are deemed suitable comparables for the company being valued.
(b) Comparable transactions – multiples are calculated by reference to the reported deal values of recent
(completed) transactions which are deemed suitable comparables for the company being valued.
The bulk of this section has been prepared from the perspective of comparable companies rather than comparable
transactions. Both the theory and practice of the two types are broadly similar, although a few points specific to
comparable transactions are summarised later on.
one entry on the Profit and Loss (income from associates). Under the equity method, the purchaser records its
investment on the Balance Sheet at original cost (and increases this with income and decreases for dividends
from the subsidiary that accrue to the purchaser) and records its share in the profit after tax from the associate in
‘income from associates’ line item. Clearly – this method results in far less information on the investment being
disclosed (as all information on sales, margins, interest etc is collapsed down into one line on the Profit and Loss
representing profit after tax – income from associates - and all information on different asset and liability classes is
collapsed down into one line on the Balance Sheet – investment in associates).
Investment – at cost
If a company owns less than 20% of another company, it is accounted for as an investment using the cost method.
The company does not need any entries to adjust this account balance unless the investment is considered
impaired or there are liquidating dividends, both of which reduce the investment account.
Minority interests
As discussed above in the section on Enterprise Value, the ‘matching principle’ should be used when assessing
whether to include or exclude minority interests in the calculation of your multiple. If financials on the denominator
(e.g. EBITDA, sales etc.) include 100% of the results generated by the subsidiary (as is the case with full
consolidation), then the numerator (EV) needs to include the capital provided by those minority interests.
Therefore, the value of a minority interests should be added to market cap and net debt in EV calculations.
One might ask, instead of adding minority interest to derive to an Enterprise Value, why don’t we just subtract the
portion of sales or EBITDA that the parent does not own. In theory, this would indeed work and may in fact lead to
a better analysis of the corporate in question. However, typically we do not have enough information about the
subsidiary to do such an adjustment. Moreover, even if we had the financial information, this method is clearly
more time consuming. Of course, if we are calculating a multiple ‘below’ minority interests, e.g. price-earnings (to
ordinary shareholders) then market cap without minority interests, is used in the multiple calculation process.
Common practice
Note – many practitioners will not make adjustments to the EV for income from associates, and will instead just
include it as a form of interest income below EBIT. Whilst this is theoretically incorrect – the impact is often
immaterial. Bear this in mind when reconciling to broker’s calculations.
Best practices
Market Capitalization – 1) double check Thomson market capitalization with that of Bloomberg, 2) check for
multiple share classes 3) adjust for known in-the-money stock options for employees
Net Debt – 1) use the latest reported financial debt, 2) deduct excess cash (or total cash if no adjustment can
be made) and marketable securities
Other adjustments – 1) deduct the latest reported value for Associates (or when listed the current market
capitalization multiplied with the amount of shares), 2) add value of Minorities, 3) make adjustments for any
other non-operating balance sheet items in line with DCF best practices
Financials – 1) For latest reported data check with annual reports, and make adjustments for one-off items 2)
for forecasted data use broker consensus whilst keeping notice to the reporting date
Valuation Manual
Average 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 - 2009
LTM 9.5 11.2 10.7 7.3 7.0 8.9 9.9 11.1 8.5 6.4 9.1
NTM 8.2 9.1 8.1 6.5 7.1 7.8 8.6 9.4 7.8 6.0 7.9
14x
13x
12x
11x 10.8x
10x
9x
8x 7.9x
7x
6x
5.6x
5x
4x
Feb-00
Jun-00
Oct-00
Feb-01
Jun-01
Oct-01
Feb-02
Jun-02
Oct-02
Feb-03
Jun-03
Oct-03
Feb-04
Jun-04
Oct-04
Feb-05
Jun-05
Oct-05
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Jun-08
Oct-08
Feb-09
LTM NTM MIN - NTM MAX - NTM Average NTM (00-09)
6. LBO analysis
6.1 Introduction
The definition of a leveraged buyout (LBO) is often stated as the purchase of a company by a small group of
private investors with a limited investment-horizon, where the purchase price is financed with high levels of debt
that will be repaid from the target’s future cash flows as quickly as possible and where equity participation of
management is relatively high to align interests. The three main elements of LBOs are:
A small group of private equity investors/financial buyers also called sponsors or promoters that acquire the
target together with existing/new management/ employees. Investors target to exit the company after a certain
holding period (normally at 3 to 5 years)
Financing with high debt levels mainly against the future cash flows of the company with the objective to repay
the debt as soon as possible. High debt service levels will induce management to curb wasteful investments
and force improvements in operating performance
Management are given incentives (via equity participation) to align their objectives with financial buyers
thereby mitigating agency costs
Financial sponsors in general look for companies with the following characteristics: high and stable cash flows,
attractive nature of the companies assets, a fat cost base, competent and experienced management, active in an
unconsolidated market, appropriate size (traditional route has been small to mid-sized takeouts up to €1.5bn),
ability to unlock breakup value and a visible exit within 3-5 years at an attractive exit price.
In generating sufficient returns on their investment, financial sponsors use the following hard factors to establish
this. Improvements in operating profitability through cost savings, revenue enhancements and group synergies.
Other factors include the reduction in operating capital by reducing working capital requirements and/or reducing
value destroying investments, make use of financial leverage and tax shields on interest expenses. Another
important factor could be multiple expansion/arbitrage through add-on acquisitions at a lower multiple than the
expected exit multiple or an exit of the target as a whole at a higher multiple than the entry multiple.
Research has indicated the sources of returns for financial sponsors are shifting over time, where operating
improvements and multiple expansion becoming more and more important while benefitting from financial
leverage becoming less important.
Estimate value
Optimise returns
Returns on
finance
Returns sufficient
Sources % Uses %
Tranche A 20% Purchase price of equity
Tranche B How will Newco 15% Redemption of existing net debt
be financed
Tranche C 15% Purchase price 95%
Total senior debt 50% How funds
will be used
Transaction costs 5%
Subordinated debt 15%
Equity 35%
Total consideration 100% Total consideration 100%
Descriptions of the different type of sources of financing are set out below. Please note that the mentioned
characteristics of the different debt items in this Chapter are based on current market views in normal market
circumstances.
6.3.1 Debt
The different types of debt financing instruments can be ranked based on return versus risk as indicated in the
figure below.
Quasi-
Vendor/shareholder loan2 equity3
(25-40%)
Mezzanine Subordinated
debt
High yield bonds/notes (10-15%)
Risk
Notes: (1) For example revolver, capex- and/or acquisition facility; (2) Pricing of vendor and shareholder loan typically not in line with the risk-profile; (3)
Shareholder loan will be discussed under equity funding
Senior Debt
Senior debt has first call on the cash of the business in case of bankruptcy/insolvency, and may be secured on
assets. It is therefore the cheapest form of debt and, subject to current market limits, should be maximised in order
to raise equity returns. Senior debt is typically underwritten by banks and tends to be syndicated into the market
post transaction. Senior debt is secured against first charge over all assets and shares and has a term between 5-
Valuation Manual
9 years. If possible always check with a Leveraged Finance banker for the latest pricing on the different debt
instruments.
The senior debt package is usually split in three tranches:
A tranche (senior bank loan) – general characteristics
- provided by banks (relationship driven)
- pricing interbank: +225 bps
- tenor: 7 years
- amortising
- average life of 4 to 4.5 years
B and C tranche (institutional loans) – general characteristics
- provided by institutional investors
- pricing interbank: +275-325 bps
- tenor: 8-9 years
- bullet
- redemption of the B and C tranche should ideally not result in refinancing risk
Subordinated Debt
Various forms of subordinated debt (i.e. ranking behind senior debt), including mezzanine, high yield, second lien
and PIK notes can be used in an LBO capital structure – such debt ranks behind senior debt but before equity. In
general these instruments have tenors of at least 9 years.
Second Lien
Second Lien is also called last-out-tranche. Second lien is usually secured by collateral and repayment is by ways
of a bullet with tenor 9-10 years. Covenants are similar to senior debt. In general second lien amounts to around
5% of the total consideration. Cash interest paid on second lien is in general around 4.5 – 5% over EURIBOR.
Mezzanine Debt
This is a mixed form financial instrument layered in a company's balance sheet between equity and Senior Debt.
This is usually provided in the form of a subordinated loan with warrants attached which crystallise upon the sale
of the company. Mezzanine seeks to exploit the opportunity created by the substantial difference between the
risk/reward profile of senior debt and equity finance. Fairly normal characteristics might be:
Bullet repayment and tenor at minimum of 10 years
Covenants at 10% discount over senior
Quantum at around 10-15% of total considerations
Cash Interest of 4.0%-5.0% over EURIBOR
PIK interest of 4.0-5.0%
High Yield
High Yield fulfils the same financing gap as Mezzanine, ranking ahead of equity but subordinated to Senior Debt.
High Yield however taps a different investor base and consequently the risk/reward balance is invariably more
skewed towards risk than that for Mezzanine Debt providers. The rules of thumb with regard to High Yield are:
• Bullet repayment and tenor of at least 10 years
• Covenants at 10% discount over senior
• Quantum at around 10-15% of total considerations
• Interest rate of 6.0%-8.0% over EURIBOR paid in fixed cash yield
Outstanding
Outstanding
Time Time
6.3.2 Equity
Institutional Equity
In looking to allocate equity between institutions, the management and, sometimes the vendor, the starting point is
to satisfy the institutional investor. Areas that need to be considered are:
Total Return
The return investors require will be heavily influenced by the perceived risk of the investment; however in general
financial sponsors will look for IRRs of c. 20-25% (or lower for infrastructure assets: often 10-15% or even lower
for core infrastructure funds investing in toll roads/PPP projects etc).
Current yield
Institutions may require some sort of current yield within a reasonable time frame of the investment being made.
Whether or not an institution requires a current yield often depends on how the institution is financed.
Different equity forms
One of the final considerations is what sort of instrument is offered. The three main categories are:
• Ordinary shares
• Preference shares
• Loan notes
Loan notes have the advantage of tax deductibility on interest although this can give the perception of high
gearing. There are however restrictions on the amount of loan notes that can be put into any financing structure
without compromising tax deductibility on the interest due to Thin Capitalisation rules.
The other main reason for not using simply ordinary shares is that a ‘geared’ equity structure can help to
incentivise management.
Vendor Equity
This type of equity has some principal benefits:
• The vendor can increase the headline price. The fact that he may not receive a portion of the value of the
company for a few years may not matter to him
• Often helps the deal get done
• Can give vendor a veto over the exit route
• Insurance – the vendor may be a distressed seller and a retained interest allows him to share in any upside
• Straight vendor equity participation is much harder to manipulate than performance related deferred
consideration – vendors share pound for pound with other equity investors on exit
Obviously vendor participation can be structured to meet particular needs such as current yield through the use of
appropriate instruments.
Management Equity
The amount of management equity will vary depending on the size and structure of the transaction – typically 5%-
15% of ordinary equity:
• The management should put in enough to make them feel at risk and work hard but not so much that they are
weighed down with a huge burden. A reasonable rule of thumb is 1-2 times their salary
• The proportional entry price paid by management should not generally be less than a third of that paid by
institutions. This is sometimes referred to as the envy ratio
• Returns on exit should give the management in the region of 10 times their investment assuming the cash flow
forecast is met
• In secondary buyouts the typical rollover of management is at least 50%
Envy ratio
Envy (also ratchet mechanism) is the ratio between the effective price paid by management and that paid by the
financial holder for their stakes in the NewCo. It refers to the inequality in investment between the financial buyer
and management (in favour of management).
[IC / I%]
Envy =
[MC / M%]
where,
MC = management investment in NewCo
M% = management % of ordinaries in NewCo
IC = financial buyer investment in NewCo
I% = financial buyer % of ordinaries in NewCo
High envy between management and financial buyer means that management can participate relatively cheap and
therefore is indicative for IRR difference between management and financial buyer. However, high envy does not
automatically mean higher IRR as financial buyer can increase return on equity layers management does not
participate in hence diluting IRR management.
Sweet equity
Financial buyers often allow for sweet equity participation (special class shares, or option structures) that are
triggered when certain internal rate of return thresholds are realised upon exit.
An example of sweet equity participation could be
• X ≤ 12.5% +0% of the exit proceeds for ordinaries
• 12.5% < X ≤ 15.0% +1% of the exit proceeds for ordinaries
• 15.0% < X ≤ 20.0% +2% of the exit proceeds for ordinaries
• 20.0% < X ≤ 25.0% +4% of the exit proceeds for ordinaries
• X > 25.0% +6% of the exit proceeds for ordinaries
where X is the IRR realised on the total initial equity investment
Valuation Manual
where,
I0 = initial investment of the financial buyer (sources)
E(CFt) = all expected cash flows to and from the financial buyer
Expected cash flows include i) intermediate dividends received (e.g. from recaps or cash dividends), ii) additional
investments in Newco (e.g. for add on acquisitions), iii) proceeds upon exit. In order to calculate IRRs in Excel one
should use the XIRR function, in order to cope with a flexible time frame between cash flows.
Valuation Manual
IRR equity providers start 2005 end 2005 end 2006 end 2007 IRR equity providers start 2005 end 2005 half 2006 end 2007
IRR 17.8%
XIRR(C29:F29,C23:F23)
IRRs vary depending on the time of disposal (exit). Sensitivity analysis can also be conducted on, inter alia, the
transaction price (the entry multiple), the level of debt provided and the exit multiple anticipated.
Business forecast
Is business forecast not too optimistic (seller) or pessimistic (management) but credible?
Are operating improvements and value enhancements (growth, margin, capex and NWC) accounted for in
forecast?
Is business forecast supported by experienced/committed management team and are they able to achieve it
Debt structure
Is debt maximised given typical LBO structures?
Are margins and redemption schemes optimised?
Are financial debt covenants satisfied with some headroom?
Are debt levels in line with business risk and quality of asset base?
Are tax (thin capitalisation) and legal (maximum upstream guarantees by operating companies) restrictions
accounted for?
Equity structure
Are incentives of financial buyers and management well balanced and aligned (in terms of envy ratio and pain
level)
Is leverage across equity layers optimal?
Are there unused tax shields to be captured with creative structures (SHLs)?
Exit route and value
Is exit multiple realistic (fundamentals) and does it differ from entry multiple? And why?
Is exit EBITDA level well calculated (LTM, normalised, consistency in accounting standard)?
Are proceeds upon exit well calculated (e.g. option exercise, sweet equity, transaction costs, mid year)?
Do we have a clear exit route?
Is exit date realistic and optimal?
Valuation Manual
Appendices
Valuation Manual
But most important of all; keep your model simple and structured (so other people can easily understand
and use it) and focused on the problem you want to solve!