The Absolute Basics

What is Being Valued?

Enterprise value – is the value of the firm to all
providers of capital.. Equity, debt and other.

Equity value – is the value of the firm to the providers

of equity capital only, i.e. Shares.
Valuation Approach – the Choices
Cashflow Valuation
 DCF
 EVA
Multiples
 Enterprise
 Equity
 Operational

Asset based – break up scenarios

Optimal Deprival Value – market power
Capitalisation Rate – real estate assets
Presentation Logic
Deals with:

Cost of capital – common to all methods

Capital structure – common to all methods

Cashflow model

Multiple model
Capital Structure I
Generally the capital structure consists of:
1. Equity – representing business and asset risk
2. Debt – representing financial risk
Capital Structure II

Debt is lower cost than equity, but

Using more debt adds financial

risk, and

Thus – increases the cost of equity

Debt may have tax advantages.

Cost of Capital I
Value is destroyed unless projects and companies meet
or beat their cost of capital:
1. Cost of capital is an opportunity cost – the sacrifice to
investing in the company
2. Cost of capital represents the risks in investing in the
company
Cost of Capital II
Value is destroyed unless projects and companies meet
or beat their cost of capital:
1. All providers face their own cost of capital – debt,
equity, or a mixture
2. The company faces a mix or blend called weighted
average cost of capital.
All Roads Lead to Cost of Capital
Despite apparent differences, all valuation methods:
1. Can and are related to a cost of capital – DCF, EVA,
Cap rate, ODV, asset value
2. Including multiples, can be directly linked to cost of
capital through the reciprocal relationship
3. Express cost of capital components in one way or
another
The Cost of Debt Capital
The market cost of raising the marginal tranche of
debt capital (the next increment)...
1. The riskfree rate (as proxied by [say] well traded
government debt in country of cashflow origin)
Plus
2. A debt premium reflecting industry and
company business risk
As determined by rating or market data.
Riskfree rate of
interest – such as
the interest paid on
government bonds
PLUS
A premium for taking risk....
The Cost of Equity Capital
The market cost of raising the marginal tranche of
equity capital (the next increment)...
1. The riskfree rate (as proxied by [say] well traded
government debt in country of cashflow origin)
Plus

2. The premium for investing in equities (ERP equity risk

premium) of 4.0% – 7.0%
Times Equity Beta (the index of company risk)
The Riskfree rate
PLUS a premium for
equity market risk
adjusted by BETA...
The company risk
index
Two Betas – Equity and Asset
Equity beta = asset beta / (1 – debt % )
 Only equity beta can be measured in the market

Asset beta = equity beta * (1 – debt % )

 Asset beta must be derived from equity beta
Example
The equity beta for the tele So:
communications industry
often sits at around 0.80.

The Debt to total capital Equity beta = 0.80

ratio for the tele
communication industry
often sits at around 50%
Asset beta = 0.80 * ( 1 - .50)
= 0.40
Estimating Beta
Building an equity beta:

 Establish the equity beta for an industry

 Find asset beta given industry capital structure
 Use company capital structure to find company
equity beta

Draw data from Bloomberg, Reuters, Valueline or

similar
Example
Industry equity beta is Asset beta is:
0.80
0.80 * (1 - .50) = 0.40)
Industry Debt to capital
is 50%

My company Debt to My equity beta is:

total capital is 65%
0.40 / (1-.65) = 1.14
Summarising....
Cost of debt = risk free + debt risk premium
Cost of equity = risk free + (equity beta * ERP)
In the capital structure of debt and equity:
 Equity is valued at the cost of equity
 Debt is valued at the cost of debt
Last twist:
Debt is adjusted for tax deductibility... Multiply it by
(1 – Tc).... The corporate tax rate.
Last twist: tax and cost of debt
Debt cost is adjusted for tax deductibility...
Multiply it by (1 – Tc).... The corporate tax rate.

So:
Corporate tax rate = 30%
Cost of debt = 8.5%
Tax adjusted cost of debt = 0.08 * (1 – 0.3) = 5.6%
Blend Equity and Debt Costs to
calculate WACC
Weighted Average Cost of Capital
Example........
Riskfree Debt Tax rate ERP Equity
rate Premium Beta
Cost of Debt 5.0% 2.0% 30.0% N/A N/A 4.9%
Cost of Equity 5.0% N/A N/A 5% 1.25 11.3%

Percent debt 40% Weighted cost debt 1.96%

Percent equity 60% Weighted cost equity 6.75%
TOTAL 100% WACC 8.71%
The Cashflow Valuation Equation
Value of near term cashflows
Plus
Terminal value

Discounted to Present value at:

1. The WACC for the value of the enterprise
2. The cost of equity for the value of equity
Cashflow to the enterprise is....
Earnings before interest and taxes (EBIT)
 Minus Cash taxes on EBIT
 Minus Investments
 Plus Depreciation
 Plus (minus) Change in Working capital
 equals
Free Cash Flow…. Available to ALL INVESTORS
Estimating Terminal Value I
1. Estimate a constant growth rate ( g ) from last year
of the near term flows out to “infinity”
2. Multiply the estimated cashflow of the last year of
the near forecast period by 1 + g
Estimating Terminal Value II
3. Divide this value by cost of capital minus g to get
terminal value
4. Discount TV back to the present using cost of
capital.
Enterprise and Equity Value
Enterprise value = near term plus terminal
Equity value = enterprise value less debt

Test:
 Cashflow sensitivities
 Cost of capital sensitivities
 Terminal value sensitivities (growth rate)
Why test?
Growth 5% Growth 3%
Cost of capital 12% Cost of capital 12%

Near term $ 150 $ 175 $ 190 Near term $ 150 $ 175 $ 190
Terminal $ 2,850 Terminal $ 2,174

PV near term $ 409 PV near term $ 409

PV terminal $ 1,811 PV terminal $ 1,382

Value $ 2,220 Value $ 1,791

The Valuation Multiple Equation
Based on comparative analysis. Popular in media:
Comparisons drawn from:
 Market observations
 Transaction observations
 Fundamental data

All adjusted to “normalise” data and allow as analysis of

“like with like” to greatest extent possible or feasible.
The idea is that, on
average, a company
should, over time
have roughly the
same value as its
peers.
Example:

If the ratio of Telco share

prices to Telco earnings is
8.0 then a “typical” Telco
earning $0.50 should trade
at about:

$0.50 x 8 = $4:00
Multiple Valuation - Process
Process to calculate:

 Identify an appropriate variable

 Find the necessary inputs for the calculation
 Normalise - adjust the numbers to remove
extraordinary or one off effects
 Compute ratio – numerous formulae available
 Apply multiple to company being valued

Check against another method

Enterprise Multiples
Estimate value of the enterprise to all capital providers:
EBITDA – most “cash like”, skirts accounting issues,
captures operating costs, only deals with tax
indirectly.

Revenue – useful with negative or zero earnings, skirts

accounting treatment, difficult to “launder”.
Equity Multiples
Estimate value of the enterprise to equity capital
providers:
 P|EBIT – avoids tax and capital structure differences,
pre tax relationship to other methods.
 P|E – very popular, oft quoted, simple to understand,
difficult to compare because of tax and capital structure
differences.

A helpful relationship:
1 / P|EBIT = (pre tax) ROIC
Operating Multiples
Many industries have unique operating multiples
which can be used comparatively:

 Media P | number of subscribers

 Energy P | KWh production capacity
 Accommodation P | number of room
 Tourism P | visitor nights / spend
 Agriculture P | output per stock unit
 Telecom P | fixed / mobile subscribers

Identical process to other cases.

Identical weaknesses.
Multiples - Characteristics
Advantages
 Simple and resource light
 Easy to communicate
 Commonly used
Disadvantages
 Single variable focus simplistic
 Assume “straight line” trend
 Subjective in normalising and comparing
Conclusions
Valuation is...

 A blend of art and science but a disciplined and systematic blend.

 Thoroughly dependent on all of the explicit and implicit assumptions
made.
 An estimation process whose outer limits ought to be tested for revision
purposes.
 Likely to perform best when it reflects “fit for purpose” decisions in
design.