Valuation Methods: An Overview

FIN Valuation methods
An overview
For details, see Finance for Strategic Decision Making,
by M. P. Narayanan & Vikram Nanda,
Published by Jossey-Bass
2006 M. P. Narayanan
FIN Methodologies
Comparable multiples
P/E multiple
Market to Book multiple
Price to Revenue multiple
Enterprise value to EBITDA multiple
Discounted Cash Flow (DCF)

NPV, IRR, or EVA based methods
WACC method
CF to Equity method
2006 M. P. Narayanan 2
FIN Understanding Value
In the context of valuing companies, it is important to

understand what we mean by value.
From an economic perspective, value is the present
value of future free cash flows (FCF) expected to be
produced by the company, discounted at the weighted
average cost of capital (WACC) that reflects the risk of
the cash flows.
For a definition of free cash flow, see cash flow template later
For an understanding of the WACC, see conceptual diagram
later
FIN Understanding Value
This value, is often called the Economic Value or

Market Value of the company.
Let us first clearly understand the differences between
Economic value of the company
Accounting or book value of the company
FIN Understanding Value: Book Value
Consider a company whose balance sheet is shown

on the next page.
The important points to note are:
Fixed assets represent the investment in property, plant and
equipment, minus the depreciation
Cash is cash on hand
Accounts receivable is the amount due from customers. It is
an interest free loan to customers.
Accounts payable is the amount owed to suppliers. It is an
interest free loan from suppliers.
Accrued expenses are amounts owed to employees,
government, etc. It is also an interest free loan.
Financial investments include holdings in other companies.
Accounting Balance Sheet

Fixed assets $1500 Current liabilities
Current assets Short-term debt $150
Cash $200 Payable $320
Marketable securities
$150 Accrued expenses $80
& financial investments
Inventory $350 Noncurrent liabilities
Receivable $400 Long-term debt $1000
Equity $1050
$2600 $2600
Finally the Shareholder funds in an accounting

balance sheet (called the book value of equity) is the
amount of equity capital invested in the company. This
includes
The original equity capital invested when the company was
started.
Additional equity invested in the company through subsequent
external equity financings minus any equity repurchases.
Profits reinvested in the company.
It is important to understand that the value of equity in
the accounting balance sheet is NOT what the
shareholders can obtain if they sold the company and
paid off all the debt.
Before we relate the accounting balance sheet to

economic values, we slightly reconfigure the
accounting balance sheet.
The cash on hand is decomposed into operating
cash and excess cash.
Operating cash is the cash required for working capital
purposes.
It is determined by the companys cash budgeting process.
Excess cash is cash that is not required for working capital
purposes.
It is presumably kept for strategic reasons
In this example, we assume that $25 cash is required for
operating purposes.
Remaining cash ($175) is Excess cash.
Marketable securities and financial investments are

taken out of current assets which is now re-labeled as
current operating assets.
If there are any interest-bearing current liabilities, they
are left on the sources side of the balance sheet.
Remaining items are re-labeled as current operating
liabilities.
Accounting Balance Sheet: Reconfigured

Uses Sources
Fixed assets $1500
Excess Cash $175
Marketable securities &
$150
financial investments
Current operating assets
Operating cash 25
Working capital
Inventory $350
Receivable $400
Current operating liabilities Short-term debt $150
Payable ($320) Long-term debt $1000
Accrued expenses ($80) Equity $1050
$2200 $2200
The total capital (on which a return must be provided)

raised by the company is $2200:
Short-term debt = $150
Long-term debt = $1000
Equity = $1050
Note that accounts payable and accrued expenses are
not included as they are not interest-bearing liabilities.
This capital is used to

Acquire fixed assets = $1500
Invest in working capital = $375
Acquire financial holdings in other companies and invest in

excess cash and marketable securities (possibly for future
investment needs) = $325
Note that working capital is the difference between
current operating assets and current operating
liabilities.
FIN Understanding Value: Economic Value
Using the reconfigured accounting balance sheet as a

model, we can now create an economic balance
sheet.
The main difference is that
Values in the accounting balance sheet represent what has
been invested.
Values in the economic balance sheet represent the current
value of what has been invested.
The goal of companies is to ensure that the economic
value exceeds the accounting value!!
Economic Balance Sheet
Free CF @ WACC $2500 Short-term debt 150
Excess Cash $175 Long-term debt $1000
Marketable securities &

$150 Equity $1675
financial investments
$2825 $2825
Enterprise value
Fixed assets and working capital in the accounting

balance sheet have been replaced by the present
value of the free cash flow they are expected to
generate in the future ($2500).
This figure is just an assumed number.
This is the economic value of the operations of the
company and is often called Enterprise Value.
Excess cash and marketable securities are usually
valued the same as in the accounting balance sheet
as their values are unlikely to be different.
Financial investments should be valued at market
It is assumed in this example that the market and book values
are the same.
The total value of the company is:

Enterprise Value + Excess cash + Marketable securities +
Financial investments
In this example it is assumed the economic value of
the debt is the same as in the accounting balance
sheet.
This is more likely to be true for short-term debt.
The value of the long-term debt is more sensitive to changes
in interest rates.
If the interest rates had increases since their issue, their value
would decrease from the face value.
In general, liabilities also include, in addition to debt,

obligations to other parties such as
Legal and environmental liabilities
Liabilities to employees such as pension
The value of equity is the difference between the total
value of the company and all its liabilities.
It is also called the market capitalization and is equal to the
share price times the number of shares outstanding.
This is the current value of the equity, i.e., what the
shareholder will receive if they were to sell the
company off at its current value and payoff all the
liabilities.
FIN Constructing Economic Value
Balance Sheet
If a company is publicly traded, it is easy to construct
the right side of the balance sheet:
Debt values can be obtained from the accounting balance
sheet
Equity value can be calculated by multiplying the share price
by the number of outstanding shares.
Value of items such as excess cash, marketable
securities, and financial investments can be obtained
from the accounting balance sheet and market prices
of these items.
The enterprise value can then be calculated as the
residual.
FIN Multiples: P/E
If valuation is being done for an IPO or a takeover,

Value of firm = Average Transaction P/E multiple EPS of
firm
Average Transaction multiple is the average multiple of recent
transactions (IPO or takeover as the case may be)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when

firms in the industry are profitable (have positive earnings)
firms in the industry have similar growth (more likely for

mature industries)
firms in the industry have similar capital structure
See next page
FIN P/E and leverage
Gordon growth model: P0 = D1/(re g)

P0 = Stock price today
D1 = Expected next-year dividend per share
re = Cost of equity
g = Expected dividend growth rate
Assume constant payout ratio

K = Payout ratio = D1/ EPS1
P0 = K EPS1/(re g)
Simple algebra yields P0/EPS1 = K /(re g)
As leverage increases, re increases, decreasing P/E
multiple
FIN Multiples: Price to book
The application of this method is similar to that of the

P/E multiple method.
Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each dollar of
equity invested.
This method can be used for
companies in the manufacturing sector which have significant
capital requirements.
companies which are not in technical default (negative book
value of equity)
FIN
Multiples: Enterprise Value to
EBITDA
This multiple measures the enterprise value, that is
the value of the business operations (as opposed to
the value of the equity).
In calculating enterprise value, only the operational
value of the business is included.
Value from investment activities, such as investment in
treasury bills or bonds, or investment in stocks of other
companies, is excluded.
FIN Value to EBITDA multiple: Example
Suppose you wish to value a target company using the

following data:
Revenue = $800 million
COGS = $500 million
SG&A = $150 million
All from continuing operations only
Excludes any non-operating income such as interest and dividend
income
Excludes interest expenses
Depreciation (from CF statement) = $50 million
Cash in hand = $25 million
Marketable securities = $45 million
Sum of long-term and short-term debt held by target = $750
million
You collect the following data about a recent takeover

in the same industry
Selling price = $40 a share (40 shares)
Cash on hand = $50 million (all assumed Excess Cash)
Marketable securities = $200 million
Market value of financial investments = $120 million
Short-term debt = $200 million
Long-term debt = $1100 million
From continuing operations
Revenue = $1000 million
COGS = $650 million
SG&A = $120 million
Depreciation = $70 million
First compute enterprise value at which this comparable company

sold.
Equity value = 40 40 = $1600 million
Enterprise value = 1600 + 1100 + 200 250 120 = $2530 million
Enterprise value $2530 Short-term debt 200
Excess Cash &

$250 Long-term debt $1100
marketable securities
Market value of financial
$120 Equity $1600
investments
$2900 $2900
Next compute the EBITDA of the comparable

company from continuing operations
EBITDA = Revenue COGS SG&A + Depreciation
EBITDA = 1000 650 120 + 70 = $300 million
Compute the Enterprise value/EBITDA multiple at
which the comparable firm sold
Enterprise value/EBITDA = 2530/300 = 8.43
Compute EBITDA of your target company
EBITDA of target = 800 500 150 + 50 = $200 million
Compute enterprise value of the target

Enterprise value of target = 200 8.43 = $1686 million
Compute equity value of target company

Equity value = 1686 + 70 750 = $1006 million
Finally, if there are acquisition costs (Investment banking, legal) and
financing costs (bank fees, transaction costs) subtract from equity
value (not done in this example).
Enterprise value $1686 Total debt $750
Excess Cash &

$70 Equity $1006
marketable securities
$1756 $1756
FIN
Valuation: Value to EBITDA
multiple
Since this method measures enterprise value it
accounts for different
capital structures
cash and security holdings
By evaluating cash flows prior to discretionary capital
investments, this method provides a better estimate of
value.
Appropriate for valuing companies with large debt
burden: while earnings might be negative, EBIT is
likely to be positive.
Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.
FIN Mutiples methods: drawbacks
While Multiples methods are simple, all of them share

several common disadvantages:
They do not accurately reflect the synergies that may be
generated in a takeover.
They assume that the market valuations are accurate. For
example, in an overvalued market, we might overvalue the
firm under consideration.
They assume that the firm being valued is similar to the
median or average firm in the industry.
They require that firms use uniform accounting practices.
FIN Valuation: DCF method
This is similar to the technique we used in capital

budgeting:
Estimate expected free cash flows of the target including any
synergies resulting from the takeover
Discount it at the appropriate cost of capital
This yields enterprise value
After calculating enterprise value, equity value of
target is calculated using the same process as before.
FIN Valuation: DCF method
DCF methods impose stricter discipline on the

acquiring company
They need to specify the value drivers of the takeover
They need to provide estimates of the value created and their
sources
Allows for post-audit of the takeover based on these
benchmarks
FIN DCF methods: Starting data
Free Cash Flow (FCF) of the firm

WACC
FIN Template for Free Cash Flow
Revenue
Less Costs
Less Depreciation
Operating Income
Profits from asset sale

Statement
Taxable income
Less Tax
NOPAT
Add back Depreciation
Less Profits from asset sale
Operating cash flow
Less increase in working capital
Less capital expenditure
Cash from asset sale
Free cash flow (or unlevered CF)
The goal of the template is to estimate cash flows, not profits.

Template is made up of three parts.
An Operating Income Statement

Adjustments for non-cash items included in the Operating

Income Statement to calculate taxes
Capital items, such as capital expenditures, working capital,
cash from asset sales, etc.
The Operating Income Statement portion differs from the usual
income statement because it ignores interest. This is because,
interest, the cost of debt, is included in the cost of capital and
including it in the cash flow would be double counting.
There are four categories of items in our Operating Income

Statement. While the first three items occur most of the time, the
last one is likely to be less frequent.
Revenue items
Cost items
Depreciation items
Profit from asset sales

Cash from asset sale Book value of asset
Book value of asset = Initial investment Accumulated depreciation
Adjustments for non-cash items is to simply add all non-cash
items subtracted earlier (e.g. depreciation) and subtract all non-
cash items added earlier (e.g. Profit from asset sale).
There are two type of capital items

Fixed capital (also called Capital Expenditure (Cap-Ex), or
Property, Plant, and Equipment (PP&E))
Working capital
We need to include only additions to capital (both fixed

and working) since the capital originally invested is still
employed in the project.
It is important to recover both types of capital at the
end of a finite-lived project.
Recover the market value property plant and equipment
Cash from asset sale
Recover the working capital left in the project (assume full
recovery)
What is the FCF template Revenue

actually doing?
Less Costs
See table on the right
Less Tax
The template is longer
because of tax calculations Less increase in working capital
Items on the right are the Less capital expenditure
value drivers Cash from asset sale
You may view this as a Free cash flow (or unlevered CF)
conceptual template
FIN Estimating Horizon
For a finite stream, it is usually either the life of the

product or the life of the equipment used to
manufacture it.
Since a company is assumed to have infinite life:
Estimate FCF on a yearly basis for about 5 years.
After that, calculate a Terminal Value, which is the ongoing
value of the firm.
FIN Terminal Value
Terminal value can be calculated several ways:

Use the constant growth perpetuity model with a long-term
growth closer to economy growth rates.
Works for mature industries
Estimate a two- or three-stage model,
Higher growth rate(s) in the initial stage(s) (for about 10 years)
A lower long-term growth for the final stage
Use a Enterprise value to EBITDA multiple based on industry
averages to estimate terminal value
FIN WACC
One of the issues in the valuation of companies for

acquisition is what WACC to use.
Should we use the target companys WACC or the acquirers
WACC? Or something else?
As always, the answer is it depends.
If a conglomerate is buying a target company, it is
appropriate to use the target companys WACC.
There is likely to be very little interaction between the target
companys operations and that of the acquirer.
If it is a horizontal merger, the WACC of acquirer and
target are likely to be close.
A weighted average WACC may be appropriate (weights
based on the enterprise values of the two parties)
FIN WACC
The idea is that if the integration of the target with the

acquirer is minimal, the targets WACC is appropriate.
If there is substantial integration, but companies are
not in the same industry, it becomes more difficult to
figure out a precise WACC to value the target.
The issue has to be dealt on a case by case basis.
FIN Valuation of private companies
Private company stocks are very illiquid

Similar to small firms with less liquid stocks, private company
stocks also will sell at a discount. The liquidity issue much
more severe with private companies.
Private company owners are likely to be less
diversified. Therefore, they bear both the market risk
and the company-specific risk, increasing their cost of
capital and decreasing the value of the firm to them.
If you own only GM stock you are bearing the risk of the auto
industry as well risk that is GM-specific (a strike at GM).
If you own all the auto company stocks (GM, Ford, Toyota,
Nissan, Volkswagen, Diamler-Chrysler), you bear only the
auto industry risk.
FIN Valuation of private companies
The typical method of valuing a private company is to

value it as if it is a public company and then apply a
discount for the reasons stated earlier.
Find a pure-play and use its WACC to discount the cash flows
of the private company
Pure-play is a public company that has the same business risk as
the private company
Or, use the multiples of a public company
The trick is to compute this discount. There are ways
to get some handle on this discount.
The discounts are in the 20-40% range
FIN Weighted average cost of capital:
Overview
Lenders Stockholders
Required rate = 8% Required rate = 12%
Equity capital
Annual return
Annual return
Debt capital
$3.20
$7.20
$60
$40
deduction = $1.12
Annual tax saving
(35% of 3.20)
from interest
Total return = $10.40
Annual return
Total capital
$9.28
$100
Rate of return on capital

required to payoff the debt and
minimally satisfy stockholders, Operations
i.e., WACC Required rate = 9.28%
FIN Costs of debt and equity
Cost of debt can be approximated by the yield to

maturity of the debt.
If the yield is not directly available, check the bond
rating of the company and find the YTM of similar
rated bonds.
Cost of equity
CAPM
Find be and calculate required re.
Use Gordon-growth model and find expected re. Under the
assumption that market is efficient, this is the required re.
You need an estimate of future dividend growth rate to do this.
Therefore, works better for firms with a history of dividend
payments
FIN Valuation: CF to Equity method
In the WACC method, we compute

Enterprise value by discounting the free cash flows at WACC
Add value of any financial investments
Subtract value of debt to obtain equity value
In CF to Equity method, we
Compute CF that are available to equity-holders
This is Free Cash Flow less principal and after-tax interest

payments
Discount this at cost of equity and directly compute equity
value
FIN Equity value: WACC method
Value from Value from

Operations investments
Enterprise value Value generated
Value of Debt
Equity value
All are values: CF discounted at appropriate cost of capital
FIN Equity value: CF to Equity method
FCF from CF from

Operations investments
Total CF generated
CF to Debt
(Principal, after-tax
interest) CF to Equity
All are CF
Equity value = CF to Equity @ re

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FIN Valuation methods

Market to Book multiple

Price to Revenue multiple

Enterprise value to EBITDA multiple

Discounted Cash Flow (DCF)

In the context of valuing companies, it is important to

This value, is often called the Economic Value or

Consider a company whose balance sheet is shown

Accounting Balance Sheet

Finally the Shareholder funds in an accounting

Before we relate the accounting balance sheet to

Marketable securities and financial investments are

Accounting Balance Sheet: Reconfigured

The total capital (on which a return must be provided)

This capital is used to

Invest in working capital = $375

Acquire financial holdings in other companies and invest in

Using the reconfigured accounting balance sheet as a

Economic Balance Sheet

Free CF @ WACC $2500 Short-term debt 150

Excess Cash $175 Long-term debt $1000

Marketable securities &

Fixed assets and working capital in the accounting

The total value of the company is:

In general, liabilities also include, in addition to debt,

If valuation is being done for an IPO or a takeover,

This method can be used when

firms in the industry have similar growth (more likely for

Gordon growth model: P0 = D1/(re g)

D1 = Expected next-year dividend per share

g = Expected dividend growth rate

Assume constant payout ratio

The application of this method is similar to that of the

Suppose you wish to value a target company using the

You collect the following data about a recent takeover

First compute enterprise value at which this comparable company

Economic Balance Sheet

Enterprise value $2530 Short-term debt 200

Excess Cash &

Next compute the EBITDA of the comparable

Compute enterprise value of the target

Compute equity value of target company

Economic Balance Sheet

Enterprise value $1686 Total debt $750

Excess Cash &

While Multiples methods are simple, all of them share

This is similar to the technique we used in capital

DCF methods impose stricter discipline on the

Free Cash Flow (FCF) of the firm

Profits from asset sale

The goal of the template is to estimate cash flows, not profits.

Adjustments for non-cash items included in the Operating

There are four categories of items in our Operating Income

Profit from asset sales

There are two type of capital items

We need to include only additions to capital (both fixed

What is the FCF template Revenue

For a finite stream, it is usually either the life of the

Terminal value can be calculated several ways:

One of the issues in the valuation of companies for

The idea is that if the integration of the target with the

Private company stocks are very illiquid

The typical method of valuing a private company is to