Module 4

Valuation
 Module 4 Topics
• Valuation of M&A
– basic principles of valuation,
– discounted cash flow
• Steps in DCF
– synergy valuation
VALUATION OF FIRMS
 Valuation
• Every asset, whether financial or real, has a value
• Value is an expression of an asset’s worth.
• Value is an intrinsic worth of an asset.
• Estimation of fair market value.
• Value is the rate of worth set upon a commodity.

• Valuation is the act of determining the value or the price

of anything.

• Factors in Valuation
– Investment; Return; Risk
 Approaches to Valuation
• Each approach brings a unique focus on value.

• DCF approach (income approach)

– Future returns

• Market Approach
– Price paid for alternative investments/ market value
of stock and debt.

• Asset approach
– Based on hypothetical sale of company’s assets.
 Approaches to Valuation of firms
1. DCF approach or Discounted Cash flow Method
 Free Cash flow to firm (Enterprise cash flow) model
(FCFF)
o Equity Valuation Model
 Adjusted Present Value

2. Market Approach
1. Comparable company Method
2. Stock and Debt Method

3. Asset Approach
1. Adjusted Book value Method
2. Liquidation Value Method
 Valuation: The Key Inputs
• A publicly traded firm potentially has an
infinite life. The value is therefore the present
value of cash flows forever.
t =  CF
Value =  t
t
t = 1 (1 + r)
 Discounted Cash flow (DCF) Valuation:
Basis for Approach
Conceptually identical to valuing a capital project using present
value method.

t = n CF
Value =  t
t
t = 1 (1 + r)
– Where
 n = Life of the asset
 CFt = Cash flow in period t
 r = Discount rate reflecting the riskiness of the estimated
cash flows
DCF Methods for M&A valuation

o Three Methods
oFree Cash flow to firm (Enterprise cash flow)
model (FCFF)
oEquity Valuation Model
o Free Cash flow to Equity (FCFE)
o Dividend Discount model
oAdjusted Present Value
 Free Cash Flow
Free Cash Flow to the
Free Cash Flow to Equity
Firm

= Cash flow available = Cash flow available

to to
Common
Common stockholders
stockholders

Debtholders

Preferred
stockholders
 FCFF and FCFE
• FCFF = EBIT (1-t) + Dpr & amotsn –
capital Expenditure – Change in non cash
W.C

• FCFE = Net income + Depreciation – Capital

Spending – Change in non cash Working
Capital – Principal Repayments + new debt
 FCFF vs. FCFE Approaches to
Equity Valuation
�
FCFFt
Firm value = � t
t =1 ( 1 + WACC )

Equity value = Firm value - Debt value

�
FCFEt
Equity value = � t
t =1 ( 1 + r )
r is required return on equity or Ke
 DCF
o When year by year detailed forecasts are not
available.

o A simplified version of DCF approach.

o Two stage growth Model
o Three stage growth Model
 FCFF
Explicit forecast period
For cyclical Business
Full cycle period
Define free cash flow to the firm (FCFF)
EBIT (1-t) + Dpr & amotsn – capital Expenditure –
Change in non cash W.C

Find out present values of FCFF

Discount rate is Weighted Average Cost of Capital (wacc)
∑ FCFFt / (1+ ko)t
DCF method – Cost of capital
WACC after tax

WACC = Ke (S/V) + Kp (P/V) + Kd(1-T) D/V

 FCFF : Two stage growth model
o Two Stage Growth Model
Value of the firm = PV of FCF during high growth
phase + PV of terminal value
• Since we cannot estimate cash flows forever, we
estimate cash flows for a “growth period” and then
estimate a terminal value, to capture the value at the
end of the period:
t = N CF Terminal Value
Value =  t +
t (1 + Ko) N
t = 1 (1 + Ko)
 DCF Method –
Free Cash flow to firm(FCFF) – 2 stage growth model

Value of a firm
Present value of free cash flows to the firm over an
indefinite period of time.

Equation for Value of firm

PV of free cash flow during an explicit forecast period
+
PV of Free cash flows after the explicit forecast period.
Free Cash flow to firm (FCFF) model - Steps

1. Forecast the cash flow during explicit forecast

period.
2. Estimate growth in earnings and the cost of
capital.
3. Determine the continuing value at the end of
explicit forecast period.
4. Calculate the firm value.
 DCF : FCFF Method –
Continuing Value (terminal Value)
o Continuing Value
CV = [FCFFn+1 / (WACC–g) ] * (1/ (1+ ko)n )

FCFFn+1 = FCFFn (1 + g)
 DCF
o When year by year detailed forecasts are not
available.

o A simplified version of DCF approach.

o Two stage growth Model
o Three stage growth Model
 FCFF : Three stage growth Model

o Three Stage Growth Model

Value of the firm =
PV FCF during the high growth period +
PV of FCF during the transition period +
PV of terminal value
 Example: Three-Stage FCF Models
Year

1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 24% 5%

FCFF Rs 130 Rs.169 Rs220 Rs 272 Rs338 355

PV of FCFF Rs 118.2 Rs139.7 Rs165.1 Rs186.1 210

 Approaches to Valuation of firms
1. Income Approach
1. Capitalisation Method
2. Discounted Cash flow Method
 Free Cash flow to firm (Enterprise cash flow) model (FCFF)
 Free Cash flow to Equity (FCFE)
 Adjusted Present Value
2. Market Approach
1. Comparable company Method
2. Stock and Debt Method

3. Asset Approach
1. Adjusted Book value Method
2. Liquidation Value Method
 DCF –
Equity Valuation Model

o Estimates Value of equity in a firm by

discounting cash flows to equity investors

oFree cash flow to equity Model

oDividend Discount Model
 DCF –
Equity Valuation Model
o Free Cash flow to Equity Model
Value = ∑ FCFEt / (1+ ke)t +
[FCFEt+1 / (ke –g)] *(1/ (1+ ke)n )

o FCFE = Net income + Depreciation – Capital Spending

– Change in non cash Working Capital – Principal
Repayments + new debt issues
 DCF –
Equity Valuation Model
o Dividend Discount Model
Basic Model:
Value per share = ∑ Dt / (1+ ke)t

(i) The Gordon (Constant) Growth Model

Value of stock = D1 / (Ke–g)
Equity value of the firm = FCFF1/(Ke –g)
(ii) The two stage Dividend Discount Model
(iii) Three stage Dividend Discount Model
 Two stage growth model
V 0 = V1 +V 2

N
D 0(1 + g 1) t
V1 = 
t =1 (1 + k ) t

DN (1 + g 2 ) 1
V2= *
k-g (1 + k ) N
 Estimating Dividend Growth Rates

g = ROE  b

g = Growth rate in dividends

ROE = Return on Equity for the firm
b = Retention percentage rate
= (1- dividend payout percentage rate)
 Free cash flow Free cash flow to Dividend
Model
to firm (FCFF) Equity (FCFE) Model

No
growth
model

Constant
growth
model
 Free cash flow to Free cash flow Dividend
Model
firm (FCFF) to Equity (FCFE) Model

Two
Two
phase
phase
model
model

Two
phase
model (2
growth
Two
rates)
phase
model (2
growth
rates)
 Exercises
• DePamphilis, p.256, Exhibit 7.3
• DePamphilis, p.257, Exhibit 7.4
• DePamphilis, p.260, Exhibit 7.5
• ICFAI, Illustration 8; p.41

• DePamphilis, p.273, 7.14

• DePamphilis, p.273, 7.18
• ICFAI, p.75
 Approaches to Valuation of firms
1. Income Approach
1. Discounted Cash flow Method
 Free Cash flow to firm (Enterprise cash flow) model (FCFF)
 Free Cash flow to Equity (FCFE)
 Adjusted Present Value

2. Market Approach
1. Comparable company Method
2. Stock and Debt Method

3. Asset Approach
1. Adjusted Book value Method
2. Liquidation Value Method
 DCF – Adjusted Present Value Method

• Steps for calculation

– Value the firm without debt
– Value the impact of debt financing both in terms of tax
benefit and bankruptcy costs

• Value of levered firm =

Value of unlevered firm +
PV of tax benefits of debt –
PV of expected bankruptcy costs
 DCF – Adjusted Present Value Method

•
– = Unlevered cost of equity

– t – tax rate; D/E- Debt equity ratio

– : Probability of default
– BC : PV of Bankruptcy costs
 Bankruptcy costs vary
• Bankruptcy costs vary for different types of firms, but they typically
include legal fees, losses incurred from selling assets at distressed fire-sale
prices, increased borrowing costs due to poorer credit, and the departure
of valuable human capital.
• Bankruptcy costs can also affect intangible assets and include indirect
costs. For example, bankruptcy could tarnish a company’s reputation and
brand equity, causing it to lose market share and competitive positioning.
It can also cause suppliers to tighten trade credit terms and cause the loss
of customers.
• The way to measure bankruptcy cost is to multiply the probability of
bankruptcy by the expected cost of bankruptcy. A company should
consider the expected cost of bankruptcy when deciding how much debt
to take on.
 Approaches to Valuation of firms
1. Income Approach
1. Discounted Cash flow Method
 Free Cash flow to firm (Enterprise cash flow) model (FCFF)
 Free Cash flow to Equity (FCFE)
 Adjusted Present Value
2. Market Approach
1. Comparable company Method
2. Stock and Debt Method

3. Asset Approach
1. Adjusted Book value Method
2. Liquidation Value Method
 Market Approach –
Comparable Company Approach

o Value assets based on how similar assets are

priced in the market place. Also called relative
valuation. Commonly applied in real estate.

o Value of a firm is derived from the value of

comparable firms on a set of common variables like
earnings, sales, cash flows, book value..
Comparable Company Approach- Steps

1. Analysis of the firm

2. Identification of comparable firms
3. Comparison and Analysis
4. Selection of valuation multiples
a. Earnings multiples (P/E)
b. Book value Multiples (P/BV)
c. Tobin’s Q = Mkt value/Replacement value of assets
5. Valuation of the firm
 Market Approach –
Stock and Debt Approach
o When the securities of a firm are publicly
traded.

o Value of the firm =

Market value of all outstanding shares +
Market value of outstanding debt

o Limitations
o stock prices are volatile, so what price to take for
valuation
 Asset Approach
o Based on hypothetical sale price of its
assets.

o Asset approach valuation are conducted

under either a going concern or a
liquidation principle

1. Going concern assumption

Adjusted book value approach
2. Liquidation Principle
Liquidation Value approach
 Asset Approach

o Adjusted Book value approach:

Valuation is done by estimating the market value of
the assets and liabilities of the firm as a going concern.
“value in use”.

o Liquidation Value Approach :

o Based on the assumption that liquidation will occur
o The costs involved in liquidation must be subtracted in
determining the net proceeds
 Asset Approach - Valuation

o Valuation of each of the tangible and

intangible assets.

o Valuation of all the liabilities

o Value of the firm =

o Value of assets – Value of liabilities
 M&A and value creation
• Synergy refers to the potential additional value from
combining two firms, either from operational or
financial sources.
• Operating Synergy can come from higher growth or
lower costs
– economies of scale or from increased market power
• Financial Synergy can come from tax savings,
increased debt capacity or cash slack.
 Valuing Synergy
The key to the existence of synergy is that the target firm controls a
specialized resource that becomes more valuable if combined
with the bidding firm's resources. The specialized resource will
vary depending upon the merger:
• In horizontal M&A: economies of scale, which reduce costs, or
from increased market power, which increases profit margins and
sales.
• In vertical integration: Primary source of synergy here comes from
controlling the chain of production much more completely.

• In functional integration: When a firm with strengths in one

functional area acquires another firm with strengths in a different
functional area, the potential synergy gains arise from exploiting
the strengths in these areas.
 Mergers and value creation
• Value is created by synergy which occurs due to
– Strategic benefit
– Economies of scale
– Market power
– Economies of vertical integration
– Complementary resources
– Tax shields
– Utilisation of surplus funds
– Managerial Effectiveness
– Diversification
– Lower financing costs
– Earnings growth
 M&A and value creation
• M&A makes sense only if
VAB > VA + VB
∆V = VAB – (VA + VB)
• Value of firm B to firm A, VB* = ∆V + VB

• VB* can be determined in two steps

• Estimating VB
• Estimating ∆V

• Net advantage (NPV) = VB* - Cost to firm A of

the acquisition
I M Pandey, Financial Management, 9 ed. New Delhi : Vikas Publishing House, p.677
th

Ross, Westerfield & Jordan (2006). Fundamentals of Corporate Finance, 7th ed. New York:McGraw -Hill Irwin, p.805,806,812.