Financial Management

财务管理

Session 4
Valuation (II)

Jia, Ning (贾宁)

School of Economics and Management
Tsinghua University

Fall 2021
Today’s Agenda

1. The Flow-to-Equity (FTE) Method

2. The Economic Profit (EVA) Method

3. The Relative Valuation (Multiples) Method

1. The Venture Capital (VC) Method for Valuing Early-Stage

Companies

2
Today’s Agenda

1. The Flow-to-Equity (FTE) Method

2. The Economic Profit (EVA) Method

3. The Relative Valuation (Multiples) Method

1. The Venture Capital (VC) Method for Valuing Early-Stage

Companies

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Flow-to-Equity Method
 In both the WACC and APV methods, we value a company/project based
on its FCF, which is computed from the perspective of maximizing the
value of both debt and stock holders (i.e., ignoring interest and debt
payments).

 But what if we

(1) want to know the benefit to stock holders only? Or

(2) participate in JVs, partnerships, or strategic alliances where ownership

of the subject company is shared by several parties?

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Flow-to-Equity Method
 In the Flow-to-Equity (FTE) method, we explicitly calculate the free cash
flows available to equity holders taking into account all payments to and
from debt holders. The cash flows to equity holders are then discounted
using the equity cost of capital.

 Steps in Executing the FTE method

Step 1: Determine the Free Cash Flow to Equity

where Net Borrowing (+ if issue debt; - if paying off principal)

Step 2: Determine the equity cost of capital

Step 3: Compute the equity value by discounting FCFE at the equity

cost of capital
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Flow-to-Equity Method – An Example

 Two adjustments to FCF

(1) interest expenses are subtracted
(2) add net borrowing

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Flow-to-Equity Method – An Example

 If equity cost of capital is 10%, then NPV (FCFE) is

2.62 + 9.98/(1.1) + 9.76/(1.1^2) + 9.52/(1.1^3)+9.27/(1.1^4) = $33.25 million

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In Class Exercise: Lucent Technology (Revisited)
 Suppose Lucent Technology has an equity cost of 10%, market
capitalization of $10.8 billion, and an enterprise value of $14.4 billion.
Suppose Lucent’s debt cost of capital is 6.1% and its marginal tax rate is
35%.

Year 0 1 2 3
FCF -100 50 100 70
Debt 46.47 37.91 16.13 0

(d) What is the free cash flow to equity for this project?

(e) What is the NPV computed using the FTE method?

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In Class Exercise: Lucent Technology - Answer
(d) Using the debt capacity calculated earlier, we can compute FCFE by
adjusting FCF for after-tax interest expense (D*rD*(1 – tc)) and net
increases in debt (Dt – Dt-1):
Year 0 1 2 3
D 46.47 37.91 16.13 0.00

FCF -$100.00 $50.00 $100.00 $70.00

After-tax Interest Exp. $0.00 -$1.84 -$1.50 -$0.64
Inc. in Debt $46.47 -$8.55 -$21.78 -$16.13
FCFE -$53.53 $39.60 $76.72 $53.23

39.60 76.72 53.23

(e) NPV  53.53   2
 3
 $85.86
1.10 1.10 1.10

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Today’s Agenda

1. The Flow-to-Equity (FTE) Method

2. The Economic Profit (EVA) Method

3. The Relative Valuation (Multiples) Method

1. The Venture Capital (VC) Method for Valuing Early-Stage

Companies

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How to Measure Value Creation?

Maximize Profit?

Maximize Market
Capitalization?

Minimize Costs?

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How to Measure Value Creation?

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What Does “Maximizing Shareholder Value” Really Mean?

Transition from Accounting Profit to Economic Profit

 Accounting profit takes into account only explicit costs (e.g., COGS)
 Economic profit also takes into account implicit costs (e.g., cost of capital)
 Economic profit says value is created (periodically) only if increase in earnings is
more than enough to cover the cost of capital
 Economic profit makes the cost of capital visible to managers and is frequently
used in measurement of internal corporate performance

Economic Profit = Accounting Profit – Cost of Capital

 Example: Enron’s accounting profit in 1999-2000 are 0.9 and

1 billion USD. But economic profit is -0.33 and -0.65 billion
USD.
 Beginning 2006, State-owned Assets Supervision and
Administration Commission of the State Council (SASAC) of
China began to promote EVA among central SOEs.

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Not All Companies in China Have the Same Objective

 Value Creation of all SOEs (2016, in 0.1B)

EVA=17369-(446797-17369)×6.0% = -8397

 Value Creation of Central SOEs

EVA=11444-(218262-11444)×6.0% = - 965

 Value Creation of Local SOEs

 EVA=5925 -(228535-5925)×6.0% = - 7432

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Not All Companies in China Have the Same Objective

Micro Income Statement

Revenue - Cost - Salary – Interest - Tax = NI

From stockholder perspective

to stakeholder perspective

Macro Income Statement

Revenue - Cost = Salary + Interest + Tax + NI

Wealth (Value) Creation Wealth (Value) Distribution

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Economic Profit (EVA) Method

Economic Profit (EP) = NOPAT – WACC * IC = (ROIC – WACC) * IC

Company Value = Invested Capital + PV (Economic Profit)

 The expression is very intuitive, i.e., value of a company equals the book
value of its invested capital plus a premium equal to the present value of
future economic benefits

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Reconcile EVA and DCF
 Technically, EVA and DCF are mathematically equivalent
 Note that if a company earned exactly its WACC every period, then the
discounted value of its projected cash flow should exactly equal its invested
capital, i.e., since no value is created, it is worth exactly what was originally
invested

DCF: FCF(t) = WACC * IC0  V0 (perpetuity) = WACC*IC0/WACC = IC0

EVA:  V0 = IC0

 EVA and DCF are considered different models because they differ in terms
of how they think about value creation, i.e., different performance benchmark
 Accounting Profits: benchmarked against zero
 Economic Profits: benchmarked against WACC*IC

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Reconcile EVA and DCF
 In practice, EVA and DCF methods often give different numbers because of
the different adjustments made to financial statements

 An advantage of the EVA model over the DCF model is that EVA is a useful
measure for understanding a company’s performance in any single year,
whereas free cash flow is not

 EVA is often used in company’s internal performance measure and

compensation

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Economic Profit (EVA) – Perpetuity and Growth
 Remember in the DCF method, for a stream of perpetual cash flow and a
growth rate g, value of a company is given by

 Similarly, in the EVA method,

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Key Value Driver - ROIC
 ROIC measures the effectiveness of capital employment. It changes over
time as companies and their product markets evolve
 General pattern for ROIC over time for a single-product company

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Key Drivers of Peak ROIC (Vertical Dim.)
 To highlight the potential sources of value creation, consider the following
representation of ROIC:

 To justify high future ROICs, you must identify at least one of the following
three sources of competitive advantage:
 Price premium
Be a price setting, not a price taker
Classic example of a price setter is Coca-Cola as a result of brand loyalty
 Cost competitiveness
Example: Wall-mart
 Capital efficiency
Example: Travel Agency

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Key Drivers of Sustainable ROIC (Horizontal Dim.)
 A company can maintain pricing power or a cost advantage only if the
company maintains a barrier to imitation (from existing competitors) or a
barrier to entry (from new competition)

 One example is this notion of “network effects”, formalized by Professor Carl

Shapiro and Hal Varian at UC Berkeley

 The basic idea is this: in certain situations, as companies get bigger, they can
earn higher margins and return on capital because their product becomes
more valuable with each customer who purchases it. In most industries,
competition forces returns back to reasonable levels. But in so-called
“increasing return” industries, returns become high and stay there

 Classic examples of “network effects” – MS Office

key driver is the desire for compatibility to share documents

 Effectively turning existing customers as part of the sales team

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Empirical Evidence on ROIC
 To put things in perspective, here are some of the empirical findings done by
McKinsey & Company

(1) The median ROIC between 1963 and 2003 was 9% and remained relatively
constant throughout the period. ROIC does, however, vary dramatically across
companies, with only half of observed ROICs between 5% and 15%

(2) Median ROIC differs by industry and growth, but not by company size. Industries
that rely on sustainable advantages, such as patents and brands, tend to have high
median ROICs (11-18%), whereas companies in basic industries, such as
transportation and utilities, tend to earn low ROICs (6-8%)

(3) Individual-company ROICs gradually regress toward medians over time but are
somewhat persistent. 50% of companies that earned ROICs greater than 20% in 1994
were still earning at least 20% 10 years later

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About Sustainability

NPV

T0 T1 T2 T3 T4 T4 T10 Terminal Value

Periodic Cash Flow

 Firm Value = Short-term Growth + Long-term Sustainability

 Going concern is a fundamental assumption in all valuation models

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However, Going Concern is a Very Strong Assumption

 According to the U.S. Small Business Administration, 70 percent of new

businesses survive at least two years, but that drops to 50 percent by the
five-year mark and 33 percent at the 10-year point, with just 25 percent
lasting 15 years or more.

 Business failures are caused by a combination of operating and financial

factors, often influenced by prolonged economic conditions that impact
demand for certain products and services.

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 The Changing Competitive Landscape

GM Apple
Mobil Google
Microsoft Microsoft
Citic Berkshire
Walmart Mobil
BP Amazon
Pfizer Facebook

BOA GE
Johnson
Johnson
Wells Fargo
HSBC

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Google Annual Revenue

Google Annual Revenue Growth ($ Millions)

$6,000.00

$5,000.00

$4,000.00

$3,000.00

$2,000.00

$1,000.00

$0.00
2000

2001

2002

2003

2004

2005

2006

2007
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Google Annual Revenue Growth

Annual Revenue Growth (%)

450%

400%

350%

300%

250%

200%

150%

100%

50%

0%
2000

2001

2002

2003

2004

2005

2006

2007
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Sustainable Performance is Difficult to Achieve

Company A Company B

Net Income 100 Mil 100 Mil

Earnings from Core Business (Toothpaste) 70 Mil -20 Mil

Earnings from Investment 30 Mil 120 Mil

Question: Which company stock would you buy？

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Who is Company B?

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The Case of LMZ

 Founded in 1941, LMZ pioneered toothpaste with traditional Chinese medicine and was
once a leader in the country's dental care market. Company sold 0.5billion toothpastes in
2004.
 After 2006, foreign competition and brand aging have slowly sapped its main business. The
company has invested in medicine, paper, real estate and other areas, but these are also
losing money.
 In 2018, LMZ logged a CNY12 million first-half operating loss on an 18 percent drop in
revenue. However, the company amassed a fortune in stock investments. Buying CITIC
Securities shares in 1999 enabled it to turn a total profit of more than CNY2
billion (USD293 million) over the years from dividends and divestments of those shares,
per its own figures.
 The company has cut its stake in CITIC Securities many times in order to become
profitable. It posted a net loss of CNY116 million in the first three quarters of 2014,
but turned a CNY22 million profit for the whole year after selling 10 million CITIC
Securities shares that December to reap CNY258 million. LMZ played this game again in
2016. It booked a net loss of CNY78.1 million in the first half. Prior to the release of its
semi-annual report (ending June 2016), its board authorized the sale of up to 11.6 million
shares for the rest of the year. It sold them, securing CNY157 million, which
undoubtedly was a decisive factor in its net profit of CNY27 million that year.

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The Case of LMZ

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The Case of LMZ

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Do Investors Understand About the Implications of Earnings Persistence?

 Research shows that among publicly traded US companies,

48% can keep 1-year NI growth,
23% can keep 3-year NI growth
0.9% can keep >10 year NI growth
 Professors Penman and Zhang took all public US firms between 1979-2002.
Classify them into 10 groups based on earnings persistence. Buy the group with
highest persistence and short the group with lowest persistence.

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Today’s Agenda

1. The Flow-to-Equity (FTE) Method

2. The Economic Profit (EVA) Method

3. The Relative Valuation (Multiples) Method

1. The Venture Capital (VC) Method for Valuing Early-Stage

Companies

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Relative Valuation Method – Use of Multiples
 Multiples analysis refers to valuing the firm based on the value of other
comparable firms, rather than value the firm’s cash flows directly
 Although many claim multiples are an easy-to-apply valuation method, the
converse is true. That is, a well-done multiples analysis also require many of
the same adjustments (and effort) as traditional DCF
 To apply multiples properly, use the following practices:
(1) To analyze a company using comparables, first create a peer group.
How? Look into the company’s industry (annual reports or industry
classification system)
(2) Choose comparable companies with similar prospects for ROIC and
growth
(3) Compute the mean and/or median multiple of the sample
(4) Use multiples based on forward-looking estimates
(5) When evaluating company with multiple business unit, should use a
separate peer group for each business unit

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Most Common Multiples – P/E Ratio
 P/E Ratio = Share Price / Earnings per share
 There are two versions of P/E ratio:
(1) Trailing P/E
using trailing earnings (i.e., earnings over the prior 12 months)
(2) Forward P/E
using forward earnings (i.e., expected earnings over the coming 12 months)

 For valuation purpose, the forward P/E is generally preferred, as we are

most concerned about future earnings

Problems with Using P/E in Particular

 P/E is meaningless for companies with negative earnings

 Net income is calculated for non-operating gains and losses. A low earning
can cause the P/E ratio to be artificially high

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Alternative Multiples
 Price-to-Sales
 Imposes an additional restriction: similar operating margins on the company’s
existing business
 Used in situations where have extremely small or even negative operating
profits
 Most commonly used in valuation of early-stage companies

 Price-to-Earnings-Growth (PEG)
 PEG ratio is calculated by dividing the P/E ratio by expected growth in earnings
per share
 More flexible because you can expand a company’s peer group to include
competitors that are in different stages of life cycle
 Limitation: what if the growth rate equals (or infinitely close to) zero?

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Alternative Multiples
 Enterprise Value Multiples
 Calculated as enterprise value / EBITDA or EBIT
 Using the enterprise value is advantageous if we want to compare firms with
different amount of leverage because it represents the total value of the firm’s
underlying business rather than just the value of equity

 Regression-based Analysis Using Nonfinancial Data

 During the tech period, numerous companies went public “pre-maturely” (i.e.,
little revenues and negative earnings)
 Accounting numbers don’t work well in valuing these companies
 An alternative solution is valuation based on nonfinancial multiples, such as
price to website hits, unique visitors, or number of subscribers
 The proper choice of nonfinancial measure depends on the underlying business
and revenue model
 Nonfinancial measures should be used only when they provide incremental
explanatory power above financial multiples. Nonfinancial multiples are
meaningless if company cannot translate visitors, page views, or subscribers
into profits and cash flow
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Relative Valuation Method – An Example

Suppose Rocky Shoes and Boots (RCKY) has earnings per share of $2.30 and
EBITDA of $30.7 million. RCKY also has 5.4 million shares outstanding and
debt of $125 million. You believe Deckers Outdoor Corporation is comparable
to RCKY in terms of its underlying business, but Deckers has no debt. If
Deckers has a P/E of 13.3 and an enterprise value to EBITDA multiple of 7.4,
estimate the value of RCKY’s shares using both P/E and enterprise value
multiples. Which estimate is likely to be more accurate?

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Relative Valuation Method – An Example
 P/E Method

Price = Earnings * P/E = $2.30 * 13.3 = $30.59

 Enterprise Value Multiple

RCKY’s enterprise value V = $30.7 million * 7.4 = $227.2 million

Price = (Enterprise value – Debt) / Number of Shares Outstanding

= (227.2 – 125) / 5.4 = $18.93

 Because of the large difference in leverage between the firms, we would

expect the second estimate, which is based on enterprise value, to be more
reliable

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Problems with Multiples
 What if the market value of the comparable company is not an accurate
reflection of its intrinsic value (i.e., market is inefficient)?
 The internet bubble period
 “herding behavior” - investors and analysts followed the crowd instead
of relying on their own independent analysis
 When equity prices cannot be justified based on fundamentals, they
resort to commenting only on relative values

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Today’s Agenda

1. The Flow-to-Equity (FTE) Method

2. The Economic Profit (EVA) Method

3. The Relative Valuation (Multiples) Method

1. The Venture Capital (VC) Method for Valuing Early-Stage

Companies

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The Venture Capital Method
 Used for venture investments that are characterized by negative
early cash flows or earnings, followed by significant project rewards

 Three Steps:
1) A company’s net income or other sensible performance indicator
X is projected for some terminal year

2) Determine the proper P/E or P/X ratio to compute terminal value

3) Terminal value is converted to a present value using a high

discount rate

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The VC Method – Basic Case (No Dilution)
Consider the situation of a venture capitalist who is contemplating a
$3.5 million investment in a company that expects to require no further
capital through year 5. The company, ME2, is expected to earn $2.5
million in year 5, and should be comparable to companies commanding
P/E ratios of about 15. The venture capitalist expects to harvest his
investment at that point through a trade sale. Assume further that the
VC requires a 50% projected rate of return. What price should he pay
now for the stock?
Fact Summary
Required IRR 50%
Investment 3.5 million
Term 5 years
Year 5 Net Income $2.5 million
Year 5 P/E 15
Current Shares 1,000,000
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The VC Method – Basic Case (No Dilution)
Post-money Valuation: 2.5*15/(1+0.5)^5 = $4.9 million

% Ownership = Investment/Post-money Valuation = 3.5/4.9 = 71%

= New Shares / (Old Shares + New Shares)

 71% = New Shares / (1,000,000 + New Shares)

 New Shares = 2,433,476
 Per Share Price = $3.5 million / 2,433,476 = $1.44

Pre-money Valuation = Post-money Valuation – New Investment

= $4.9 mil - $3.5 mil = $1.4 mil

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VC’s Discount Rate

Discount
Stage of Investment Description
Rate
Seed Business Plan > 80%
Startup R&D, Prototype [50%, 80%]
Working Product, Possibly
First Stage [40%, 60%]
Post-Revenue
Mature Products, Possibly
Second Stage [30%, 50%]
Post-Profit
Bridge/Mezzanine Close to IPO [20%, 35%]

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The VC Method – Multiple Rounds (With Dilution)

Step 1: Estimate the size of the future pie

Step 2: Carve up the future pie

Step 3: Convert the future pie into the present

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The VC Method – Multiple Rounds (With Dilution)

Step 1: Estimate the size of the future pie

Same as the basic case

Terminal value = Yr5 Profit * P/E = $2.5*15 = $37.5

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The VC Method – Multiple Rounds (With Dilution)
Step 2: Carving up the future pie

Assume:
Round Year Amount Required Return
1 1 $ 1.5 mil 50%
2 3 $ 1.0 mil 40%
3 5 $ 1.0 mil 25%

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 The VC Method – Multiple Rounds (With Dilution)
Step 3: Convert the future pie into the present

Retention % = 1- [additional future shares/final shares]

= 1 – total % of Terminal Value to be sold to other owners

Round1: Retention% = 1- (7.3%+3.3%) = 89.3%

Round2: Retention% = 1-3.3% = 96.7%
Round3: Retention% = 100%

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 The VC Method – Multiple Rounds (With Dilution)
Step 3: Convert the future pie into the present

Round1: Current % Ownership = 30.4% / 89.3% = 34%

Round2: Current % Ownership = 7.3% / 96.7% = 7.6%
Round3: Current % Ownership = 3.3% / 100% = 3.3%

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 The VC Method – Multiple Rounds (With Dilution)
Step 3: Convert the future pie into the present

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