Valuation

Chapter 17: 6,9,11,13,15

 Myths about valuation
• Since valuation models are quantitative,
valuation is objective
• A well-researched and well-done valuation is
timeless
• A good valuation provides a precise estimate of
value
• The more quantitative a model, the better the
valuation
• The market is generally wrong
• The product of valuation (i.e. the value) is what
matters; the process of valuation is not important
 The science of Valuation in M&A
McCaw Cellular acquires 52% of Lin Broadcasting;
the contract allows them to buy the remaining
48% 5 years later. At that time, if the two sides
are more than 10% apart in price, the sales
documents require them to call in an
independent 3rd banker.
(McCaw Cellular acquired by AT&T)

March 1995: What price should AT&T pay for the

balance of Lin shares?
 Lin Broadcasting, March 1995
• Morgan Stanley (for AT&T) $105 / share
• Lehman (for Lin) $155 / share

– > 10% apart, so Wasserstein Perrela is hired

* Market price = $140 / share

Other public debates over valuation
• National Gypsum
– Management $182.9 million
– Creditor group 1,037.0 million
Valuation Example: Exide Technologies (November 2003)
 Equity value vs. TEV
Equity value = market price or value of equity
(or per share value)

TEV = market value of equity + market value

of debt – cash
 Valuation Methodologies
Relative valuation models
Comparable companies valuation
(trading market valuation)
Comparable transactions valuation
Discounted cash flow
TEV: FCF@WACC
Adjusted Present Value (APV)
Equity: Flows to equity (FCFE@re)
Dividend discount model (DDM)
 Relative Valuation Models: Trading market
(Comparable companies) valuation
1. Define a set of publicly traded
comparable companies
2. Observe how those companies are
valued by the market
3. Apply that valuation to the firm
Exide: Comparable Co.
 Exide: Comparable Co.

* Company is 66% industrial, 34% transportation

 Comparable Companies Analysis
• Good things:
– Easy to produce
• Bad things:
– Measures relative, not intrinsic value
– Different estimates of value, depending on
which multiple you use
– Availability of comparables?
– Vulnerable to manipulation (definition of
comparables)
 Comparable Transactions Valuation
• Identify a set of “comparable”, “recent”
acquisitions
• Observe the prices paid (total purchase
price) for those companies
• Apply that valuation to the firm
• Data limitations
• Doesn’t imply the firm will be sold
(Exide: Comparable Transactions)
(Exide: Comparable Transactions)
(Exide: Comparable Transactions)
 DCF valuations
• Discount FCF at WACC
discount cash flows of the “unlevered” firm
WACC uses after tax cost of debt
• Adjusted Present Value (APV)
discount cash flows of unlevered firm plus
cash flows from interest tax shield
discount rate does not include interest tax
shield
 Reminder: Free Cash Flow (FCF)
Operating cash flow (OCF)
= EBIT + depreciation* - taxes
= EBIT(1-T) + depreciation

FCF
= OCF – reinvestment
= OCF - capital spending - working capital
spending
= OCF - capex – ΔNWC

* depreciation, or more generally any non-cash charges

 Discounting FCF @ WACC
Firm value (TEV)
= PV of FCF during forecast period +
PV of terminal value
n
FCFt Ter min alValue n
TEV   
t 1 (1  WACC t ) t
(1  WACC n ) n

Terminal value = proxy for all cash flows

after the forecast period.
 Terminal Value
n
FCFt Ter min alValue n
TEV   
t 1 (1  WACC t ) t
(1  WACC n ) n

Terminal value can be estimated as:

• Multiple (of EBITDA, or final year’s FCF)
• Growing perpetuity:
Terminal valuen = FCFn+1/(WACC-g)
 Assumptions in terminal value
• Long term growth rate
• Reinvestment versus growth
• Consistency between perpetuities/multiples:
if WACC=12%, in an industry with a long term
growth rate of 2%, what is a sensible multiple of
FCF?

• If a firm is already in “steady state”,

FCF1
TEV0 
WACC  g
 Discounting FCF@WACC
Example: Hershey
Free cash flow 1993 1994 Forecast 1995 Forecast 1996 Forecast 1997
….
Revenues 1996 2170 2387 2625 2888
Operating Expenses 1745 1893 2083 2291 2520
EBIT 251 277 304 334 368
Taxes 95 108 116 111 122
Net oper profit less adj tax 156 169 188 223 246
Depreciation 50 56 63 70 77
Gross cash flow 206 225 251 293 323
Change in WC 15 39 18 20 22
Capital expenditures 109 147 145 160 176
Increase in net other assets 3 95 2 3 3
Gross investment 127 281 165 183 201
FCF 79 -56 86 110 122

Source of capital Proportion of Opportunity cost Tax Benefit After-tax cost Contribution to
total capital weighted ave
Debt 25.00% 9.90% 3.90% 6.00% 1.50%
Equity 75.00% 13.30% 13.30% 10.00%
WACC 11.50%
 Hershey (continued)
Valuation: Year FCF Discount Present value of FCF
factor @
11.5%
1995 86 0.8969 77
1996 110 0.8044 88
1997 122 0.7214 88
1998 133 0.647 86
1999 146 0.5803 85
2000 161 0.5204 84
2001 177 0.4667 83
2002 195 0.4186 82
2003 214 0.3754 80
2004 235 0.3367 79
Continuing value (g=.06) 4529 0.3367 1525
Value of operations 2357
Less: value of debt 254
Equity value 2103
Equity value per share 23.5
(Exide: DCF)
(Exide: DCF)
(Exide: DCF – discount rate)
(Exide: DCF)
Exide: Alternative valuation summary
 Other issues in DCF valuation
• Growth vs. reinvestment rate (capex vs.
depreciation)
• Length of projection period? (see MSDW,
National Gypsum examples)
• Other sources of value (cash, holdings in
other firms, non-operating assets)
 National Gypsum: Comparison of Competing Financial Projections

Year of projections:
Actual Est. Est. Est. Est. Est. Est.
1991 1992 1993 1994 1995 1996 1997
1. Net revenues
Bond committee $442.9 $458.0 $496.8 $572.8 $629.1 $618.0 $604.3
Management 442.9 450.8 477.4 520.9 561.3 521.7 483.4
Difference 0.0 7.2 19.4 51.9 67.8 96.3 120.9

2. Gross margin
Bond committee 19.8% 17.5% 23.3% 29.6% 33.0% 31.6% 30.3%
Management 19.8 21.2 24.3 28.5 31.5 29.9 28.1
difference 0.0 -3.7 -1.0 1.1 1.5 1.8 2.2

3. FCF
Bond committee 50.1 63.4 98.8 81.2 71.1
Management 20.0 29.1 40.4 23.3 8.3
Difference 30.1 34.3 58.4 57.9 62.8

Estimated enterprise value (Dec. 31, 1992)

Bond committee $1,037.0
Management 182.9
Difference 854.1
 ZDnet 1999 IPO
Ten months Year ended Pro forma
ended Dec 31, ended
12/31/1996 1997 12/31/1998
(in thousands)
Statement of Operations Data:
Revenue, net 16,215 32,218 56,143
Cost of Operations:
Production and content 14,863 23,543 26,208
SG&A 13,280 23,475 30,993
Stock-based compensation -- -- 3,317
Depreciation and amortization 5,485 7,681 6,448
Loss from operations (17,413) (22,481) (10,823)
Minority interest -- 400 134
Interest income -- -- 1,372
Loss before income taxes (17,413) (22,081) (9,317)
Net loss (16,925) (21,238) (9,051)

EBITDA (11,928) (14,400) (4,241)

 ZDnet Comparables

($ in millions, except per share data) Price Market Enterprise Value/Revenue

3/15/1999 Cap. 1999P 2000P

ZDNet (ZDZ) (at mid-point) (1) $12.00 $858.00 11.3x 8.5x

Average (2) 51.9x 30.9x

Cnet (CNET) $97.00 $3,697.5 41.7x 30.3x

Excite (XCIT) 105.69 6,417.7 27.6x 18.4x
Infoseek (SEEK) 84.56 2,993.9 19.3x 13.5x
Lycos (LCOS) 105.75 4,952.4 32.0x 19.9x
Yahoo! (YHOO) 179.44 39,370.7 105.2x 64.8x
broadcast.com (BCST) 93.38 3,614.0 97.9x 56.3x
DoubleClick (DCLK) 134.00 2,830.1 20.5x 17.5x
Earth Web (EWBX) 44.56 371.6 20.6x 10.0x
eBay (EBAY) 156.81 19,628.0 153.3x 105.7x
GeoCities (GCTY) 115.00 4,146.0 91.9x 45.5x
MarketWatch.com (MKTW) 74.00 928.2 59.4x 32.3x
SprotsLine USA (SPLN) 56.88 1,263.2 22.2x 11.0x
Ziff-Davis Inc. (ZD) 23.75 2,415.7 3.1x 2.8x
 ZDnet: Relative Value vs. CNET
($ in millions) ZDNet Filing Range CNET
Low Mid High Current

Enterprise Value $770.0 $840.0 $910.0 $3,653.6

1998A Revenues $56.1 $56.1 $56.1 $56.4

1999E Revenues 74.4 74.4 74.4 87.7
2000E Revenues 98.4 98.4 98.4 120.6

Enterprise Value / :
1998A Revenues 13.7x 15.0x 16.2x 64.7x
1999E Revenues 10.3x 11.3x 12.2x 41.7x
2000E Revenues 7.8x 8.5x 9.2x 30.3x

Discount to CNET Multiple:

1998A Revenues -373% -333% -300% NA
1999E Revenues -303% -269% -241% NA
2000E Revenues 287% -255% -228% NA
 FCF@WACC example: steady state firm
FCF1
TEV0 
WACC  g
TLC Corp. had earnings before interest and taxes of
$100 million in 2003 and faced a tax rate of 40%. The
firm had depreciation amounting to $50 million,
capital spending of $55 million, and working capital
investment of $5 million. The firm is in steady state
and should grow 3% a year in the long term. The
stock was trading at $10/share in December 2003, and
there were 60 million shares outstanding. The beta of
the stock is 0.80. The debt outstanding was $250
million (market price = book value), and the firm had a
BB rating (leading to an interest rate on the debt of
8%). The Treasury bond rate is 6%, and market risk
premium is 5.5%.
What is your valuation of the company (assume today is
Dec 31, 2003)?
 FCF@WACC example: steady state firm
Union Pacific Railroad reported net income of $770 million in
2003, after interest expenses of $320 million. The
corporate tax rate was 36%. It reported depreciation of
$960 million in that year, and capital spending was $1.2
billion. The firm also had $4 billion in debt outstanding on
the books, rated AA, carrying a yield to maturity of 8%,
trading at par. The beta of the stock is 1.05, and there
were 200 million shares outstanding trading at $60 per
share. Working capital requirements are negligible. The
treasury bond rate is 7%, and the market risk premium is
5.5%
a. Estimate free cash flow in 2003.
b. If the expected growth in free cash flow is 6.5%, estimate
the value of the firm at the end of 2003.
c. Estimate the value of equity at the end of 2003.
Discounting FCF@WACC: Lockheed Corporation
Lockheed Corporation (prior to its merger) reported EBITDA of
$1290 million in 1993, prior to interest expenses of $215 million
and depreciation charges of $400 million. Capital expenditures
in 1993 amounted to $450 million, and working capital was 7%
of revenues (which were $13,500). The firm had debt
outstanding of $3.068 billion (book value), trading at a market
value of $3.2 billion, and yielding a pre-tax interest rate of 8%.
There were 62 million shares outstanding, trading at $64 per
share, and the most recent beta is 1.10. The tax rate for the
firm is 40%; the treasury bond rate is 7% (risk premium 5.5%).
The firm expects revenues, earnings, capital expenditures and
depreciation to grow at 9.5% per year from 1994 to 1998, after
which the growth rate is expected to drop to 4%. Capital
spending will offset depreciation in the steady state period.
The company also plans to lower its debt/equity ratio to 50%
for the steady state (which will result in the pre-tax interest rate
dropping to 7.5%).
Lockheed: Cash flow projections
Yr 1993 1994 1995 1996 1997 1998
Revenue 13,500 14,783 16,187 17,725 19,408 21,252

EBITDA 1,290 1,413 1,547 1,694 1,855 2,031

- Depr 400 438 480 525 575 630
EBIT 890 975 1,067 1,169 1,280 1,401

EBIT(1-t) 534 585 640 701 768 841

+ Depr 400 438 480 525 575 630

- Capex 450 493 540 591 647 708
-  in NWC 82 90 98 108 118 129

FCF 402 440 482 527 578 634