APRIL 2010

INTRODUCTION TO VALUATION
C O N F I DEN T I AL

Presented by Tristan Fitzgerald

ST R I C T L Y

P R I VAT E

AN D

Overview of the session

Introduction Discounted cash flow (DCF) Trading multiples Transaction multiples

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VAL U AT I O N

What does the term value mean?1

The Oxford Dictionary definition the material or monetary worth of a thing; the amount at which it may be estimated in terms of some medium of exchange or other standard of a like in nature It is important to note that there is no general statutory definition of value Valuation is an art, not a science2 In practice, we rely heavily on experience and judgement

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1 2

Extracts taken from The Valuation of Business, Shares and Other Equity; Wayne Lonergan Gold Coast Selection Trust v. Humphrey; 1948

Why valuation is important?

Acquisitions How much should we pay to buy the company? Research Should our clients buy, sell or hold positions in a given security?

Divestitures How much should we sell our company/division for? Fairness opinions Is the price offered for our company/division fair (from a financial point of view)?

Valuation
Hostile defense Is our company undervalued/vulnerable to a raider Debt offerings New business presentations Various applications What is the underlying value of the business/assets against which debt is being issued? Public equity offerings For how much should we sell our company/division in the public market?

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J.P. Morgan uses a number of valuation methodologies

Valuation methodologies

Publicly traded comparable companies analysis Public Market Valuation Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium

Comparable transactions analysis Private Market Valuation Value based on multiples paid for comparable companies in sale transactions Includes control premium

Discounted cash flow analysis Intrinsic value of business Present value of projected free cash flows Incorporates both short-term and long-term expected performance Risk in cash flows and capital structure captured in discount rate

Leveraged buyout/recap analysis Value to a financial/LBO buyer Value based on debt repayment and return on equity investment

Other

Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model

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different bet. trading premium & transaction premium

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The final recommended valuation is a triangulation of each of the methodologies

Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies valuation methodologies

Analyses the Analyses the present value of a present value of a company's free company's free cash flow. cash flow.

1. Discounted cash flow

2. Publicly Traded Comparable Companies

Utilises market Utilises market trading multiples trading multiples from publicly traded from publicly traded companies to derive companies to derive value. value.

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Utilises data from M&A Utilises data from M&A transactions involving transactions involving similar companies. similar companies.

3. Comparable Acquisition Transactions

4. Leveraged Buy Out

Used to determine range Used to determine range of potential value for a of potential value for a company based on company based on maximum leverage maximum leverage capacity. capacity.

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The valuation summary is one of the most important slides in a valuation presentation
The science is performing each valuation correctly, the art is using each method to develop a recommendation The science is performing each valuation correctly, the art is using each method to develop a recommendation
Implied Adjusted EBITDA multiples Jun-09F EBITA: A$33.0m1 7.6x 8.0x Implied Management EBITDA multiples A$35.5mm2 7.0x 7.5x

Valuation range: A$240 $260mm Multiple of management 09F EBITDA: 6.8x 7.3x Multiple of X team 09F EBITDA: 7.3x 7.9x Discounted Cash Flow (base case) IPO valuation - JPMorgan estimate - Vendor expectations
250 265

250 270

275 300

7.6x 8.3x 8.2x 9.1x

7.0x 7.7x 7.6x 8.5x

Trading comparables VAL U AT I O N

250

285

7.6x 8.6x

7.0x 8.0x

Transaction comparables

225

250

6.8x 7.6x

6.3x 7.0x

First round bid range

220

240

6.7x 7.3x

6.2x 6.8x

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50% IRR (approx.)

230

7.0x
250 300

6.5x

200
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Based on Project X team estimates, which forecast Jun-09F EBITDA to be A$33.0mm Based on the management 30-Sep-08 presentation Jun-09F EBITDA of A$35.5mm

Overview of the session

Introduction Discounted cash flow (DCF) Trading multiples Transaction multiples

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DCF allows for rigorous analysis of value

DCF - mechanism used to estimate the value of an asset by discounting the estimated future cash flows generated by the asset by a rate that reflects the risk of the cash flows Free cash flow to the firm (FCFF) model = present value of expected future cash flows Dividend discount model = present value of expected future dividends Forces an understanding of the value drivers of the asset (revenue and cost) of the underlying business/unit Can divide value into components Value of various businesses, product lines or divisions (sum of the parts valuation)
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Value of free cash flows versus terminal value (TV can be very important) Contribution of various synergies (e.g. cost reductions, cross-selling) Various cases can be evaluated Upside (favourable) versus downside (unfavourable) cases Key sensitivities on price, volumes, cost, growth etc.

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justify where and what key dactors need to do more work on

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DCF has three key components

1. Estimate the cash flows 1. Estimate the cash flows

Free cash flow to the firm model

n

V =
t =1

FCFFt
t

(1 + WACC ) (WACC g )(1 + WACC )

FCFFn +1
n

FCFF = EBIT (1 + ) + Depreciation Capital expenditure Working capital

Attempt to move from accounting profit to cash flows Add back non-cash expenses (e.g. depreciation) Minus outflows of cash that do not appear on the income statement (e.g. capital expenditure)
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Why adjust for changes in working capital? Dividend discount model

n

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E =
t =1

Dt

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(1 + re )

Terminal value

(1 + re )

E =
t =1

Dt

(1 + re )

Dt +1

( re g )(1 + re )

usuful for financial institution. e.g.) bank, what is the maximum dividend however maintaining the sustaining growth

Need to forecast the entire income statement to get to expected dividends Not used as much in practice but commonly used to value financial institutions

Projecting cash flows requires in-depth understanding of the business and the industry
Anticipated industry growth (supply versus demand) Major opportunities and risks How does this impact on the company in question? Pricing flexibility Possible market share changes Cost structure Working capital Required capital expenditures Discretionary investments New product lines and Greenfield expansions Development costs Economies of scale

Industry outlook Competitive position Ongoing reinvestment needs Expansion opportunities

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Sources of information

Company and competitor reports/presentations Equity research analyst reports and industry sector reports Other (e.g. market data such as forward curves, regulators)

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Use of financial statement analysis in practice

For valuation, remember that our focus is primarily on future not past performance However, the past can be useful in assessing the reasonableness of future forecasts Example: a pharmaceutical company versus an infrastructure company Some of the key ratios used in practice Profitability ratios Frequent use of EBITDA/EBIT margins Risk analysis ratios (e.g. financial risk ratios)
e.g. if the inerest coverage below 2 times? more garentee required
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what is the driver of the perfomance in the past, is it going to last?

Gearing and interest coverage Can impact on a firms credit rating which can in turn impact on the cost of capital Efficiency ratios Accounts receivable turnover, inventory turnover etc. Key focus of private equity firms

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private equity & sponsor firm

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DCF has three key components

2. Estimate the appropriate discount rate 2. Estimate the appropriate discount rate

Free cash flow to the firm model

n

V =
t =1

FCFFt
t

(1 + WACC ) (WACC g )(1 + WACC )

E D + rd (1 + ) V V

FCFFn +1
n

WACC = re

The weighted average cost of capital (WACC) should be commensurate with the riskiness of the project
VAL U AT I O N

More advanced definitions of WACC (imputation credits, hybrids) Dividend discount model
n

E =
t =1

Dt

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(1 + re )

Terminal value

(1 + re )

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re = rf + e MRP
Always remember to be consistent in your cash flow definition and the discount rate applied

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The cost of equity is a major component of the WACC

The cost of equity represents the long-term return expected by the market for this project Industry wide use of the capital asset pricing model (CAPM) Practical issues when using the CAPM Extremely difficult to estimate an appropriate beta (e.g. data issues, length of estimation period, benchmark rate of return) Sometimes include a country risk premium
Australia discount rate Australia discount rate
Cost of equity
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Risk free rate

Beta

Equity risk premium

Long term return on Long term return on equity investment equity investment

Long term risk Long term risk free rate of free rate of return return

Adjustment for Adjustment for correlation to correlation to stock market returns stock market returns

Appropriate extra Appropriate extra return above return above risk free rate risk free rate

= 11.50% =

10 year bond yield 5.50%

+ +

Predicted betas 1.00

x x

Estimated using various techniques 6.00%

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Cost of debt calculation

rd = (b + s) x (1 - t)
Cost of Cost of debt debt Benchmark Benchmark rate rate Debt Debt spread / spread / premium premium Marginal Marginal tax rate tax rate

Generally use cost of a companys medium-term debt (7-10 year money) Domestic debt
VAL U AT I O N

Quoted as spread over a benchmark rate Benchmark rates include BBSW, 10-year government bonds Adjusted for tax-deductibility of interest expense Check this against the approximate borrowing costs associated with a companys corporate credit rating and/or comparable companies

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DCF has three key components

3. Terminal value 3. Terminal value

careful the assat of the cor., to determine how many years into perpeturity &terminal value

Terminal value is the portion of a companys total value that can be attributed to cash flows expected in the period beyond the specific forecast horizon Terminal value should be estimated when the company reaches steady state Long-term assumptions have been stabilised Length of explicit forecast period is company specific Terminal value is typically based on some measure of the performance of the business in the terminal year of the projection (which should depict the business operating in a steadystate/normalised manner) Growth in perpetuity method

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E.g.

g = (1 DPR ) E ( ROE )

Terminal or exit multiple method Since an exit multiple has an implied growth rate and vice versa, cross check for reasonableness

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JPMorgans approach to free cash flow and valuation

Free cash flow is the cash that remains after all necessary reinvestments have been made, e.g. capital expenditure and working capital Free cash flow is measured prior to any debt service (interest and debt repayment), but after cash taxes Note the effect of carryforward losses on taxes paid Free cash flow therefore is the amount of cash that can be distributed to shareholders and debt holders (also known as the unlevered cash flow) Cash flows discounted at the weighted-average cost of capital to calculate firm value
VAL U AT I O N

Sometimes we calculate cash flows after interest expense/income (levered cash flow) Levered cash flows discounted at the cost of equity Present value represents equity value

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Summary presentation of DCF results

how sesitive the value is to the assumption?
Free cashflow summary1 Free cashflow summary1
Year end 30 June Total sales % growth EBIT % margin Taxes % rate Deprecn & Amortisation Less: Capex Less: NWI change Free cashflow2 2009 277.0 -24.8 8.9% 9.2 36.9% 17.8 (9.8) 2.2 25.6 2010 290.9 5.0% 30.5 10.5% 9.1 30.0% 16.1 (9.8) 0.4 28.1 2011 305.4 5.0% 42.9 14.0% 12.9 30.0% 7.5 (9.8) 0.4 28.2 2012 320.7 5.0% 46.2 14.4% 13.8 30.0% 8.4 (10.5) 0.5 30.6 2013 336.7 5.0% 50.2 14.9% 15.1 30.0% 8.7 (10.5) 0.5 33.8 2014 350.2 4.0% 52.1 14.9% 15.6 30.0% 8.5 (11.0) 0.4 34.4 2015 364.2 4.0% 53.4 14.7% 16.0 30.0% 8.9 (11.0) 0.4 35.7 2016 375.1 3.0% 54.7 14.6% 16.4 30.0% 8.7 (11.0) 0.3 36.3 2017 386.3 3.0% 56.1 14.5% 16.8 30.0% 8.4 (11.5) 0.3 36.5 2018 397.9 3.0% 57.5 14.4% 17.2 30.0% 8.2 (11.5) 0.3 37.3 2019 409.9 3.0% 59.2 14.4% 17.8 30.0% 8.5 (10.4) 0.4 39.8

Key valuation outputs2 Key valuation outputs2

Firm value (A$mm)
VAL U AT I O N

Equity value (A$mm) Terminal growth (%) 2.5% 9.3% WACC 9.8% 10.3% 10.8% 11.3% 462.7 430.6 402.6 377.9 356.1 3.0% 483.4 447.7 416.9 390.0 366.4 3.5% 507.7

Equity value per share (A$) Terminal growth (%) 2.5% 9.3% WACC 9.8% 10.3% 10.8% 11.3% $4.63 $4.30 $4.03 $3.78 $3.56 3.0% $3.83 $4.48 $4.17 $3.90 $3.66 3.5% $5.08 $4.68 $4.33 $4.04 $3.78

Terminal growth (%) 2.5% 9.3% WACC 9.8% 10.3% 10.8% 11.3%
1 2

3.0% 492.8 457.1 426.3 399.4 375.8

3.5% 517.1 477.0 442.7 413.1 387.4

472.1 440.0 412.0 387.3 265.5

467.5 433.3 403.7 378.0

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Assumed valuation date of 1 December 2009 Calculated as per J.P. Morgan base case DCF model; figures may not add due to rounding

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Overview of the session

Introduction Discounted cash flow (DCF) Trading multiples Transaction multiples

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VAL U AT I O N

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Firm value and equity value are two different concepts . . .

Firm value = Market value of all capital invested in a business1 (also referred to as enterprise value or asset value) The value of the total enterprise: market value of equity + net debt Equity value = Market value of the shareholders equity (also referred to as offer value) The market value of a companys equity (shares outstanding x current stock price) Equity value = Firm value - net debt2

Assets
VAL U AT I O N

Liabilities and Shareholders Equity

Enterprise value

Enterprise Value

Net debt

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Equity value
1

The value of debt should be a market value. It may be appropriate to assume book value of debt approximates the market value as long as the companys credit profile has not changed significantly since the existing debt was issued. Net debt equals total debt (short and long-term) + minority interest + preferred equity + capitalized leases - cash and cash equivalents.

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. . . and are used for different multiples

The defining difference lies in the treatment of debt and its associated cost (interest expense) A multiple that has debt in the numerator must have a statistic before interest expense in the denominator

Equity value Equity value

Firm value Firm value

Value for owners of business (after interest expense)

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Value available to all providers of capital (before interest expense) Multiples of: sales EBITDA EBIT

Multiples of: net income after tax cash flow book value

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A broad range of trading multiples are typically used

Multiple Firm value / sales (LTM, FY1, FY2) Firm value / EBITDA (LTM, FY1, FY2) Comment Generally not very accurate although essential for high-tech companies Generally most accurate multiple to use (watch out for interest income) Good ratio in cyclical industries Good for cross-country comparisons Independent of leverage Firm value / EBIT (LTM, FY1, FY2) Market cap. / Net income (also known as P/E)
VAL U AT I O N

Most useful when assessing a capital intensive business Historical P/E ratio affected by one-off charges Forward looking P/E actively used by Wall Street analysts; forward looking avoids problems with different fiscal years Most appropriate for financial institutions Australian trading bank multiples in particular Useful when assessing utilities and other fixed-asset based companies Price per subscriber / barrel / production, etc.

Market cap. / book value Firm value / total assets Industry specific

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Example trading comparables page

Trading comparables
Market cap (A$mm) 1,248 1,260 276 555 521 454 444 283 208 178 Ent. Value (A$mm) 1,211 1,186 325 560 514 497 493 304 238 167 EV/Sales 2008E 4.0x 1.2x 1.1x 2.5x 4.1x 1.3x 1.1x 0.6x 0.8x 1.5x 1.8x 1.2x 2009E 3.3x 1.1x 1.0x 2.2x 2.9x 1.1x 1.0x 0.5x 0.5x 1.4x 1.4x 1.1x EV/EBITDA 2008E 21.0x 12.2x 7.6x 10.7x 19.9x 10.9x 10.0x 5.5x 9.3x 11.1x 11.4x 10.7x 2009E 15.6x 10.8x 6.4x 9.2x 14.2x 8.9x 9.0x 4.8x 5.6x 9.6x 9.1x 9.0x EV/EBIT 2008E 22.2x 14.1x 10.9x 13.8x 21.3x 12.2x 11.8x 7.0x 13.3x 11.7x 13.6x 12.2x 2009E 16.5x 12.4x 8.9x 11.9x 15.0x 10.0x 10.4x 6.1x 7.9x 10.1x 10.7x 10.1x P/E 2008E 28.1x 20.4x 15.9x 18.6x 24.8x 16.5x 16.6x 9.5x 16.6x 16.6x 18.1x 16.6x 2009E 21.5x 18.2x 13.4x 15.5x 20.1x 13.2x 14.3x 8.0x 11.0x 13.8x 14.8x 13.8x Div. yield 2008E 3.1% 6.3% 3.4% 3.5% 1.9% 4.6% 6.6% 3.5% 0.7% 6.4% 4.1% 3.5% 2009E 4.0% 7.2% 3.9% 4.4% 1.9% 5.9% 7.3% 4.1% 0.0% 7.3% 4.7% 4.4%

Company Ausenco Monadelphous Walter Diversified Sedgman Industrea Cardno Coffey RCR Tomlinson
VAL U AT I O N

AJ Lucas Lycopodium Mean Median

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Source: IBES, IRESS, Company reports Note: Calendarised to 30 June; Market data as at 4-Dec-07

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Why trading values can differ from DCF

DCF exclude real option value

Market may view the firms outlook differently (different implied forecast) Discounts (eg. lack of liquidity, conglomerate) Difference in capital structure Company doesnt distribute all of its free cash to flow to shareholders Option value Acquisition speculation

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Event risk

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Some important points to remember when calculating trading multiples

The choice of the peer group is crucial Need to understand in detail the industry segments that competitors operate in Must identify and explain significant differences in multiples across the peer group We always calculate the numbers ourselves EBIT and other figures shown in annual reports and sources such as equity research reports are often inconsistent with J.P. Morgan definitions We always normalise earnings measures by removing one-off distortions Deducting material profits on sale of assets Adding back abnormal losses
VAL U AT I O N

Generally focus on forward-looking multiples We use median of forecast EBITDA, EBIT and NPAT Mean often skewed by outliers due to poor / outdated estimates As a general rule of thumb, multiples always run lowest to highest from EBITDA, EBIT and P/E Expected given use of depreciable equipment in typical business (EBITDA to EBIT multiple) Expected given most businesses generate a higher rate of capital return on capital employed than the after-tax cost of debt (EBIT to P/E multiple)

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Overview of the session

Introduction Discounted cash flow (DCF) Trading multiples Transaction multiples

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Comparable deals analysis is usually problematic

Transaction multiples - estimate of value based on what buyers have paid for a similar asset in the past Often a limited number of transactions Dated information stock market has changed business has changed financing has changed bidders have changed Missing data
VAL U AT I O N

earnings usually unavailable on subsidiary transactions Hard-to-find data

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Why bother with comparable transactions?

Important part of deal speak our clients typically want to know deal history within their industry our competition will certainly provide this Provides insight into various factors premium needed in the past to win bidding (control premium) valuation techniques used by buyers list of likely bidders possible bidding strategies Industry-specific multiples can be important
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Often necessary information for Board of Directors, fairness opinions, etc. Useful cross-check of other valuation techniques such as DCF

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Sources used to locate comparable transactions

Thompson Financial database (SDC) Locates targets based on SIC code, business description, industry Identifies transactions based on hostile vs. friendly, transaction size, announcement date, and several other deal elements The Comprehensive Summary Report is very helpful in hand-picking transactions since it includes a synopsis of the deal in addition to general information regarding both parties and the transaction Available on through the Business Research Center Senior bankers who work in the industry Will be able to point you toward previously used presentations or valuations Ensures you do not exclude any landmark deals or other deals they would specifically like to include Merger proxies for similar transactions
VAL U AT I O N

Fairness opinions of financial advisors disclose the comparable transactions used in their valuation of the target Other sources include: JPMorgan transaction comps databases (BRC has access) News runs Equity research reports

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Indicative presentation of transaction comps

Domestic equipment rental transaction summary (A$mm) Domestic equipment rental transaction summary (A$mm)
EBIT multiple Target Coates PCH Group Ltd Concept Hire Ltd Prime Industrial Rentals United Rentals Inc Allplant Hirequip NZ Ltd Hirepool Ltd Allied Equipment AH Plant Hire Sherrin Hire Pty Ltd Allight Holdings Pty Ltd The Cat Rental Store WA Australian Oil and Gas Median Mean
Source: Coates Hire Scheme Booklet, Independent Experts Report Note: NTOA is NTA + net debt surplus assets

Acquirer National Hire Cape Australia Pty Ltd Cape Australia Pty Ltd Coates Cerberus Capital Management Coates Nikko Next Capital Coates National Hire Boom Logistics Ltd National Hire National Hire Ensign Ltd

Ann. date 10/02/2007 16/10/2007 11/09/2007 29/08/2007 23/07/2007 30/11/2006 28/11/2006 1/07/2006 1/07/2005 21/10/2005 27/06/2005 1/11/2004 1/11/2004 12/04/2002

EV (A$mm) 1,645 $268.1 128.7 39.7 US$6,600.0 72.4 189.1 172.0 135.7 106.5 130.0 82.5 46.9 149.9

Historical 12.4x 18.2 12.6 5.0 9.6 NA 12.6 10.4 NA 8.4 7.2 12.5 12.7 13.2 12.5x 11.2x

Forecast 11.2x 13.2 9.8 4.5 9.0 7.6 10.2 NA 5.9 8.2 NA 7.2 6.2 12.0 8.6x 8.8x

EV/NTOA multiple NA 2.4x 2.4 1.1 1.5 1.3 2.1 NA 1.4 1.9 1.3 1.6 1.0 1.1 1.5x 1.6x

EM EC O

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Anatomy of a takeover premium

Highest final offer Must win! Defensive / greenfield / platform / option
Potential cost to bidder if a competitor gets target Cost of building from scratch vs. purchase Potential value of ownership, either due to high return investments or unforeseen events

Potential control premium

Outlook

Buyers perception of the future is different from the markets view

Synergies

Net cost savings and revenue enhancements

Buyers cost of capital is lower than targets

Cost of capital
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(sometimes viewed as a synergy)

Under-valuation

Target trades at a discount to DCF value (eg. Diversified holdings; industry out of favour, poor communications with investors, etc.)

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Target company price

Trading price before announcement

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When can transaction values differ from DCF?

Cost of capital differences buyer may have a lower cost of capital Higher level of synergies revenue enhancements cost savings Cross border differences in capital costs, tax rules, repatriation levels, etc. Differences in view of the future buyer may have a dramatically different view of the future than the market
VAL U AT I O N

Other strategic reasons buy versus build platform for other investments defensive acquisition

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I N T R O DU C T I O N

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VAL U AT I O N

Welcome to the team!

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