Professional Documents
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Firm Valuation:
Valuation models
‘
1
Learning objectives
2
Firm valuation
• The term firm valuation refers to determining the true or
intrinsic value of the firm
– This value may significantly differ from the asset-based book
value of the firm
• Investors and financial analysts conduct firm valuation for
various purposes needed in their decision making
– Investment decisions
– In M&A transactions and IPOs, firm valuation plays a key role
• From firms’ point of view, valuation models help
understanding the key value drivers of the firm
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Example: What are these two figures?
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Firm valuation in theory and practice
5
Valuation process
Business Analysis
GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions
Valuation
Time
Historical Periods Valuation Date Forecast Periods
6
Valuation process
1. Business analysis
Internal and external business analysis
What are the key business drivers of the firm?
2. Financial statement analysis
Historical financial statements are analyzed to learn about the
profitability, leverage, growth, etc. of the firm
3. Forecasting
Future financial statements are projected
4. Valuation
Valuation models
Relative valuation
What is the value of the equity of the firm?
7
Valuation tools
• Two different types of valuation tools are mainly used
– Valuation models
• Dividend discount model (DDM)
• Free cash flow model (DCF)
• Abnormal earnings model (AE)
– Price multiples
• P/E-, P/B-, EV/EBIT- etc. ratios
• Valuation models are more sophisticated valuation tools
– Infinite forecast horizon
– Risk and time-value of money are taken into account in the cost
of capital
8
Valuation process
Business Analysis
GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions
Valuation
Time
Historical Periods Valuation Date Forecast Periods
9
Business analysis and financial
statement analysis
• The key to developing a forecast needed in valuation
is to understand the business
• Business analysis
– Highlights issues we need to study further in the financial
statement analysis stage
• External business analysis
• Internal business analysis
• Financial statement analysis
– Identifies concerns that require more detailed business
analysis
10
External business analysis analyzes
• Industry economics
– to determine the firm’s returns, profitability and cash flows
• Individual competitors
– to understand the existing rivalry on a macroeconomic level
– to assess competitors’ strategies, products, marketing, supply
chain and profitability
• Potential entrants
– to know the number of potential competitors, and
– how they will affect competitive rivalry
• Substitute products
– to understand how substitute products can remove profits
– to consider the available substitute products
11
External business analysis analyzes
• Buyers
– to understand the customers' strong bargaining position
• Suppliers
– Suppliers generally have more bargaining power to raise prices
and lower quality if there are only a few of them and if there are
not many substitutions for their products
• Customers
– to understand how the customers’ needs drive demand
• Governmental regulations
– to understand the governmental and regulatory environment of a
firm
12
Internal business analysis
• Mission
– What the firm hopes to accomplish
• Products and services
– What do these do?
– How does the customer use them?
– What is the market scope?
• Pricing and differentiation
– The more differentiated the product, the less competition
focuses on price
• Marketing and selling strategies
– Are needed to understand the firm's strategy for bringing the
product to the customer
13
Internal business analysis
• Supply chain
– To understand how each part works in order to project future
cash flow
– Includes
• Purchasing, Manufacturing, Research and development,
Distribution
• Human resources
– To understand the strengths and weaknesses on the people
side
• Investment priorities
– To know what makes a firm successful through understanding
its investment priorities
14
Valuation process
Business Analysis
GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions
Valuation
Time
Historical Periods Valuation Date Forecast Periods
15
Forecast assumptions
• Methods of predicting financial information can be
classified as follows:
Univariate Multivariate
Mechanical Statistical models Statistical models
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Mechanical prediction methods
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Mechanical prediction methods
4
E(Xi,t ) Xi,t n
1
4
n 1
18
Non-mechanical prediction methods
• In non-mechanical prediction approach, an analyst
incorporates a judgemental factor of her own into the
analysis
• This factor may reflect an ever-changing mix of economic
inputs
• A typical example of univariate non-mechanical approach
is ’free-hand’ extrapolation of a time-series plot of earnings
referred to as a trend analysis
• Analysts’ earnings forecasts are a typical example of a
multivariate non-mechanical prediction method
– Analysts use many quantitative and qualitative information sources
including financial reports of the firm, macro-economic forecasts,
company visits etc. 19
Analysts’ earnings forecasts
20
Example: Accurace of analysts’ earnings
forecasts
GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions
Valuation
Time
Historical Periods Valuation Date Forecast Periods
22
Valuation using valuation models
There are three steps involved in valuing a company:
• Dividends
• Free cash flows
• Accounting earnings
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Dividend discount model (DDM)
• Value of equity is simply the present value of future dividends
• Cost of equity capital is used as a discount rate
= Value of equity
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Dividend discount model (DDM)
𝐷𝐼𝑉1
𝑃0 =
𝑘𝐸 −𝑔
25
Dividend discount model (DDM)
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Example: Using DDM
• Expected dividends per share (DPS) for the next three
years are 0.84, 0.69 and 0.65
• The estimated long-term dividend growth rate is 3%
• Cost of equity capital is 9,84 %
• Value of equity is:
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Where to get the forecasts?
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Equity value and dividend growth rate
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Discounted free cash flow (DCF) model
Expected future free cash flows
Present value of
future free cash
flows
+
Financial assets • Present value of future cash flows is the
Enterprise Value, i.e. the value of both equity
Interest-bearing debt and debt
= • After adding financial assets and substracting
Value of equity interest-bearing debt (i.e. interest-bearing net
debt), we get the value of equity
30
Discounted free cash flow (DCF) model
• Value of the firm, i.e. the Enterprise Value (debt plus
equity), is the present value of the expected free cash
flows discounted by WACC:
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Value creation, cash flows and WACC
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Valuation process Business Analysis
revised
Free Cash
GAAP Historical Free Cash
Flow Forecast
Financial Flow Statements
Statements
Valuation
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Example: Applying DCF model to Kesko
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Example: Applying DCF model to Kesko
Predicted numbers
2015 2016 2017 2018 Term. Value
Net sales 9 145,9 9 221,8 9 298,3 9 375,5
Costs and expenses -8 798,0 -8 871,0 -8 944,6 -9 018,9
EBITDA 347,9 350,8 353,7 356,6
EBITDA-% 3,8 % 3,8 % 3,8 % 3,8 %
Depreciations -110,4 -111,3 -112,2 -113,1
EBIT 237,5 239,5 241,5 243,5
EBIT-% 2,6 % 2,6 % 2,6 % 2,6 %
Financial items
Taxes, reported
Net tax effect on financial items
Taxes, adjusted -66,4 -66,9 -67,5 -68,0
Taxes, adjusted / EBIT -27,9 % -27,9 % -27,9 % -27,9 %
Earnings before financial items 171,1 172,6 174,0 175,4
+ Depreciations 110,4 111,3 112,2 113,1
- Capital expenditures -192,1 -193,7 -195,3 -196,9
Capital expenditures / Net sales -2,1 % -2,1 % -2,1 % -2,1 %
- Change in working capital -7,8 -7,9 -8,0 -8,0
Change in Working capital / Change in Net sales -10,4 % -10,4 % -10,4 % -10,4 %
Free cash flow 81,6 82,3 83,0 83,7 2521,1
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Present values of free cash flow 77 73 69 65 1967,8
Example: Applying DCF model to Kesko
Valuation summary
2015 2016 2017 2018 Term. Value
Free cash flow 81,6 82,3 83,0 83,7 2521,1
Present values of free cash flow 76,7 72,7 68,9 65,3 1967,8
39
Example: and the formula behind the DCF
valuation of Kesko…
40
Example: Direct method of measuring
free cash flow, Kone 2013
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Case: Direct method of measuring free
cash flow, Kone 2013
• Interest received and paid (and other financial items) are
not included in the free cash flow
• Taxes include the amount of taxes that Kone has paid for
its financial income
– Since the free cash flow measures the cash flow before financial
related items and taxes on operations include taxes on net
financial items, we need to add taxes on net financial back to
cash flow
– Tax adjustment: 0,245*(29,5-2,4+10,8+2,7) = 9,9
– Adjusted taxes: -231,3 + 9,9 = -221,4
42
DCF model, summary
• DCF model is the most commonly used valuation model
that has a clear logic
– Value of the firm is the sum of the NPVs of projects
– The same model works for both project and firm valuation
– There is a link between the DCF model and the current value
creation of the firm
• DCF model also has its problems
– It relies heavily on the terminal value
→Very sensitive to the estimated growth rate, WACC, and steady
state conditions
– It is subject to the timing of payment streams
→ Estimating the period in which payments will occur is difficult
→ Free Cash Flow streams are highly volatile over time.
DCF model is not a value creation concept
4-44
Can EVA be used in a valuation model?
• Earnings-based valuation models are based on the logic
of EVA and residual income we have already learnt
– Rely on future EVA or residual income (abnormal earnings) –
not the current or past
• Important characteristics
– Much smaller terminal value
less forecasting needed
– Earnings are less volatile than cash flows
more precise forecasting
Directly associated with the value creation of the firm
Abnormal earnings (AE) model
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Principle in the AE model is the same as
in the DDM and DCF models...
DDM model:
DIV1 DIV2 DIV3
Equity value0 V0 ...
(1 rE ) (1 rE ) 2
(1 rE ) 3
DCF model:
FCF1 FCF2 FCF3
Enterprise Value0 EV0 ...
(1 WACC ) (1 WACC ) 2
(1 WACC ) 3
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… but the algebra is different:
If accounting follows a clean surplus relation:
Clean Surplus Relation:
DIVt NI t Bt 1 Bt
Bt = Bt-1 + NIt – DIVt
Add and subtract rEBt-1:
DIVt NI t rE Bt 1 Bt 1 rE Bt 1 Bt
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Abnormal earnings model, derivation
Substitute this expression for DIV into the Dividend Discount Model:
DIVt
V0 DIVt AEt Bt (1 rE ) Bt 1
t
t 1 (1 rE )
AEt Bt (1 rE ) Bt 1
V0
t 1 (1 rE )t
AE B AE B B1 AE3 B3 B2
V0 1 1
B0 2 2
...
(1 rE )1 (1 rE ) 2 (1 rE ) (1 rE ) 3
(1 rE )
2
49
Abnormal earnings model, derivation
AE B1 AE2 B2 B1
V0 B0 1
(1 rE ) (1 rE ) (1 rE ) 2
(1 rE ) 2 (1 rE )
AE B3 B2
3 ...
(1 rE ) (1 rE ) (1 rE )
3 3 2
AE AE AE
B0 1 2 3 ...
(1 rE ) (1 rE ) 2 (1 rE )3
AEt NI t rE Bt 1
B0 B0
Recall that
t t
t 1 (1 rE ) t 1 (1 rE ) AEt NI t rE Bt 1
T
NI t rE Bt 1 (1 g )( NIT rE BT 1 )
B0
t
t 1 (1 rE ) (rE g )(1 rE )T
50
Abnormal earnings model, derivation
NI t rE Bt 1 NIT rE BT 1
T Bt 1 B (1 g ) BT 1
V0 B0 t 1 Bt 1
T 1
B B T 1
t 1 (1 rE )t (rE g )(1 rE )T
NIt
ROEt
Bt 1
T
( ROEt rE ) Bt 1 (1 g )( ROET rE ) BT 1
V0 B0
t
t 1 (1 rE ) (rE g )(1 rE )T
51
Abnormal earnings model
Important points
• One assumption - Clean Surplus Relation
• Definition of ROE as current Net Income over last period’s
book value of equity
• Definition of abnormal earnings as the difference between:
• Net Income and cost of equity (in $ terms), or equivalently,
• ROE and rE, multiplied by last period’s book value of
equity (in % terms)
• A firms creates value when ROE > rE
52
Abnormal earnings model, implications
a) Management does better than
expected:
• What matters most to investors is: + $100 of
1. The amount of money they turn abnormal
over to management earnings
$300
2. The profit management is able to
$200
earn on that money
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AE model protects from paying too much
for earnings growth
• Suppose a firm increases earnings by a new investment
– Abnormal earnings before the new investment:
AE = 12 – (0.10 x 100) = 2
– Abnormal earnings after the new investment of $20 million
earning at 10%:
AE = 14 – (0.10 x 120) = 2
• No value added from the new investment
• Creating earnings by accounting methods also increases
residual earnings but reduces book value
The net effect of these action on the equity value is zero
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Beware of paying too much for growth
6-56
Example: Applying AE model to Kesko
Analysts' earnings forecasts
2014 2015 2016 2017 2018
EPS 1,45 1,85 1,96 2,28
DPS 1,60 1,65 1,70 2,17
Pay-out ratio 1,10 0,89 0,87 0,95
BPS 22,00 21,85 22,05 22,31 22,41
Required earnings 1,56 1,55 1,57 1,58
Abnormal earnings, AE -0,11 0,30 0,39 0,69
Present values of AE, PV(AE) -0,10 0,26 0,32 0,53
Terminal Value, TV 13,90
Valuation summary
BPS (2014) 22,00
Sum of PVs (2015-2018) 1,00 Long-term growth in AE: 2,00 %
Present value of TV 10,56 Cost of equity capital: 7,1 %
Value of equity: 33,57
57
Example: Value profile of Kesko
0,80
0,70
0,60
0,50
0,40
%
0,30
0,20
0,10
0,00
-0,10
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Example: Value profile of Novo Nordisk
0,50
0,45
0,40
0,35
0,30
% 0,25
0,20
0,15
0,10
0,05
0,00
59
AE model, some modifications
• If the balance sheet is at market value, then
– Book value of equity is expected to earn at the required
return, that is, ROE = cost of equity
– Abnormal earnings are expected to be zero
V0 = B0 , that is, the market and book values of
equity are equal
13-60
AE model, some modifications
• AE model:
V0 B0 PV ( AE )
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AE model, some modifications
This is the AE model we have been
talking about so far
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AE model, some modifications
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AE model, some modifications
V0NOA
V0NFO
EVA1 EVA2 EVA3
V0 NOA0 ... NFO0
( 1 WACC) ( 1 WACC)2 ( 1 WACC)3
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Abnormal earnings (AE) model:
Summary
• A company’s future earnings are • Firms expected to generate
determined by: positive abnormal earnings sell at
1. the resources (net assets) a premium to equity book value.
available to management;
2. the rate of return (profitability)
• Those expected to generate
earned on those net assets.
negative abnormal earnings sell at
a discount to equity book value.
• If a firm can earn a return above its
cost of capital, then it will generate
positive abnormal earnings. • The abnormal earnings valuation
model makes explicit the role of:
1. Income statement and balance
• Firms that earn less than their cost sheet information;
of capital generate negative 2. Cost of capital
abnormal earnings.
65
IAS 36: Valuation of assets for potential
impairment
66
IAS 36 (p. 18-57), Measuring recoverable
amount
• Recoverable amount is defined as the higher of an
asset’s or CGU’s fair value less costs of disposal and its
value in use (p. 18)
recoverable amount = max (fair value, value in use)
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IAS 36, Example of an impairment test
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IAS 36, Example of an impairment test
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Summary
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