Business Valuation

BUSINESS VALUATION

The decision to invest in or finance any business, whether the acquisition of an existing shareholding  (e.g. M&A, private equity), subscription for a new shareholding (e.g. Venture Capital) or financing of a new project or general capital expenditure, requires an estimate of the Intrinsic Value of the underlying business, based on its operating performance and future cash flows. An investment should only be made if the value of the business exceeds the cost of investment. This value cannot be observed but can be estimated using accepted corporate finance valuation techniques. The 3 part Business Valuation Series discusses a number of Discount Cash Flow techniques (including Economic Profits, Residual Income, Equity Cash Flows, Adjusted Present Value and Capital Cash Flows), covering the main topics: steady state cash flows, terminal value formulae, CAPM, WACC, tax shields, cross border valuation, rates of return and the Enterprise Value-Equity value 'bridge'.   Multiples are also discussed. Examples are given, including in Part 3 where the 7 DCF methods are shown to give the same value under certain assumptions.

BUSINESS VALUATION - PART 1:  Cash Flows & Value

BUSINESS VALUATION - PART 2: Discount Rates & Tax Shields

BUSINESS VALUATION - PART 3:   Alternative DCF Methods & Multiples

BUSINESS VALUATION SERIES

Business Valuation – Part 1: Cash Flows & Value

The intrinsic value of a business is an estimated value attributable to current performance and expected future growth opportunities, based on key measures of operating performance, either cash flows or profit. One valuation approach uses, as its operating measure, future cash flows that are available to pay out to all the providers of financial capital (‘Free Cash Flows to the Firm’ / ‘FCFF’) expressed in economically equivalent value today (‘Discounted’ to their ‘Present Value’) and adjusted for risk (in the discount rate) and the weighted average probability of occurrence. This is the most common form of a ‘Discounted Cash Flow’ / ‘DCF’ valuation, and is discussed in this article, Part 1 of 3 that focus on the intrinsic value of a business (with a brief discussion of relative valuation using multiples in Part 3).

FCFF represent cash flows generated by operating activities, effectively Earnings Before Interest and Tax (‘EBIT’) less Depreciation and Amortisation (‘EBITDA’) less investment in working and fixed capital required to generate the EBITDA, net of associated operating taxes (all financing cash flows and related financing taxes are ignored – these are discussed in Part 2). FCFF can also be calculated as EBIT less operating taxes (‘Net Operating Profits After Tax’ / ‘NOPAT’) less investment in working capital and fixed capital in excess of the annual depeciation charge (‘New Invested Capital’ / ‘NIC’), which is included in EBIT (this can be considered an approximation of ‘growth’ capital expenditure in excess of the amount required to maintain the existing fixed capital base).

‘Invested Capital’ (‘IC’) is the amount of net operating assets that generate EBITDA, and, in a simple case,  increases each period by the addition of NIC. A common measure of operating returns is the ‘Return On Invested Capital’ (‘ROIC’):  NOPAT for the period t (NOPATt) divided by opening (or average) Invested Capital (ICt-1). If only NIC is considered, an equivalent return measure is the ‘Return On New Invested Capital’ (‘RONIC’), which, when making certain assumptions, can be calculated as the change in NOPAT in the period divided by NIC in the prior period. Part 3 will discuss these return measures in more detail, particularly how they link to value creation.

FCFF estimated over the forecast period (say years 1 – 10) are discounted back to the valuation date from each year using the discount rate appropriate for that year. The ‘Terminal Value’ (‘TV’) at the end of the forecast period is discounted at the discount rate for the final year (TV x 1 / (1 + r)^10). This TV represents value arising in the terminal period and can be calculated using DCF perpetuity methods or multiples.

FCFF estimated for the first year in the terminal period (year 11) can be assumed to grow at a rate that is constant in perpetuity, starting immediately from year 12 (the ‘Gordon Growth Model’ where TV = FCFF11 x 1 / (r – g) ) or starting after an interim period which is either (1) a single period over which growth rates are constant (‘2-stage growth’) or decline linearly (‘h-model’), or (2) two periods over which growth rates are high in the first period and either immediately drop to a lower rate in the second period (before stepping down to the perpetuity rate in perpetuity) (‘3-stage growth’) or decline over the second period to the perpetuity rate (‘3-stage growth with fade’). The TV can also be expressed in terms of NOPAT by replacing FCFF with NOPAT x (1 – R), where R is the ‘Reinvestment Rate’ (equal to NIC divided by NOPAT), which can also be shown in terms of growth rates and RONIC. The Gordon Growth term 1 / (r – g) is effectively a multiple applied to FCFF, so the TV can be estimated using multiples (discussed in Part 3). A common approach would be to apply a multiple to a ‘normalised’ sustainable EBITDA.

At the date the FCFF growth rate is assumed to grow in perpetuity, the financial measures used in the valuation must have reached their ‘steady state’ to allow for rates of growth and return and margins to remain stable in perpetuity. This means that in the prior year, revenues, net fixed assets, working capital and other net operating assets must all be growing at the long term perpetuity rate (capital expenditure and depreciation being set accordingly) and all margins are constant. This allows all components of the financial statements to grow at the perpetuity growth rate, and results in a stable ROIC.

The sum of the PV of the forecast and terminal period cash flows is the operating DCF Enterprise Value. The market value of non-operating assets, such as surplus cash and assets that do not contribute to EBITDA, is added in to calculate the final Enterprise Value, the amount allocated to debt and debt-equivalents (borrowings net of cash, straight and convertible bonds, preference shares treated as liabilities, leases, defined benefit pension deficits, etc) and equity and equity-equivalents (ordinary shareholders, stock optionholders, etc).  Fair value estimation of some of these capital instruments will be discussed in other articles.

The method described above is a static DCF with fixed assumptions, and in practice input scenarios would be used (base case as above,  with worst and best cases as a minimum). Simulation techniques can also model many more scenarios. Real Option analysis might be suitable as an extra layer of strategic value (theoretically) available from future investment decisions that can only be made as a result of an initial outlay (option premium).
 

Business Valuation – Part 2: Discount Rates & Tax Shields

In a DCF valuation, ‘Free Cash Flows to the Firm’ / ‘FCFF’ are discounted at a rate of return required by the providers of each type of capital (‘Cost of Capital’). This is Part 2 of a three part series on Business Valuation. Part 1 discussed Discounted Cash Flows (‘DCF’) and Enterprise Value.  This article discusses how the Cost of Capital is calculated in a simplified capital structure (debt and equity) to give a blended rate (‘Weighted Average Cost of Capital’ or ‘WACC’) that is used to discount the FCFF to their ‘Present Values’ / ‘PV’. Theory relating to the tax benefits of debt finance and impact on the cost of capital (‘Tax Shield’) is discussed in the Appendix.

The WACC is the average current required rate of return (for long term holdings) for equity and debt holders, weighted by the market value of their financial instruments. The required return for equity investors (the ‘Cost of Equity’) will be higher than that for debt holders (the ‘Cost of Debt’), since equity is more risky:  debt principal and interest payments are contractually promised (dividends and any return of capital for equity investors is at the discretion of the company) and debt holders rank ahead in any formal insolvency proceedings. Furthermore, as FCFF are measured on an after-tax basis, the required return must be reduced to reflect tax relief on financing costs, and because this only applies to debt interest (if deductible in the investor’s tax jurisdiction), the post-tax cost of debt reduces even more.

The relative cheapness of debt makes it an attractive source of funding if tax relief is available (insufficient profits or losses and tax rules that restrict interest deductions may limit deductions). Increasing leverage (debt as a proportion of total financial capital) will increase financial risk for equity investors, increasing the cost of equity via an increase in the risk premium. At some point, increasing leverage will increase the WACC, as the net benefits from tax relief on interest are offset by the risk of financial distress and default (increasing the pre-tax cost of debt as well). An optimal capital structure may lie in a range, and in a DCF valuation it is common to use a target leverage in the WACC calculation, on the basis that the company will be moving towards it as part of its financial strategy.

The cost of debt for a quoted company can be taken from observable market yields (the yield to maturity) on its own traded bonds or estimated by adding a risk premium (spread) to the risk free rate, based on its actual or likely credit rating (using a credit rating model). The cost for a private company can also be based on the ‘synthetic’ rating approach, but also by inferring it from quoted comparable company bond yields.

The cost of equity cannot be observed directly in the market and so a pricing model needs to be used. The most common model, the Capital Asset Pricing Model (‘CAPM’), estimates the expected return by ignoring any return for risk that can be fully diversified away by holding a sufficiently broad stock portfolio  - only non-diversifiable, systematic or market risk is priced in (adjusted by the degree, the equity beta, to which the stock return matches the market return).  

The tax benefits from debt financing effectively add value to an otherwise identical ungeared company. The amount of value depends on what discount rate is assumed to discount tax shield cash flows (pre-tax cost of debt x interest rate x debt), and this has an effect on how the geared cost of equity and hence WACC is calculated. The appendix contains a detailed discussion on tax shield theory. This article and Part 3 assume that the tax shield is discounted at the ungeared cost of equity, because debt has been set in the examples as a fixed percentage of the enterprise value (the Harris & Pringle approach).

When valuing businesses located in a jurisdiction different to the investors and lenders, the DCF approach and WACC calculation require consideration of additional risks (e.g. political, regulatory, currency and inflation risk) and whether these should be treated in the cash flows (diversifiable risks) or discount rate (non-diversifiable risks). Several versions of the international CAPM  have been suggested.
 

Business Valuation – Part 3: Alternative DCF Methods & Multiples

In a DCF valuation, discounting ‘Free Cash Flows to the Firm’ / ‘FCFF’ at the ‘Weighted Average Cost of Capital’ (‘WACC’) to calculate the ‘Enterprise Value’ (‘EntV’) is one of several discounting approaches. This is the final article in a three part series on Business Valuation. Part 1 discussed DCF and Enterprise Value,  and Part 2 the WACC. In this article 7 DCF methods are illustrated with examples that all give the same enterprise and equity values (net non-operating assets have been ignored for simplicity), and an introduction to valuation with multiples is given.  The steps involved in the 7 DCF methods are as follows:

Method 1:    Discount FCFF at the post-tax WACC (the traditional method - see Part 1):  

  1. Forecast FCFF (= operating EBITDA - capital expenditures  (‘capex’) - increase in working capital  - cash taxes on operating activities), discount back to the valuation date at the post-tax WACC for each period and sum to get the PV of forecast FCFF.
  2. Calculate the Terminal Value (‘TV’), having ensured cash flows being valued in perpetuity have reached steady state, and discount back to the valuation date at the post-tax WACC for the final forecast year (a variety of perpetuity formulae can be used, as discussed in Part 1) and add to 1) to get the operating DCF Enterprise Value.

Integrated financial statements (income, balances and cash flows) should be prepared as part of the forecasting process, and all items should be re-classified as operating and  non-operating.

Method 2:   Discount operating economic profits at the post-tax WACC:  

  1. Forecast Net Operating Profits After Taxes (‘NOPAT’) (= operating EBIT - cash taxes on operating activities) and operating net assets (‘Invested Capital’ / ‘IC’)
  2. Calculate the Return On Invested Capital (‘ROIC’) (= NOPAT / opening IC )
  3. Calculate the economic profits for each period ( = (ROIC – WACC) x opening IC or NOPAT – (WACC x opening IC) )
  4. Calculate the economic profit TV (= { NOPAT in first terminal year – (WACC x IC at end of forecast period) } / {WACC – growth rate}.  More advanced formulae (discussed in the article) can be used to calculate the TV using the Return On New Invested Capital (‘RONIC’).
  5. Discount the forecast economic profits and TV back to the valuation date at the WACC and add the IC to arrive at the operating Enterprise Value

Economic Value Added (EVA®), created by Stern Value Management, is a value management framework which uses this approach.
    
Method 3:   Discount Capital Cash Flows at the pre-tax WACC:

  1. Add the tax shield cash flows (=tax rate x interest rate paid x debt) to the forecast FCFF from method 1 to determine CCF. This assumes interest is paid at the cost of debt rate (this would imply bonds are priced at par for the yield to maturity – used as the cost of debt – to equal the coupon rate)
  2. Step 2)  Discount the forecast CCF and the TV (based on the first terminal yield tax shields growing in perpetuity) at the pre-tax WACC to arrive at the operating DCF Enterprise Value

Method 4:  Adjusted Present Value

  1. Step 1)  Discount the forecast FCFF at the ungeared cost of equity (as for method 1 but using the higher ungeared cost of equity discount rate).
  2. Discount the tax shields at the pre-tax cost of debt or, as in this article, at the ungeared cost of equity on the basis that the tax shields have the same risk as the business operating cash flows. This is the same approach as for method 3.

Method 3 and 4 give equal values because in this case the pre-tax WACC equals the ungeared cost of equity because a debt beta has been assumed and calculated based on the Equity Risk Premium (debt beta = debt risk premium / equity risk premium).

Method 5:  Discount Free Cash Flows to Equity (FCFE) at the geared cost of equity:

  1. Discount the forecast FCFE at the geared cost of equity.  If all net cash flows are paid out as dividends, FCFE = profit after tax + debt funding – New Invested Capital  or FCFE = FCFF + debt funding – debt interest (after tax relief)
  2. Discount the TV at the geared cost of equity. The TV is calculated as for method 1, but using the first terminal year FCFF and geared cost of equity

Method 6:  Discount the Residual Income (RI) at the geared cost of equity. Similar to method 2:

  1. Discount the forecast RI at the geared cost of equity:  RI = profits after tax  -  geared cost of equity x equity book value at start of each period
  2. Discount the TV at the geared cost of equity: RI in first terminal year = first terminal year profits after tax x equity book value at start of first terminal year, growing in perpetuity as for all the above.
  3. Add the PV from 1) and 2) to the equity book value at the valuation date

The calculations can be shown in terms of the Return On Equity (‘ROE’), calculated as profits after tax / opening equity book value

Method 7:  Discount dividends at the geared cost of equity:  since all equity cash flows are distributed as dividends, this will give the same answer as method 5.

A brief discussion on multiples is also given, with a focus on which multiples are relevant, how to adjust them and then apply them.
 

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