test1

Enterprise Value Multiples & Momentum Indicators & Central Tendency Tasks: ➢ Calculate and interpret EV multiples and evaluate the use of EV/EBITDA ➢ Explain the sources of differences in cross-border valuation comparisons ➢ Describe momentum indicators and their use in valuation ➢ Explain the use of arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples Market-Based Valuation: Price and Enterprise Value Multiples 327Enterprise Value Multiple ➢ Enterprise Value (EV) or Firm Value = MV of common stock + MV of debt + MV preferred – cash and investments ➢ EBITDA = earnings before interest, taxes, depreciation, and amortization ➢ cash and investment (cash equivalent, short-term investments) are subtracted because EV is designed to measure the net price an acquirer would pay for the company 328Enterprise Value Multiple ➢ Ratio provides an indication of company/firm value, not equity value ➢ EBITDA is a earnings flow to both debt and equity holders ➢ Because the numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common stock 329Enterprise Value Multiple Rationales: ➢ appropriate for comparing firms with different financial leverage since EBITDA is pre-interest ➢ Controls for depreciation/amortization differences among businesses ➢ EBITDA usually positive when EPS is negative Drawbacks: ➢ Ignores changes in working capital investments ➢ FCFF (which controls for capital expenditures) is more closely tied to value 330Enterprise Value Multiple Enterprise Value is: ➢ positively related to the expected growth rate in FCF ➢ positively related to expected profitability as measured by return on invested capital (ROIC) ➢ negatively related to the business’s weighted average cost of capital (WACC) 331Enterprise Value Multiple Valuation using EV Multuple: ➢ Firm EV/EBITDA < benchmark Relatively Undervalued ➢ Firm EV/EBITDA > benchmark Relatively Overvalued 332➢ Importance: ☆☆ ➢ Content: • Enterprise value multiples ➢ Exam tips: • 重点掌握企业价值乘数优缺点和计算 Summary 333Contents Market-Based Valuation: Price and Enterprise Value Multiples    ⚫ General Ideas ☆ ⚫ Price Multiples ☆☆☆ ⚫ Enterprise Value Multiples ☆ ☆ ⚫ Others ☆ 334Others Tasks: ➢ describe momentum indicators and their use in valuation ➢ explain sources of differences in cross-border valuation comparisons ➢ explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples Market-Based Valuation: Price and Enterprise Value Multiples 335Cross Border Valuation Differences ➢ Comparing companies across borders frequently involves accounting method differences, cultural differences, economic differences, and resulting differences in risk and growth opportunities ➢ For example, P/E ratios for individual companies in the same industry across borders have been found to vary widely 336Momentum Indicators ➢ Momentum indicators based on price, such as the relative strength indicator have also been referred to as technical indicators ➢ Unexpected earnings (also called earnings surprise) is the difference between reported earnings and expected earnings UEt = EPSt – E(EPSt ) ➢ the rationale is that positive surprise may be associated with persistent positive abnormal return, or alpha. 337Momentum Indicators ➢ Another momentum indicator based on the relative change in earnings per share is called standardized unexpected earnings ➢ the smaller (larger) the historical size of forecast errors, the more (less) meaningfull a given size of EPS forecast error. (EPS E(EPS ) EPS E(EPS ) SUE t t t t t − − =  338Measuring Central Tendency in Multiples ➢ Arithmetic mean • Most affected by outliers ➢ Harmonic mean • Less affected by large, more by small, outliers ➢ Weighted harmonic mean • Effect of outliers depend on market value weight ➢ Median • Least affected by outliers 339Measuring Central Tendency in Multiples ➢ Harmonic mean ➢ Weighted harmonic mean ➢ are the portfolio value weights (summing to 1) = = n i n 1 i H 1/ X X = = n i i 1 i WH / X 1 X  i 340Measuring Central Tendency in Multiples Harmonic mean: ➢ Less weight on higher ratios ➢ More weight on lower ratios ➢ Reduces impact of large outliers ➢ May worsen impact of small outliers ➢ Small outliers bounded by zero, so less problematic ➢ Lower value than arithmetic mean (unless all observations are the same value) ➢ Used when market weight information unavailable 341Measuring Central Tendency in Multiples Weighted harmonic mean: ➢ Similar to simple harmonic mean except in weighting: ➢ Uses market value weights ➢ Major advantage: Corresponds to portfolio value (e.g., total price/total earnings) 342Example: Measuring Central Tendency in Multiples A股票价格$10, EPS=$1, P/E=10 B股票价格$16, EPS=$2, P/E=8 现portfolio中A、B股票各一股，求其市盈率 343➢ Importance: ☆ ➢ Content: • Cross-border valuation differences • Momentum indicators • Central tendency ➢ Exam tips: • 了解跨境估值差异 • 了解动能指标及其运用 • 了解价格乘数均值计算方法 Summary 344Contents Residual Income Valuation    ⚫ Definition of Residual Income ☆ ☆ ☆ ⚫ Valuations using Residual Income ☆ ☆ ☆ ⚫ Accounting Issues ☆ 345Definition of Residual Income Tasks: ➢ Calculate and interpret residual income, economic value added, and market value added ➢ Describe the uses of residual income models Residual Income Valuation 346Concept of Residual Income (RI) ➢ Traditional financial statements are prepared to reflect earnings available to owners. Net income includes an interest charge to represent the cost of debt capital (interest expense). ➢ Dividends or other charges for equity capital are not explicitly deducted ➢ Accounting rules leave equity owners the task to determine whether the resulting earnings exceeded the cost of equity capital 347Defining Residual Income ➢Residual income (RI): • Equivalent to “economic profit” • RI = net income less opportunity cost of equity capital ➢Accounting income will overstate returns from equity investor perspective because ignores cost of equity ➢Residual income explicitly deducts all capital costs of both debt and equity ➢companies generating more income than its cost of obtaining capital are creating value 348Defining Residual Income RI = Net Inc – (equity capital × cost of equity) Alternatively, using a pre-levered figure RI = EBIT (1 – t) – (total capital × WACC%) ➢Recall, WACC implicitly accounts for both the cost of debt and equity on a weighted average basis 349Defining Residual Income Example 1: ➢ Estimated 2009 EPS = $1.20 ➢ Book value per share 2008 = $10.00 ➢ Equity required return = 10% Calculate Residual Income ➢ RI = EPS1 – (BVPSt–1 × r) ➢ $0.20 = $1.20 – ($10.00 × 0.10) ➢ The firm earned positive RI of $0.20 providing value to both debt and equity holders 350Defining Residual Income Example 2: The Maisy Grain Company makes gourmet bread products • Assets = $100.8 million • Liabilities = $40.2 million • Equity = $60.6 million • Pretax cost of debt = 7.1% • Cost of equity = 13.3% • Tax rate = 40% Calculate residual income from EPS or EBIT 351Defining Residual Income Maisy Grain Company – Partial Income Statement ➢Equity charge = equity capital × cost of equity = $60.6 million × 0.133 = $8,059,800 ➢RI = net income – equity charge = $2,823,600 – $8,059,800 = –$5,236,200 ➢Positive accounting income; negative economic income EBIT $7,560,000 Less: Interest expense 2,854,000 Pre-tax income 4,706,000 Less: Income tax expense 1,882,400 Net income $2,823,600 352Defining Residual Income ➢EBIT (1 – t) = $7,560,000 × (1 – 0.40) = $4,536,000 ➢Total Capital (TC) = $100.8 million ➢WACC = re × (E/TC) + id (1 – t)(D/TC) ➢WACC = (.133)(.601) + (.071)(1 – .4) (.399) = 9.69% ➢RI = EBIT (1 – t) – (Total Cap × WACC%) ➢RI = $4,536,000 – $9,771,000 = –$5,235,000 close! 353Alternative RI Measures: EVA ➢Economic value added (EVA® ) measures valued added to shareholders by management ➢EVA® = NOPAT – (WACC% × Total Capital) ➢NOPAT = EBIT (1 – t) ➢Positive EVA® – management is adding value ➢Negative EVA® – value not added ➢Evaluate the relative change in EVA over time 354Alternative RI Measures: Market Value Added (MVA) ➢ MVA measures the effect on value of management’s decisions since the firm’s inception MVA = market value of firm – invested capital ➢ invested capital = the accounting book value of total capital ➢ A company producing positive MVA will have an excess of market value over the book value of invested capital ➢ Evaluate the change in MVA over time 355Uses of Residual Income ➢Common usage: • Evaluate managerial effectiveness • Executive compensation ➢For exam, we are most interested in the equity valuation applications 356➢ Importance: ☆☆☆ ➢ Content: • Definition of residual income • Economic value added • Market value added • Uses of residual income ➢ Exam tips: • 重点掌握剩余收入，增加的经济价值和增加的市场价值概 率 • 了解剩余收入模型的用途 Summary 357Contents Residual Income Valuation    ⚫ Definition of Residual Income ☆ ☆ ☆ ⚫ Valuations using Residual Income （1）☆ ☆ ☆ ⚫ Accounting Issues ☆ 358Residual Income Model (1) Tasks: ➢ Calculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models ➢ Explain fundamental determinants of residual income ➢ Explain the relation between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals Residual Income Valuation 359Residual Income Model ➢ RI model breaks intrinsic value V0 of equity into these two components: 1. Current book value of equity B0 , plus 2. Present value of expected future RIt 0 0 1 1 (1 ) ( ) n t t t t t t RI V B r RI E r B = − = + + = −   360Residual Income Model ➢ Two methods for calculating RIt • RIt = EPSt – (r × BVPSt–1 ) • RIt = (ROEt – r) x BVPSt–1   = + − = + 1 t t t-1 0 0 (1 r) (ROE )BVPS V BVPS t r 361Residual Income Model Example: • Required return on equity = 12% • BV/share = $3.40 year end 2008 • Earnings forecast: 2009 = $0.90; 2010 = $1.10; 2011 = $1.20 • Payout ratio = 50% • Dividend in 2011 is liquidating event ➢ Calculate: Intrinsic value using RI model 362Residual Income Model 2009 2010 2011 Beginning BV/share (Bt–1) $3.40 $3.85 $4.40 EPS forecast (Et) 0.90 1.10 1.20 DPS forecast (Dt) – 50% payout 0.45 0.55 5.60 BV/share forecast (Bt–1 + Et– Dt) 3.85 4.40 0.0 Equity charge/share (r × Bt–1) 0.41 0.46 0.53 RI/share (Et – (r × Bt–1)) 0.49 0.64 0.67 363Residual Income Model Solution: ➢ Calculate the PV (using calculator) • CF0 = +3.40 (current BV) • CF1 = +0.49 (RI1 ) • CF2 = +0.64 (RI2 ) • CF3 = +0.67 (RI3 ) • I = 12 (%) ➢ CPT → NPV = $4.82 = equity value today 364Difference in Value Recognition: Between RI vs. DCF Models ➢ Value is recognized earlier under RI model (BV0 ) than under the DCF model, therefore less sensitive to terminal value estimates ➢ BV0 usually represents a large percentage of intrinsic value ➢ In the DDM or FCF model, terminal value is most of the value estimate, which is subject to substantial forecasting risk due to the forecast horizon and the relationship between r and g 365Fundamental Determinants of Residual Income ➢ Main point: If ROE > required return: • RI will be positive • Justified market-to-book > 1 ➢ If ROE = required return: • Justified market value = book value • Market-to-book ratio = 1 366RI Valuation and Justified P/B Ratio ➢ Residual Income Models can be used to calculate justified P/B ratio based on forecasted ROE and EPS ➢ Assume constant growth rate ➢ When the present value of expected future RI is positive, the justified P/B based on fundamentals is greater than 1.0 r g ROE g − − = 0 0 B V 367➢ Importance: ☆☆☆ ➢ Content: • Residual income model • Differences in value recognition between RI and other PV models • Fundamental determinants of residual income • Residual income and justified P/B ratio ➢ Exam tips: • 重点掌握剩余收入模型，剩余收入模型与其他现金流模型的 价值确认差别 • 理解剩余收入的基本决定因素，剩余收入与合理市净值比率 的关系 Summary 368Contents Residual Income Valuation    ⚫ Definition of Residual Income ☆ ☆ ☆ ⚫ Valuations using Residual Income （2）☆ ☆ ☆ ⚫ Accounting Issues ☆ 369Residual Income Model (2) Tasks: ➢ Calculate and interpret the intrinsic value of a common stock using single-stage (constant growth) and multistage residual income models ➢ Calculate the implied growth rate in residual income, given the market P/B ratio and an estimate of the required rate of return on equity ➢ Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects Residual Income Valuation 370Constant Growth (Single-Stage) Residual Income Model ➢ Single-stage RI assumes: • Constant ROE • Constant earnings growth: r g ROE r − − V0 = B0 + B0 Value generated by firm’s ability to produce economic profits when ROE > r 371Constant Growth (Single-Stage) Residual Income Model ➢ Example: ➢ North Pacific Whaling Co: • Book value $37.00 • ROE 23% • Required return 18% • Dividend payout 40% ➢ Calculate: Share value using single-stage RI model 372Constant Growth (Single-Stage) Residual Income Model ➢ Solution: ➢ Growth rate: g=b*ROE = (1-0.40)*0.23 = 0.1380=13.8% ➢ Intrinsic value: 0 (0.23 0.18) 37.00 $37.00 [ ] 0.18 0.138 V −  = + − 373Calculating Implied Growth Rate ➢Market P/B ratio = 1.50 ➢Current book value per share B0 = $9.00 ➢Estimated ROE = 12% Required return on equity = 10% ➢Assume P0 = V0 , market is in equilibrium. ➢Solving for the implied growth rate… Solution ➢Market price = P/B x BVPS Market price = 1.50 × $9.00 = $13.50 0 0 0 ( ) [ ] B ROE r g r V B  − = − − $900 (0.12 0.10) 0.10 [ ] 0.06 6% $13.50 $9.00 g  − = − = = − 374Multi-Stage Model ➢ Continuing RI: Expected RI beyond the estimation horizon • Method 1: premium over book value • Method 2: persistence factor ✓ Four hypothetical situations 375Multi-Stage Model Method 1 ➢ at the end of time horizon T, a certain premium over book value (Pt - Bt) exists ➢ the longer the forecast period, the greater the chance the company’s residual income will converge to zero, thus (Pt - Bt) may be treated as zero 376➢ Importance: ☆☆☆ ➢ Content: • Single stage residual income model • Implied growth rate • Continuing residual income: premium over book value ➢ Exam tips: • 重点掌握单阶段剩余收入模型计算 • 通过剩余收入模型计算增长率 • 通过净资产值溢价计算连续剩余收入 Summary 377Contents Residual Income Valuation    ⚫ Definition of Residual Income ☆ ☆ ☆ ⚫ Valuations using Residual Income （3）☆ ☆ ☆ ⚫ Accounting Issues ☆ 378Residual Income Model (3) Tasks: ➢ Calculate and interpret the intrinsic value of a common stock using single-stage (constant growth) and multistage residual income models ➢ Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects Residual Income Valuation 379Multi-Stage Model Method 2 ➢ 用persistence factor (ω)来估计RI消失速度 • ω=0 → RI在第T+1期开始消失 • ω=1 → RI在第T+1期开始保持不变 ➢ V0=B0+PV( interim high-growth RI ) + PV( continuing RI ) 1 r - RI PV(continuing RI in year T -1) T + = 380Multi-Stage Model Method 2 ➢ Factors suggesting higher ω: • Low dividend payout • High historical RI persistence in the industry ➢ Factors suggesting lower ω: • Extremely high ROE • Large special items (nonrecurring iterms) • Large accounting accruals 381Multi-Stage Model Method 2 ➢ Possible assumptions for continuing RI: 1. Drop immediately to zero (ω = 0), no competitive advantage, pure competition 2. Persist at current level forever (ω = 1), perpetual competitive advantage 3. Decline over time to zero (0 < ω < 1) 4. Decline to mature industry level 382Multi-Stage Model Method 2 1. RI drops immediately to 0→ ω=0 2. RI persists at current level forever→ ω=1 3. RI declines over time to 0 → 0<ω<1 383Multi-Stage Model Method 2 4. RI declines to long-run level in mature industry → the same with method 1 384Multi-Stage Model Example: ➢ ROE of 20% per year for four years ➢ BV0 = $8.00 ➢ No dividends ➢ Required return = 15% ➢ Forecast earnings = BV0 × ROE (by definition) ➢ Case #1: After 4 years RI = 0 ➢ Calculate: Intrinsic value 385Multi-Stage Model Year Et Ending BV ROE Equity Charge Residual Income 0 $8.00 1 1.60 9.60 0.20 1.20 0.40 2 1.92 11.52 0.20 1.44 0.48 3 2.30 13.82 0.20 1.73 0.57 4 2.76 16.58 0.20 2.07 0.69 = $8.00 × 0.2 end BV = beg BV + E = $8.00 × 0.15 = $1.6 – $1.2 = $8(0.2 – 0.15) 386Multi-Stage Model ➢ PV (continuing RI year 3) = 0.69/1.15 = 0.60 ➢ Calculate intrinsic value: • CF0 = 8.00 • CF1 = 0.40 • CF2 = 0.48 • CF3 = 0.57 + 0.60 = 1.17 • I = 15% (given) ➢ CPT → NPV = $9.48 (lowest value) 0 1 2 3 $8.00 0.40 0.48 1.17 387Multi-Stage Model ➢ Case 2: • Assume: Constant residual income of $0.69 after 3 years, “think perpetuity” • Include the PV of RI for years 4 to infinity PV (continuing RI in year 3) = 0.69/0.15 = 4.60 388Multi-Stage Model ➢ Calculate intrinsic value: • CF0 = 8.00 • CF1= 0.40 • CF2 = 0.48 • CF3 = 0.57 + 4.60 = 5.17 • I = 15% (given) ➢ CPT → NPV = $12.11(highest value) 0 1 2 3 $8.00 0.40 0.48 5.17 389Multi-Stage Model ➢ Case 3: • Assume: Starting in year 4 RI will decrease to zero over time with a persistence factor of 0.6 3 $0.69 1 0.15 0.6 ContRI = = + − $1.25 Notice we stop one year earlier in year 3 not year 4 because it’s the PV of RI in t – 1! 390Multi-Stage Model ➢ Calculate intrinsic value: • CF0 = 8.00 • CF1 = 0.40 • CF2 = 0.48 • CF3 = 0.57 + 1.25 = 1.82 • I = 15 ➢ CPT → NPV = $9.91 0 1 2 3 $8.00 0.40 0.48 1.82 391Multi-Stage Model ➢ Case 4: • Assume: At t = 4 price-to-book falls to 1.1 • BV4 = • PV4 of RI after yr 4 = Cont RI3 = $18.24 – $16.58 = $1.66 $0.69 + $1.66 = $2.04 1.15 $16.58,  P4 = 1.1 × $16.58 = $18.24 From table MP = 10% premium over BV 392Multi-Stage Model ➢ Calculate intrinsic value: • CF0 = 8.00 • CF1 = 0.40 • CF2 = 0.48 • CF3 = 0.57+2.04 =2.61 • I = 15 ➢ CPT → NPV = $10.43 0 1 2 3 $8.00 0.40 0.48 2.61 393➢ Importance: ☆☆☆ ➢ Content: • Multistage models ➢ Exam tips: • 必须掌握多阶段剩余收入估值模型 • 理解影响持续因子的因素 Summary 394Contents Residual Income Valuation    ⚫ Definition of Residual Income ☆ ☆ ☆ ⚫ Valuations using Residual Income ☆ ☆ ☆ ⚫ Accounting Issues ☆ 395Other Issues of Residual Income Model Tasks: ➢ Compare residual income models to dividend discount and free cash flow models ➢ Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock ➢ Describe accounting issues in applying residual income models Residual Income Valuation 396RI, DDM, and FCFE Models ➢ DDM and FCF models measure value by discounting a stream of expected cash flows including a future terminal value ➢ RI starts with BV0 and adds the expected stream of positive or negative residual income ➢ Theoretically, RI values should have the identical recognition values as DCF values if inputs used are the same 397Strengths of Residual Income Model 1. Terminal value does not dominate intrinsic value estimate 2. Accounting data usually accessible 3. Applicable even without dividends or negative cash flow 4. Applicable even when cash flows are volatile or unpredictable 5. Focus on economic profitability 398Weaknesses of Residual Income Model 1. Accounting data can be manipulated by management 2. Requires many adjustments (link to FSA) 3. Assumes clean surplus relation holds or that its failure to hold has been taken into account (link to FSA): Bt = Bt-1 + Et − Dt 399RI Models and Company Characteristics RI appropriate when: 1. No dividends or volatile dividends 2. Negative free cash flows 3. Uncertainty in forecasting terminal values RI not appropriate when: 1. Clean surplus solution violated significantly 2. Unreliable estimates of BV and ROE 400Accounting Issues While RI is straightforward, in practice it requires many adjustments: 1. Violations of clean surplus relationship 2. Off-balance sheet items 3. Non-recurring items on income statement 4. Aggressive accounting practices 5. International accounting differences 401Accounting Issues Violations of clean surplus relationship ➢ Violations of clean surplus relationship occur when items bypass the income statement and direct adjustments to equity are made ➢ Examples: • FX translation gain/losses • Balance sheet adjustments to fair value • Pension liability • Unrecognized gain/(loss) on available-for-sale securities • Deferred gain/(loss) on cash flow hedges 402Accounting Issues Off-Balance Items ➢ Examples of items needing adjustment: • Operating leases • Off-balance sheet SPEs • LIFO to FIFO inventory • Deferred tax assets and liabilities ➢ Implication: Book value misstated 403Accounting Issues Nonrecurring Items ➢ Examples of items requiring exclusion: • Discontinued operations • Accounting changes • Restructuring charges ➢ Implication: Exclude nonrecurring items on the income statement, RI should be based on recurring items only 404Accounting Issues Aggressive Accounting Practices ➢ Examples: • Accelerating revenue to current period • Deferring expenses to later period • Using reserves to smooth income 405Accounting Issues International Accounting Differences ➢ Point: Difficult to apply RI in international context with less strict accounting regulations ➢ Questions to consider: 1. Are EPS forecasts reliable? 2. Is clean surplus relation violated? 3. Do financial statements reflect economic reality? 406➢ Importance: ☆ ➢ Content: • Comparison of RI, DDM and FCF models • Strengths and weaknesses of residual income models • Accounting issues ➢ Exam tips: • 比较剩余收入模型，股利和自由现金流模型 • 理解剩余收入模型的优缺点 • 理解在运用剩余收入模型时存在的会计考虑 Summary 407Contents Private Company Valuation  ⚫ Introduction ☆ ☆ ⚫ Income Approach ☆ ⚫ Market Approach ☆ ☆ ⚫ Asset-Based Approach ☆ 408Introduction to Private Company Valuation Tasks: ➢ Compare public and private company valuation ➢ Describe uses of private business valuation explain application of greatest concern to financial analysts ➢ Explain various definitions of value and demonstrate how different definitions can lead to different estimates of value ➢ Explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach Private Company Valuation 409Private vs. Public Companies Company-specific factors ➢ stages in lifecycle ➢ size ➢ overlap of shareholders and management ➢ quality/depth of management ➢ quality of financial and other information ➢ pressure from short term investors ➢ tax concerns 410Private vs. Public Companies Stock-specific factors ➢ liquidity of equity interests in business ➢ concentration of control ➢ potential agreements restricting liquidity 411Uses of Private Business Valuation Transaction-related ➢ private financing ➢ initial public offering (IPO) ➢ acquisition ➢ bankruptcy ➢ share-based compensation 412Uses of Private Business Valuation Compliance-related ➢ financial reporting ➢ tax reporting Litigation ➢ Shareholder suits ➢ Damage claims ➢ Lost profits ➢ Divorces 413Definitions of Value ➢ Fair market value ➢ Fair value for financial reporting ➢ Fair value for litigation ➢ Market value ➢ Investment value ➢ Intrinsic value 414Approaches to Valuation ➢ the income approach values an asset as the present discounted value of the income expected from it ➢ the market approach values an asset based on pricing multiples from sales of assets viewed as similar to the subject asset ➢ the asset-based approach values a private company based on the values of the underlying assets of the entity less the value of any related liabilities nature of operations, lifecycle stage and size should be considered when selecting an appropriate approach 415➢ Importance: ☆ ☆ ➢ Content: • Private Vs. public company • Uses of private business valuation • Definitions of value • Approaches to valuation ➢ Exam tips: • 比较上市公司与私人公司的估值特征 • 了解私人公司估值运用 • 了解私人公司估值方法 Summary 416Contents Private Company Valuation  ⚫ Introduction ☆ ☆ ⚫ Income Approach ☆ ☆ ⚫ Market Approach ☆ ⚫ Asset-Based Approach ☆ 417Income approaches Tasks: ➢ Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings ➢ Calculate the value of a private company using free cash flow, capitalized cash flow, and excess earnings methods ➢ Explain factors that require adjustment when estimating the discount rate for private companies ➢ Compare models used to estimate the required rate of return to private company equity Private Company Valuation 418Normalized Earnings Adjustments ➢ normalized earnings are economic benefits adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and facilitate comprisons ➢ adjustments required to normalize earnings inclue: • Nonrecurring and unusual items • Discretionary expenses • Non-market compensation levels • Personal expenses • Real estate expenses • Non-market lease rates 419Issues in Cash Flow Estimation ➢ Controlling vs. non-controlling interests ➢ Scenario analysis ➢ Lifecycle stage ➢ Management biases ➢ Capital structure changes 420Income Approach Methods ➢ Free cash flow ➢ Capitalized cash flow ➢ Excess earnings 421Income Approach Methods ➢ the free cash flow method values an asset based on estimated future cash flows that are discounted to present value • PV (discrete CFs plus a terminal value) • Terminal value ✓ Constant growth model ✓ Price-multiple approach 422Income Approach Methods ➢ the capitalized cash flow method values a private company by using a single representative estimate of economic benefits and divide that by an appropriate capitalization rate value of the firm = FCFF1 WACC g − value of the equity = r g FCFE − 1 423Income Approach Methods ➢ the excess earnings method estimates the value of all of the intangible assets by capitalizing future earnings in excess of the estimated return requirements associated with working capital and fixed assets. the value of the intangible assets is then added to the value of working capital and fixed assets to arrive at the value of the business ➢ NI0 = current normalized earnings ➢ RI0 = NI0 – rwc * WC – rfa * FA ➢ value of the intangible ASSETS: ➢ value of the whole firm: Vfirm = Vintangible + WC +FA r g RI g angible − + = int 0 intangible (1 ) V 424Income Approach Methods Example: Working capital $500,000 Fixed assets $2,000,000 Normalized earnings (year just ended) $235,000 Required return for working capital 5% Required return for fixed assets 10% Growth rate of residual income 4% Discount rate for intangible assets 20% 425Income Approach Methods Solution: Return on WC = 5% ×$500,000 = $25,000 Return on FA= 10% ×$2,000,000 = $200,000 Residual Income= $235,000－ $25,000 －$200,000= $10,000 Value of intangible assets = ($10,000×1.04)/(0.20－0.04) = $65,000 Value of firm = $500,000+$2,000,000+$65,000 = $2,565,000 426Discount Rate Estimation Elements ➢ Size Premiums ➢ Availability and Cost of Debt ➢ Acquire vs. Target’s cost of capital ➢ Projection Risk ➢ Lifecycle Stage 427Discount Rate Model ➢CAPM - generally not appropriate ➢Expanded CAPM - add to the CAPM a premium for small size and company-size ➢Build- up Approach: appropriate when guideline public companies are not available ➢Possible risk premiums for • Size • Company-specific risk • Industry risk 428➢ Importance: ☆☆ ➢ Content: • Normalized earnings adjustment • Issues in cash flow estimation • Free cash flow/capitalized cash flow/excess earnings approaches • Discount rate estimation ➢ Exam tips: • 重点掌握现金流估值方法计算 • 了解正常利润调整和贴现率评估 Summary 429Contents Private Company Valuation  ⚫ Introduction ☆ ☆ ⚫ Income Approach ☆☆ ⚫ Market Approach ☆ ☆ ⚫ Asset-Based Approach ☆ 430Market approaches Tasks: ➢ Calculate the value of a private company based on market approach methods and describe advantages and disadvantages of each method Private Company Valuation 431Market Approaches ➢ Guideline Public Company Method ➢ Guideline Transactions Method ➢ Prior Transaction Method 432Guideline Public Company Method (GPCM) ➢ Guideline Public Company Method obtains a value estimate based on the observed multiples from trading activity in the shares of public companies comparable to the subject private company. the multiples from the public companies are adjusted to reflect differences in risk and growth ➢ Advantage: potentially large pool of guideline companies and significant financial and trading information available ➢ Disadvantage: issues regarding to comparability and subjectivity in the risk and growth adjustment 433Guideline Public Company Method (GPCM) ➢ for valuation of a controlling interest, a control premium may be added if the value is derived from the GPCM (the trading of interests in public companies typically reflects small blocks without control of the entiry) ➢ control premium can be estimated based on transactions in which public companies were acquired 434Guideline Public Company Method (GPCM) Considerations in estimating a control premium: ➢ Transaction Type (strategic VS. financial transaction) • control premium for a strategic acquisition is larger than that of a financial transaction due to synergies ➢ Industry Conditions • historical control premiums might reflect a different industry environment ➢ Type of Consideration ➢ Reasonableness 435Guideline Public Company Method (GPCM) Example: 1. Public price multiple will be deflated by 25% due to increased risk of private firm 2. Buyer is strategic so a control premium is applied Market value of debt $3,300,000 Normalized EBITDA $33,500,000 Average MVIC/EBITDA multiple 8.0 Control premium from past transaction 20% 436Guideline Public Company Method (GPCM) Solution: Risk adjustment: 8.0×(1－0.25) = 6.0 Control Premium: 6.0×(1+ 0.20) = 7.2 Value of firm: 7.2×$33,500,000 = $241,200,000 Value of equity: $241,200,000 －$3,300,000 = $237,900,000 437Guideline Transactions Method (GTM) ➢ the guideline transactions method obtains a value estimate based on pricing multiples derived from the acquisition of control of entire public or private companies that were acquired. ➢ GPCM uses a multiple that could be associated with trades of any size, GTM uses a multiple specially related to sales of entire companies ➢ most relevant for valuation of a controlling interest 438Guideline Transactions Method (GTM) Considerations in assessing GTM price multiples: ➢ Transaction Type (strategic VS. financial transaction) ➢ contingent consideration (potential future payments to the seller contingent on the achievement of certain events) • often related to uncertainty regarding the future financial performance of the company ➢ Type of Consideration ➢ availability of transactions (meaningful transaction for a specific private company may be limited) ➢ changes between transaction date and valuation date 439Prior Transaction Method (PTM) ➢ the prior transaction method uses the actual price paid for shares or the price multiples implied by past transactions in the stock of the subject private company as the guideline ➢ most relevant when considering the value of a minority equity interest in a company ➢ Disadvantage: historical transactions in the subject stock are very limited 440➢ Importance: ☆ ☆ ➢ Content: • Guideline public company method • Guideline transaction methods • Prior transaction method ➢ Exam tips: • 重点掌握三种市场估值法的计算和优缺点 Summary 441Contents Private Company Valuation  ⚫ Introduction ☆ ☆ ⚫ Income Approach ☆☆ ⚫ Market Approach ☆ ☆ ⚫ Asset-Based Approach ☆☆ 442Asset-based Approach Adjustment to Comparable Value Tasks: ➢ Describe the asset-based approach to private company valuation ➢ Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability Private Company Valuation 443Asset – Based Approach ➢ the value of equity is calculated as the fair value of total assets less the fair value of total liabilities • Not used for going concerns • Usually the lowest valuation • Difficulties in valuation: ✓ Individual assets ✓ Specialized assets ✓ Intangibles 444Discount for Lack of Control (DLOC) ➢ a discount for lack of control (DLOC) is an amount or percentage deducted from the pro rata share of 100 percent of the value of an entity interest in a business to reflect the absence of some or all of the powers of control ➢ the lack of control is disadvantageous because: • unable to select directors/management • unable to distribute cash or other property, to obtain financing, and to bring about other actions control premium DLOC 1 1 1 + = − 445Discount for Lack of Control (DLOC) Comparable Data Subject Valuation Adjustment to comparable data Controlling Interest Controlling Interest None Controlling Interest Non-controlling Interest DLOC Non-controlling Interest Controlling Interest Control Premium Non-controlling Interest Non-controlling Interest None 446Discount for Lack of Marketability (DLOM) ➢ a discount for lack of marketability (DLOM) is an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of a ready market for a company’s shares ➢ factors affecting a marketability discount: • Likelihood of IPO, firm sale, or dividends • Assets duration • Contractual restrictions • Pool of buyers • Asset risk 447Discount for Lack of Marketability (DLOM) Methods of estimating DLOM: ➢ Restricted vs. Publicly traded shares ➢ Pre-IPO vs. Post-IPO prices ➢ Put prices 448DLOC and DLOM Example Total Discount = 1－[(1－DLOC)(1－DLOM)] If DLOC is 18% and DLOM is 15% Total Discount = 1－[(1－0.18)(1－0.15)] = 30.3% 449➢ Importance: ☆☆ ➢ Content: • Asset-based approach • DLOC • DLOM ➢ Exam tips: • 重点掌握DLOC和DLOM • 了解asset-based估值