Advanced Valuation

Introduction

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Who I am

• Professor of Finance
• Director of the Institute for Financial Management
• Teaching interests:
− Corporate financial policy, Valuation, Sustainable Finance,
Empirical Methods

• Research interests: Corporate finance, mergers &

acquisitions, product markets, law and finance
• Personal:
− Married, three children

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Objectives of the course

• Course: Advanced Valuation

• This course develops and applies tools and methods for the
valuation of firms and other assets.
• It also analyzes mergers & acquisitions (M&A) as an important
corporate event.
• The goal is to develop methods that allow us to value firms and
other assets in many different situations.
• This is an applied course. We will discuss many examples and
solve a case study to illustrate how the methods and tools are
applied in real settings.

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Organization of the course

• Lectures are held once per week:

− Wednesday, 10.15h – 13.00h, Main building 120

• Assistants for the course:

Sascha Jakob ([email protected])
Christian Steiner ([email protected])

• Office hours:
− By appointment

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Organization of the course

• The lecture takes place in person.

• In addition to the in-person class, the lecture is recorded and

made available to students as a podcast on ILIAS on the
following day.

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Course material

• There are several books that are useful for this course. I will
mostly rely on the book by Damodaran throughout the
course.

Damodaran, Investment Valuation. Tools and

Techniques for Determining the Value of any Asset,
3rd edition, Wiley Finance, 2012.

• There is a website for the course on ILIAS, where I will post

lecture notes and additional class material.

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Case study

• We will discuss one case study together in class:

– Pacific Grove Spice Company; HBS case 4366

• Students do not have to hand in a report or solution for the

case. However, I expect all students to read the case
beforehand and to participate actively during the case
discussion.

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Assignments

• 30% of the final grade will be based on two assignments.

− The first assignment covers financial analysis and the derivation
of cash flows.
− The second assignment covers the estimation of the cost of
capital and the implementation of the DCF and multiple
methods.
• Students work in groups of 3-4 students to solve the
problem sets.
• Students should submit the team composition here
− Students without a group are free to sign up to any group that
has free places.

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Grade for the course

• 70% of the final grade will be based on an individual final

written exam.
• The exam will be two hours and closed book.
− Students can use a (programmable or non-programmable)
calculator.
− Students are allowed to bring along a cheat sheet (one A4
page, written (hand or computer) on front and back).
• No connected devices!
• The final grade is a weighted average of the final exam and
the assignments.
• The dates of the final exam are 10.01.2023 and 10.02.2023.

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Why should I care about this course?

• Here are some questions that you may be asking yourself:

− Why should I care about this course?

− Why is it interesting?

− What can I learn that is useful and that I do not know yet?

− What is this course all about?

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What is this course about?

• Most of you are familiar with project valuation and Discounted

Cash Flow (DCF) valuation.

• The value of an asset corresponds to the present value of the

future cash flows that it generates.

(2) Make them comparable across time (discounting)

Today Year 1 Year 2 Year 3 …

(1) Determine the relevant cash flows

(3) Value

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What is this course about?

• The purpose of “Advanced Valuation” is to go further and

investigate how to value firms in more complex situations.

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What is this course about?

• The course “Valuation” mostly deals with the valuation of

investment projects.

• The course “Financing and Capital Structure” deals with

the “passive side” of the balance sheet
− How are the assets (or firms) “optimally” financed?

• The course “Advanced Valuation” deals with the valuation

of entire firms.

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What is this course about?

(Market value) Balance sheet

Assets Liabilities

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 What is this course about?

(Market value) Balance sheet

Assets Liabilities

Project 1
Valuation
Project 2

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What is this course about?

(Market value) Balance sheet

Assets Debt

Financing
and Capital
Structure

Equity

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 What is this course about?

(Market value) Balance sheet

Assets Debt

Financing
Advanced
and Capital
Valuation
Structure

Equity

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 What is this course about?

(Market value) Balance sheet

Assets Debt

Advanced How can we value the

assets of a firm?
Valuation

Equity

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 What is this course about?

(Market value) Balance sheet

Assets Debt

Advanced What are the key value

drivers?
Valuation

Equity

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 What is this course about?

(Market value) Balance sheet

Assets Debt
What are the
advantages and
Advanced disadvantages of the
Valuation different valuation
methods?

Equity

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 What is this course about?

(Market value) Balance sheet

Assets Debt

What is the role

Advanced of valuation in a
Valuation M&A setting?

Equity

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Why is valuation important?

• In finance, value matters!

• In finance, we focus on firm value because it is the basis of
many decisions.
− Should the firm invest in a project?
− How should the project be financed, debt or equity, or both?
− Should the firm acquire its competitor?
− In which stocks should the investor invest?
− …
• The value implications of a corporate/investor decision are
in many instances the central decision criteria!
Why is valuation important?

• Portfolio management
− Fundamental analysis
− Franchise buyers (e.g. Warren Buffet)
− Chartists
− Information traders
− Market timers
− Efficient marketers
• Acquisition analysis
• Corporate Finance
Examples of valuation situations

• There are countless situations, in which we must assess the

value of a firm.
• For example:
− Merger and acquisitions
− Leveraged buyouts
− Initial public offerings
− Going private transactions
− Spin-offs and split-offs
− Startups
− Succession planning
− …
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 Mergers & Acquisitions

Source: FT.com
Leveraged buyouts

• Transactions that are financed with a lot of debt (leverage)

and little equity. How do these transactions create value?
Private equity fundraising

Source: McKinsey & Company

Initial public offerings (IPO)

• Example: On running
− Offer price range of US$ 20 – 22
− Final offer price set to US$ 24 on September 14th, 2021, valuing On
running at around US$ 7.3 billion.
− 31.1 million shares sold (from On Holding AG and some investors).
− On September 15th, 2021, the shares began trading on NYSE and
closed at $35
– Underpricing of 45.8%
– On September 14th, 2022, the stock is trading at US$ 19.1.
– Goldman Sachs & Co. LLC, Morgan Stanley and J.P. Morgan were acting
as joint lead book-running managers for the proposed offering, with Allen &
Company LLC, UBS Investment Bank, and Credit Suisse acting as joint
book-running managers.
Startups

• Each year, approximately 11’000 new companies are

established in Switzerland. In the US, it’s more than
600’000…
Succession plan

• In Switzerland, 99.6 percent of all firms are SME

• They are often run by the founder and her descendants
• At regular times, the owner-manager has to find a successor (or sell
off or liquidate).
• Among many other things, this requires a valuation.
Myths about valuation

• Before we talk about valuation, let’s discuss some myths.

− Myth 1: Since valuation models are quantitative, valuation is objective.

− Myth 2: A well-researched and well-done valuation is timeless.
− Myth 3: A good valuation provides a precise estimate of value.
− Myth 4: The more quantitative a model, the better the valuation.
− Myth 5: To make money on valuation, you have to assume that
markets are inefficient.
− Myth 6: The product of valuation (i.e., the value) is what matters; the
process of valuation is not important.
Advanced Valuation
Earnings and Cash Flows

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Understanding financial statements

• From earnings to cash flows

• From earnings to cash flows – Example

• Additional topics

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Financial statements

• Financial statements provide the fundamental information

that we use to analyze and answer valuation questions.
• It is therefore important that we understand financial
statements and that we know how to manipulate them.
• “Difference” between finance and accounting
− Accounting: Measures (mostly) the current standing and
immediate past performance of a firm.
− Finance: Forward looking and mostly interested in value. How
much cash flow are the assets going to generate in the future?
What is the value of these cash flows today?

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Financial statements

• Three main financial statements:

1. Balance sheet
– Cumulated investments and their financing (through retained
earnings and/or security issuance)
2. Income statement
– Measures the firm’s financial performance
3. Cash flow statement
– Cash movements

• As financial economists, we try to understand the big

picture.
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Balance sheet

• Snapshot of the firm’s assets, liabilities, and equity

− Sources of capital (Liabilities and equity)
− Uses of capital (Assets)

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Balance sheet

• Basic structure of the balance sheet:

− Current assets: All assets that are reasonably expected to be
converted into cash within 1 year.
− Non-current assets: Assets which are expected to be in use for
more than 1 year.
− Operating liabilities: Money that is owed to business partners
from transactions related to the actual production and sale of
the firm's goods and services.
− Financial liabilities: Money that is owed to the providers of
debt capital.
− Equity: Capital contributed by the owners of the company.

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Balance sheet

Assets 20x1 20x2

Cash 1000 1200
Accounts receivable 2000 2100
Inventory 1500 1200
Prepaid expenses 500 1000
Total current assets 5000 5500
Property, plant, equipment (PPE) 8000 9000
Intangible assets 2500 2000
Goodwill 5000 5000
Total assets 20500 21500

Liabilities and shareholders' equity 20x1 20x2

Accounts payable 1500 1700
Taxes payable 800 1200
Short-term debt 2000 0
Long-term debt 8000 9000
Total liabilities 12300 11900
Share capital 100 100
Retained earnings 8100 9500
Total equity 8200 9600
Total liabilities and equity 20500 21500

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Balance sheet

• Assets:
− All assets that are depreciated, amortized, or impaired are the result of
investment activities.
– Mostly non-current assets: Property, plant & equipment; Investments &
advances; Intangible assets.

− All other assets are operating assets.

– Mostly current assets: A/R; Inventories; Other current assets

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Balance sheet

• Liabilities:
− All interest-bearing liabilities are financing liabilities.
– Mostly financial liabilities: Short-term debt; Long-term debt

− All liabilities that are not interest bearing are part of the firm's
operating liabilities.
– Mostly: A/P; Taxes payable

• Equity: All equity items refer to the firm's financing activity.

− Everything listed under equity

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 Sometimes the balance sheet is simplified

Assets 20x1 20x2

Cash 1000 1200
Accounts receivable 2000 2100
Inventory 1500 1200
Prepaid expenses 500 1000 Simplified balance sheet
Total current assets 5000 5500 Assets 20x1 20x2
Property, plant, equipment (PPE) 8000 9000 Cash 1000 1200
Intangible assets 2500 2000 Operating assets 4000 4300
Goodwill 5000 5000 Long-term assets 15500 16000
Total assets 20500 21500 Total assets 20500 21500

Liabilities and shareholders' equity 20x1 20x2 Liabilities and shareholders' equity 20x1 20x2
Accounts payable 1500 1700 Operating liabilities 2300 2900
Taxes payable 800 1200 Financial liabilities 10000 9000
Short-term debt 2000 0 Share capital 100 100
Long-term debt 8000 9000
Retained earnings 8100 9500
Total liabilities 12300 11900
Total liabilities and equity 20500 21500
Share capital 100 100
Retained earnings 8100 9500
Total equity 8200 9600
Total liabilities and equity 20500 21500

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Income statement

• The income statement measures the company’s financial

performance over a specific accounting period (typically one
year or one quarter).
EBIT/sales = EBIT margin

• Performance is measured by comparing revenues and

expenses (both from operating and non-operating activities),
typically scaled by some measure of invested capital.
Net income
− For example, Return on equity (ROE) =
Book value equity

ROCE (Return on capital employed) = (EBIT * (1-tau))/Invested capital

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Income statement

20x2
Revenues 18000
- Costs of goods sold (excl. depreciation & amortization) 8000
- Selling, general, and administrative expenses 2000
- Other operating expenses 1000
Earnings before interest, taxes, and D&A (EBITDA) 7000
- Depreciation & amortization (D&A) 3000
Earnings before interest and taxes (EBIT) 4000
- Interest expense 500
Earnings before taxes (EBT) 3500
- Income taxes (20%) 700
Net income 2800

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Linking the balance sheet and the income
statement

• The part of the firm’s net income (income statement), which

is not distributed to shareholders as a dividend, is added to
retained earnings (Balance sheet).

• Retained earningst = retained earningst-1

+ net incomet – dividendt

• Example:
− Net income = 2’800
− Retained earnings increase by 1’400 from 8’100 to 9’500
− Hence, the dividend was 2’800 – 1’400 = 1’400
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The accounting equation

Liabilities
Share capital
Assets = + Other equity
Equity + Retained earningst-1
+ Net income
- Dividends

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Measuring earnings

• The EBIT and net income are easily observables for publicly
traded firms.
• However, sometimes these figures have little resemblance
with the true earnings of the firms. As a result, we must
make sure to:

1. Obtain updated earnings estimates

2. Be aware that managers may have incentives to manage

earnings

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Update earnings

• Firms reveal their earnings in their financial statements and

annual reports to stockholders.
− These reports are released at the end of the firm’s fiscal year.
• Consequently, the last annual report available for a firm may
be several months old.
• Updating makes the most difference for smaller/more volatile
firms, and firms that have undergone significant restructuring.
− Make use of quarterly filed reports with the regulator (if
available)
− Aggregate numbers over the most recent four quarters
• If necessary, rely on unofficial sources to update the
numbers.
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Earnings management

• Firms generally manage earnings because they believe that they

will be rewarded by markets for delivering earnings that are
smoother and come in consistently above analyst estimates.
• It may be of best interest for managers of firms to manage earnings.
− Avoid being fired for missing earnings targets
− Compensation may be based on profit targets such as EPS
• When valuing firms, we must be aware that managers are doing
such practices…
• Managers have several techniques available to them.

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Cash flows

• The firm’s cash flows are typically divided into three

components based on firm activity:

Firm activities

Investments Financing Operations

Defines what the firm How the firm’s assets How the firm uses its
owns, i.e., the assets in are financed (debt and assets.
place to produce and equity).
sell the products and
services.

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Cash flow definitions

• Cash flow from operations: Reflects all cash in- and outflows
related to the actual production and sale of the firm’s goods and
services.
• Cash flow from investment: Reflects all cash in- and outflows
related to the firm’s investment activities.
• Cash flow from financing: Reflects all cash in- and outflows
related to the firm’s debt and equity (and other sources of finance).
Cash flows from Cash flows from Cash flows from
operating activities investment activities financing activities
Sales New investments Interest payments
Purchases of material Replacement investment Dividend payments
Salary payments Divestments Raising of debt
Taxes etc. Repayment of capital
etc. etc.

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Overview

• Understanding financial statements

• From earnings to cash flows

• From earnings to cash flows – Example

• Additional topics

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Earnings versus cash flows

• For valuation, we focus on the firm’s future ability to

generate cash.
• Cash is what the firm needs to pay salaries, taxes, bills, etc.
• Ultimately, the providers of capital want a cash
compensation (interest payments, dividend payments,
repayment of capital, etc.) for their investments.
• The profit figures from the income statement (e.g., EBITDA,
EBIT, net income) are not cash flows.
− It includes non-cash transactions, such as depreciation, sales
on account etc.
− It ignores cash transactions, such as capital expenditures
− Net income is contaminated by financing activities
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Earnings versus cash flows

• We therefore need to derive the relevant cash flow for

valuation purposes and “correct” for the non-cash and cash
positions.
• The cash flow we want to derive for valuation (i.e., the Free
Cash Flow) captures the cash that the firm derives from its
operating and investment activities.
− It excludes the cash flows associated with debt and equity
financing.
• We typically start with the operating profit of the firm, i.e.,
the firm’s EBIT.

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Deriving cash flows

EBIT
- Taxes
NOPLAT
+ Depreciation
- Increase Operating cash
- Increase Accounts receivable
Activities related to - Increase Inventory
operations - Increase other assets
+ Increase accounts payable
+ Increase accrued expenses
+ Increase other liabilities
Operating cash flow
Activities related to
investment - Net long-term investments
Free Cash Flow
Activities related to + Increase long-term debt
debt financing - Interest expenses (after taxes)
Residual cash flow
Activities related to + Increase share capital
equity financing - Dividend
Change in excess cash
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From EBIT to NOPLAT

• Interest expenses are tax deductible and are part of

financing activities. Consequently, the tax in the income
statement is affected by the amount of interest expenses.
• But we do not want our Free Cash Flow to be contaminated
by financing activities.
• Therefore, we compute the taxes the firm would have to pay
without debt financing. These are adjusted taxes.
• Then we derive the operating profit the firm would have
without debt financing. That’s the so-called Net Operating
Profit Less Adjusted Taxes (NOPLAT).
− NOPLAT = EBIT – adjusted taxes = EBIT × (1 – Tax rate)

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From EBIT to NOPLAT

• Let’s assume a tax rate of 20% in the previous example:

• NOPLAT = EBIT × (1 – Tax rate)

NOPLAT = 𝟒𝟒𝟒𝟒𝟒𝟒𝟒𝟒𝟒 × 𝟏𝟏 − 𝟎𝟎. 𝟐𝟐 = 𝟒𝟒𝟒𝟒𝟒𝟒𝟒𝟒 × 𝟎𝟎. 𝟖𝟖 = 𝟑𝟑𝟑𝟑𝟑𝟑𝟑𝟑𝟑

• NOPLAT = Net income + After-tax interest expenses

NOPLAT = 𝟐𝟐′𝟖𝟖𝟖𝟖𝟖𝟖 + 𝟒𝟒𝟒𝟒𝟒𝟒 = 𝟑𝟑′𝟐𝟐𝟐𝟐𝟐𝟐

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Corporate taxes

• We are faced with a choice of several different tax rates.

− Effective tax rate: It is computed as the taxes due divided by
the taxable income.
− Marginal tax rate: It is the tax rate which a firm faces on its last
dollar of income.
– This rate depends on the tax code and reflects what firms have to
pay as taxes on their marginal income.

• While the marginal tax rates for most firms within a

country/region should be similar, effective tax rates may wary
widely.

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Corporate taxes

• Why are there differences between marginal and effective

tax rates?
− Firms may use different accounting standards for tax and for
accounting purposes (straight line depreciation for reporting,
and accelerated depreciation for tax purposes).
− Firms may use tax credits to reduce the taxes they pay.
− Firms may defer taxes on income to future periods.
− Firms may generate substantial income for foreign domiciles
with lower tax rates.
• In many cases the safer choice is to use the marginal tax
rate.

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Depreciation & Amortization

• Depreciation & amortization spread the investment cost of

the acquisition of tangible and intangible assets over time.

• There is no cash flow associated with D&A.

• The only effect is on the taxable profit. We therefore need to

add back D&A after taxes have been calculated.

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Net working capital

• In accounting terms, the working capital is the difference between

current assets (inventory, cash and accounts receivable) and
current liabilities (accounts payables, short term debt and debt
due within the next year)
• A cleaner definition of working capital from a cash flow perspective
is the difference between non-cash current assets (inventory
and receivables) and non-debt current liabilities (payables)
• Any investment in this measure of working capital ties up cash.
Therefore, any increases (decreases) in working capital will
reduce (increase) cash flows in that period.
• We therefore need to adjust earnings for increases and decreases
in the components of working capital

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Net working capital

• Net working capital (NWC):

Operating cash + Inventory
+ Receivables (+ pre-paids)
– Payables (account payables and taxes)
= Net working capital
• Most projects will require an investment NWC.
• The change in net working capital is defined as:
ΔNWCt = NWCt – NWCt-1

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Net long-term investments

• Firms need to re-invest in their long-term assets.

− Purchase of new machines, trucks, technology, etc.
− Purchase of patents, brands, etc.
• These cash expenses do not show up in the income
statement (they show up through D&A).
• When estimating cash flow, we therefore need to subtract
these expenses and add back cash from potential asset
sales (for example machines that the firm does not anymore
need).
• Net long-term investments are investments in long-term
assets minus after-tax sales proceeds from asset sales.

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Free cash flow

• The relevant cash flow measure in valuation is the Free Cash

Flow.

• It is the amount of money the firm generates that is not tied

up in the operating or the investment activities.

• It is the amount of money that, in principle, can be

distributed to the providers of capital (debt and equity).

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Residual cash flow

• Another important cash flow measure is the Residual Cash

Flow, or the Free Cash Flow to Equity (FCFE)

• The Residual Cash Flow shows how much money is

available for distribution to the firm’s shareholders.

• We take the Free Cash Flow and subtract after-tax interest

expenses and (Principal Repayments - New Debt Issues)

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Overview

• Understanding financial statements

• From earnings to cash flows

• From earnings to cash flows – Example

• Additional topics

34
 Example

• How much cash (cash flow) did the firm generate in 20x2?

Assets 20x1 20x2 20x2

Cash 1000 1200 Revenues 18000
Operating assets 4000 4300 - Costs of goods sold (excl. depreciation & amortization) 8000
Long-term assets 15500 16000 - Selling, general, and administrative expenses 2000
Total assets 20500 21500 - Other operating expenses 1000
Earnings before interest, taxes, and D&A (EBITDA) 7000
Liabilities and shareholders' equity 20x1 20x2 - Depreciation & amortization (D&A) 3000
Operating liabilities 2300 2900 Earnings before interest and taxes (EBIT) 4000
Financial liabilities 10000 9000 - Interest expense 500
Share capital 100 100 Earnings before taxes (EBT) 3500
Retained earnings 8100 9500 - Income taxes 700
Total liabilities and equity 20500 21500 Net income 2800

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Operating cash flow

• We start with the EBIT and subtract adjusted taxes to get the
NOPLAT.

• NOPLAT is the after-tax operating profit, which is attributable

to the firm’s operations.

• Three adjustments are typically needed to get form NOPLAT

to Operating Cash Flow:
− Add back depreciation
− Subtract increases in operating assets
− Add increases in operating liabilities
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 Operating cash flow

20x2 20x2
Revenues 18000 EBIT 4000
- Costs of goods sold (excl. depreciation & amortization) 8000
- Taxes (EBIT × 20%) 800
- Selling, general, and administrative expenses 2000
- Other operating expenses 1000 NOPLAT 3200
Earnings before interest, taxes, and D&A (EBITDA) 7000 + Depreciation 3000
- Depreciation & amortization (D&A) 3000 - Increase Operating assets 300
Earnings before interest and taxes (EBIT) 4000 + Increase operating liabilities 600
- Interest expense 500 Operating cash flow 6500
Earnings before taxes (EBT) 3500
- Income taxes (20%) 700
Net income 2800

Assets 20x1 20x2 Change

Cash 1000 1200 200 Interpretation: With its operating
Operating assets 4000 4300 300
Long-term assets 15500 16000 500
activities, the firm has generated a
Total assets 20500 21500 1000 cash flow of 6'500 in 20x2. Because
Liabilities and shareholders' equity 20x1 20x2 Change
of the substantial depreciation and
Operating liabilities 2300 2900 600 amortization charges, this operating
Financial liabilities
Share capital
10000
100
9000
100
-1000
0
cash flow is considerably higher
Retained earnings 8100 9500 1400 than the NOPLAT of 3'200.
Total liabilities and equity 20500 21500 1000

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 Free Cash Flow

20x2 20x2
Revenues 18000 EBIT 4000
- Costs of goods sold (excl. depreciation & amortization) 8000 - Taxes (EBIT × 20%) 800
- Selling, general, and administrative expenses 2000
- Other operating expenses 1000
NOPLAT 3200
Earnings before interest, taxes, and D&A (EBITDA) 7000 + Depreciation 3000
- Depreciation & amortization (D&A) 3000 - Increase Operating assets 300
Earnings before interest and taxes (EBIT) 4000 + Increase operating liabilities 600
- Interest expense 500 Operating cash flow 6500
Earnings before taxes (EBT) 3500
- Net long-term investments 3500
- Income taxes (20%) 700
Net income 2800 Free Cash Flow 3000

Assets 20x1 20x2 Change

Cash 1000 1200 200
Operating assets 4000 4300 300 Net long-term investments =
Long-term assets 15500 16000 500
Total assets 20500 21500 1000
Depreciation + Change in book
value of long-term assets
Liabilities and shareholders' equity 20x1 20x2 Change
Operating liabilities 2300 2900 600 LTt = LTt-1 + It -Dt
Financial liabilities 10000 9000 -1000
Share capital 100 100 0 Dt + (LTt - LTt-1) = It
Retained earnings 8100 9500 1400 delta Lt
Total liabilities and equity 20500 21500 1000

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 Residual Cash Flow

20x2 20x2
Revenues 18000 EBIT 4000
- Costs of goods sold (excl. depreciation & amortization) 8000 - Taxes (EBIT × 20%) 800
- Selling, general, and administrative expenses 2000 NOPLAT 3200
- Other operating expenses 1000
+ Depreciation 3000
Earnings before interest, taxes, and D&A (EBITDA) 7000
- Depreciation & amortization (D&A) 3000
- Increase Operating assets 300
Earnings before interest and taxes (EBIT) 4000 + Increase operating liabilities 600
- Interest expense 500 Operating cash flow 6500
Earnings before taxes (EBT) 3500 - Net long-term investments 3500
- Income taxes (20%) 700 Free Cash Flow 3000
Net income 2800 + Increase long-term debt -1000
- Interest expenses (after taxes) 400
Assets 20x1 20x2 Change
Cash 1000 1200 200 Residual cash flow 1600
Operating assets 4000 4300 300
Long-term assets 15500 16000 500
Total assets 20500 21500 1000 We find the residual cash flow
Liabilities and shareholders' equity 20x1 20x2 Change
(RCF) by subtracting cash outflows
Operating liabilities 2300 2900 600 to debtholders and adding cash
Financial liabilities
Share capital
10000
100
9000
100
-1000
0
inflows from debtholders to the free
Retained earnings 8100 9500 1400 cash flow.
Total liabilities and equity 20500 21500 1000

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Free Cash Flow and Residual Cash Flow

• By subtracting the net capital expenditures from the operating cash

flow, we get the Free Cash Flow (FCF).
− The free cash flow is the most important cash flow figure in firm
valuation.
• It is the amount of money the firm generates that is not tied up in
the operating or the investment activities.

• It is the amount of money that, in principle, can be distributed to the

providers of capital (debt and equity).

• The residual cash flow shows how much money is available for
distribution to the firm’s shareholders.

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 Change in excess cash

20x2 20x2
Revenues 18000 EBIT 4000
- Costs of goods sold (excl. depreciation & amortization) 8000 - Taxes (EBIT × 20%) 800
- Selling, general, and administrative expenses 2000 NOPLAT 3200
- Other operating expenses 1000
+ Depreciation 3000
Earnings before interest, taxes, and D&A (EBITDA) 7000
- Depreciation & amortization (D&A) 3000 - Increase Operating assets 300
Earnings before interest and taxes (EBIT) 4000 + Increase operating liabilities 600
- Interest expense 500 Operating cash flow 6500
Earnings before taxes (EBT) 3500 - Net long-term investments 3500
- Income taxes (20%) 700 Free Cash Flow 3000
Net income 2800
+ Increase long-term debt -1000
Assets 20x1 20x2 Change
- Interest expenses (after taxes) 400
Cash 1000 1200 200 Residual cash flow 1600
Operating assets 4000 4300 300 + Increase share capital 0
Long-term assets 15500 16000 500 - Dividend 1400
Total assets 20500 21500 1000 Change in excess cash 200

Liabilities and shareholders' equity 20x1 20x2 Change

Operating liabilities 2300 2900 600
Financial liabilities 10000 9000 -1000
Share capital 100 100 0 Dividend = Net income – Change
Retained earnings 8100 9500 1400 in retained earnings
Total liabilities and equity 20500 21500 1000

41
Change in excess cash

• Change in excess cash is the cash that remains "unused” on

the balance sheet.

• It is the amount of cash the firm has generated in excess of the

cash required to run the operating activities, maintain the assets,
and satisfy the claims of the debt and equity holders.

• This cash is not tied up in any of its three sets of activities –

operations, investments, and financing.

• A look at the balance sheet confirms that Cash has indeed

increased by 200 from 1'000 to 1'200.
42
Summary: Cash flow derivation

20x2
EBIT 4000
- Taxes (EBIT × 20%) 800
NOPLAT 3200
+ Depreciation 3000
- Increase Operating assets 300
+ Increase operating liabilities 600
Operating cash flow 6500
- Net long-term investments 3500 Cash flow from investments
Free Cash Flow 3000 Available for debt/equity holders
+ Increase long-term debt -1000
Cash flow from debt financing
- Interest expenses (after taxes) 400
Residual cash flow 1600 Available for equity holders
+ Increase share capital 0
- Dividend 1400 Cash flow from equity financing
Change in excess cash 200

43
How much cash (cash flow) did the firm
generate in 20x2?

Question Answer
How much cash did the firm generate in It depends… 200 excess cash; other cash
20x2? flow definitions see below.
How much did it generate from operations? Operating Cash Flow = 6‘500
How much was used for investments? Cash Flow from Investment
= –3’500
How much was available for distribution to Free Cash Flow = 3‘000
the providers of capital (debt and equity)?
How much was available for distribution to Residual Cash Flow = 1‘600
the providers of equity?

44
Overview

• Understanding financial statements

• From earnings to cash flows

• From earnings to cash flows – Example

• Additional topics

45
Additional topics

• There are a couple of additional issues that we may have to

consider when deriving cash flows:

− Leases
− Minority interests
− Currency translation differences
− Share repurchases and treasury shares

46
Leases

• In the past, operating leases would not show up on the

balance sheet, and the information would be buried in the
footnotes.
• Firms are now required to capitalize operating leases on the
balance sheet.
− Operating lease, Right-of-Use asset
− Operating lease liability
• This is a significant change compared to previous years that
must be considered when analyzing historical financial
statements.

47
 Leases – Example Starbucks

Source: Starbucks Annual Report

48
 Leases – Example Starbucks

Source: Starbucks Annual Report

49
Minority interest (non-controlling interest)

• Minority interests are securities or assets owned in another

firm (less than 50% of the overall ownership of that firm).

• It’s recorded in the shareholder’s equity section of the

parent’s balance sheet.

• Here, we treat changes in minority interests as cash flows

from equity financing:
− Add increases in minority interest to the residual cash flow
− Subtract decreases in minority interest from the residual cash
flow

50
Currency translation differences

• The problem: Exchange rate differences from foreign currency

translations are reflected in the balance sheet. But they bypass the
income statement and are directly taken to “Other comprehensive
income”.
• Example: Accounts receivable (AR) increased from 300 to 325 (in
CHF). Suppose AR are all in Euro and the EUR exchange rate
went from 1.10 to 1.20 CHF/EUR.
20x1 20x2 Δ Our cash flow statement assumed that
Exchange rate (CHF/EUR) 1.1 1.2 0.1 the adjustment associated with AR is -25.
CHF-value of AR 300.0 325.0 25.0
EUR-Value of AR 272.7 270.8 -1.9 In reality, AR actually decrease by 1.9
EUR. At the exchange rate of 1.2, this
corresponds to a cash inflow of 2.3.
CHF value of EUR-change in AR [=-1.9*1.2] -2.3
Translation gain (loss) [= 272.7*0.1] 27.3  We underestimate the operating
Total 25.0 cash flow by 27.3 (that is, the
translation gain)!

51
Currency translation differences:
The (quick and a bit dirty) fix
• Add translation gains (subtract losses) in the cash flow statement.
• In our example, the statement of comprehensive income would list a
translation exchange difference of 27.3:
Income statement 20x2
2014
Sales 1,300.0
- Operating expenses 1,048.0
- Depreciation 65.0
EBIT 187.0
- Interest expenses 27.0
EBT 160.0
- Taxes (40%) 64.0
Net income 96.0
Add this translation gain (subtract a loss)
Other comprehensive income:
Translation differences 27.3 to the operating cash flow to correct for
the underestimation.
Total comprehensive income 123.3

• … In general, you have to read the footnotes to assess whether the

translation differences are related to operations, investments, or
financing. Make adjustments accordingly.
52
Example cash flow statement

EBIT 187.0 20x1 20x2

- Taxes (40%) 74.8 Excess cash 0.0 0.0
NOPLAT 112.2 Operating cash 200.0 260.0
+ Depreciation 65.0 Accounts receivable 300.0 325.0
- Increase Operating cash 60.0 Other assets 50.0 50.0
- Increase Accounts receivable 25.0 Fixed assets 540.0 597.0
- Increase other assets 0.0 Total assets 1,090.0 1,232.0
+ Increase accounts payable 13.0
+ Increase other liabilities 20.0 Accounts payable 143.0 156.0
+ Translation differences (loss) 27.3 Short-term debt 70.0 90.0
Operating cash flow 152.5
Other liabilities 50.0 70.0
- Capex 122.0
Long-term debt 270.0 282.0
Free Cash Flow 30.5
Share capital 100.0 100.0
+ Increase short-term debt 20.0
Retained earnings 457.0 534.0
+ Increase long-term debt 12.0
Total liabilities and equity 1,090.0 1,232.0
- Interest expenses (after taxes) 16.2
Residual cash flow 46.3
+ Increase share capital 0.0
Retained Earnings 20x2 =
- Dividend 46.3 = Retained Earnings 20x1
Change in excess cash 0.0 + Total comprehensive income – Dividend

= 457 + 123.3 – 46.3 = 534

If we want to maintain a Δ Excess cash of 0,
the new dividend is 46.3

53
Translation differences

• Because of international activities and volatile exchange rates,

translation differences can be material.
• Therefore, it is important to reflect them in the cash flow statement.
• How?
− Add translation gains
− Subtract translation losses

• Where?
− Try to identify the affected positions (info in the footnotes).
− Often, however, we have insufficient information to adjust each
item separately.

54
 Share repurchases

Source: www.swissre.com
55
Share repurchases

• Companies frequently engage in share repurchases and

return cash to their shareholders (typically in the open
market).
− The repurchased shares show up in the treasury shares of the
firm’s equity (with a negative sign)

• The cash that is spent on share repurchases represents a

cash outflow from shareholders’ perspective.

• We therefore treat share repurchases as a cash outflow from

equity financing.

56
 From earnings to cash flows:
Practice example
• Below you find a firm’s income statements and balance sheets for
20x1 and 20x2:
20x1 20x2 Income statement 20x2
Excess cash 50.0 20.0 Sales 1,800.0
Operating cash 130.0 110.0 - Operating expenses 1,400.0
-20
Accounts receivable 300.0 325.0 +25 - Depreciation 200.0
Inventory 200.0 210.0 +10 EBIT 200.0
Other assets 50.0 50.0 +0 - Interest expenses 50.0
Fixed assets 400.0 450.0 +50 EBT 150.0
LT Intangible assets 200.0 150.0 -50 - Taxes (25%) 37.5
inv Total assets 1,330.0 1,315.0 Net income 112.5

Accounts payable 150.0 180.0 +30

Accrued expenses 75.0 100.0 +25
Other liabilities 50.0 70.0 +20
Long-term debt 500.0 400.0 -100
Share capital 100.0 100.0 0
Retained earnings 455.0 465.0 +10 Div = 112.5 - 10 = 102.5
Total liabilities and equity 1,330.0 1,315.0

• There is no other comprehensive income. Compute the firm’s FCF, RCF,

dividend payments, and change in excess cash for the year 20x2.
57
Valuation
Leasing adjustments

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Operating leases

• Problem: Operating lease expenses are (sometimes) treated

as operating expenses in computing operating income.
However, lease expenses should be treated as financing
expenses, with the following adjustments to earnings and
capital:

− Debt value of operating lease = Present value of operating

lease commitments at the pre-tax cost of debt.
− When converting operating leases into debt, we create an asset
to counter it of the same value.

• Adjusted operating earnings = operating earnings + operating

lease expenses – depreciation on leased assets

2
Operating leases – Starbucks

• Starbucks financials 2016:

− Debt outstanding: approx. $3.2 billion
− Market value of equity: approx. $79.5 billion
− Pre-tax operating income (ordinary): approx. $4.2 billion.

• Starbucks has operating leasing obligations. In 2016, it paid

roughly $1’032 million and for the next years, it expects to
pay:

Minimum future cash

flows associated with
the firm’s operating
leases.

3
Operating leases – Starbucks

• Let’s consider our Starbucks example and assume a pre-tax cost of

debt of 3%.

• As of the end of 2016, the numbers imply that Starbucks essentially

has roughly $6.5 billion of additional debt which was used to finance
the purchase of assets.

4
Adjusting for operating leases – example

• You have a firm with the following information:

Balance Sheet 20x1 20x2
Cash Flow Statement 20x2
Fixed Assets 1'000.00 1'200.00
EBIT 300.00
Total Assets 1'000.00 1'200.00
- EBIT × Tax rate (25%) 75.00
NOPLAT 225.00
Liabilities 0.00 0.00
+ Depreciation 200.00
Equity 1'000.00 1'200.00
Operating cash flow 425.00
Total L&E 1'000.00 1'200.00
- Capex 400.00
Income Statement 20x2 Free Cash Flows 25.00
Sales 1'000.00 + Debt 0.00
- Operating expenses 500.00 - Interest expenses a.t. 0.00
- Depreciation 200.00 Residual cash flow 25.00
EBIT 300.00 - Dividend 25.00
- Interest expenses 0.00 Change excess cash 0.00
EBT 300.00
- Taxes 75.00
Net income 225.00

• The tax rate is 25% and the pre-tax cost of debt is 5%.
• At the end of 20x1 and 20x2, the capitalized future leasing obligations
were 300 and 350, respectively. 20x2’s leasing payment was 100.

5
© Institut für Finanzmanagement
Activate capitalized
Balance Sheet 2018 2019 leasing expenses Balance Sheet 2018 2019

Solution
Fixed Assets
Total Assets
1'000.00 1'200.00
1'000.00 1'200.00 Activated assets
Fixed Assets
Total Assets
1'300.00 1'550.00
1'300.00 1'550.00
are financed with debt
Liabilities 0.00 0.00 Liabilities 300.00 350.00
Equity 1'000.00 1'200.00 Equity 1'000.00 1'200.00
Total L&E 1'000.00 1'200.00 Total L&E 1'300.00 1'550.00

Income Statement 2019 Exclude effective leasing rate Income Statement 2019
Sales 1'000.00 (100) Sales 1'000.00
- Operating expenses 500.00 - Operating expenses 400.00
- Depreciation 200.00 - Depreciation 285.00
EBIT 300.00 Depreciate new assets EBIT 315.00
- Interest expenses 0.00 (85=100-15) - Interest expenses 15.00
EBT 300.00 EBT 300.00
- Taxes 75.00 - Taxes 75.00
Net income 225.00 Net income 225.00

Cash Flow Statement 2019 Cash Flow Statement 2019

EBIT 300.00 EBIT 315.00
- EBIT × Tax rate (25%) 75.00 - EBIT × Tax rate (25%) 78.75
NOPLAT 225.00 Pay interest on new debt NOPLAT 236.25
+ Depreciation 200.00 + Depreciation 285.00
Operating cash flow 425.00 Operating cash flow 521.25
- Capex 400.00 - Capex 535.00
Free Cash Flows 25.00 Free Cash Flows -13.75
+ Debt 0.00 + Debt 50.00
- Interest expenses a.t. 0.00 - Interest expenses a.t. 11.25
Residual cash flow 25.00 Residual cash flow 25.00
- Dividend 25.00 - Dividend 25.00
Change excess cash 0.00 Change excess cash 0.00

September 28th, 2017 6

Advanced Valuation
Financial Analysis

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
The setting: Imagine you are…

• A sell side analyst at Goldman Sachs, issuing recommendations

about Roche
− What is Roche’s probability of default?
− Is Roche’s stock overvalued?

• A partner at Barclays private equity, bidding for the Basel airport

− At what price should we bid?
− Can the financing take a 9:1 leverage?

• A manager with the corporate finance division of BNP-Paribas,

advising LVMH on their convertible bond issue
− How will shareholders react to this?
− Does it preserve LVMH’s ability to borrow from banks, to invest?

2
Overview

• Financial analysis – overview

• Performing a financial analysis

• Market information

3
What is a financial analysis?

• Before equity analysts proceed with a firm valuation, they typically

perform a financial analysis.

• The purpose of a financial analysis is to provide a global

assessment of the firm’s current and future position.

• Financial analysis is a tool used by existing and potential

shareholders of a company, as well as lenders or rating agencies.

− Shareholders want to know whether the firm creates value.

− Lenders want to know whether the firm is solvent and liquid.

• The aim is to portray a firm’s economic reality.

4
How to perform a financial analysis?

• A (typical) financial analysis consists of three parts:

• Part 1: Carry out an analysis of the firm’s business, the

industry, and the firm’s competitive positioning
− Business strategy
− Distribution network
− Ownership structure
− Sector of the firm
− Competitors

• Part 2: Carefully analyze auditors’ reports and accounting rules

• Part 3: Examine the company’s financial accounts

− Four steps

5
Overview

• Financial analysis – overview

• Performing a financial analysis

• Market information

6
Part 1: Business and industry analysis

• Use economic reasoning and a good deal of common sense. The

following questions can guide this analysis:

• What is the firm’s market?

− Market growth, product cycles, market share, market risk?
• What is the firm’s position within that market?
− Competition?
• What is the firm’s production model?
− Production sites, capital expenditures, outsourcing?
• What is the firm’s distribution network?
− Logistics?
• What motivates the firm’s key people?
− Shareholders, managers, corporate culture?

7
Part 2: Auditor’s reports

• The goal of part 2 is to understand the rules that govern the

financial statements of the firms.

• What do the auditors say about the financial accounts of the firm?

• In particular: Have there been any recent changes in the

accounting principles that the firm applies?

− If yes, it will make it difficult to compare numbers over time

8
Part 3: Financial analysis in four steps

• Part 3 consists of a detailed analysis of the firm’s financial

accounts. Such analysis can be done in four steps:

1. Margin analysis (value): Trend in sales, margins; break even point

2. Investment analysis: Trend in investment and working capital

3. Financing analysis: Trend in cash flow and balance sheet fragility

4. Profitability analysis: Trend in ROE and ROCE

• 1) Wealth creation… 2) requires investments… 3) that need to be

financed… 4) and provide sufficient returns.

9
Step # 1: Margin analysis

• Trend analysis: Rate of change in the main sources of revenue

and cost.

• What do the figures tell us about the strategic position of a

company?
− The strategic position of a company directly influences the size of its
margins and its profitability.

1. Sales growth:
− Cornerstone of financial analysis
− Volume and price, product and regional trends
− Compare growth rates with market at large
− Internal vs. acquisition led growth

10
Margin analysis

2. Growth in costs:
− What are the main costs (raw materials, transportation, energy,
advertising,…)? How have they changed over the past?
− Has there been any major change in the price of each of these
components?
EBITDA/sales

3. EBITDA margin:
− How does EBITDA relate to sales? => EBITDA margin
− Based on sales and cost analysis, one should be able to explain WHY
the EBITDA margin increases/decreases

4. EBIT (operating) margin:

− How does the EBIT margin compare to the EBIT margin of industry
peers?

11
Step # 2: Investment analysis

Current assets
Shareholders
equity

Fixed assets

Debt

12
Investment analysis

• Discusses trends in overall assets.

• Focus mostly on working capital (WC) management:

WC = Inventories + Receivables – Payables

• Working capital pros and cons:

Cons:
− Needs to be financed with costly debt or equity
Pros:
− avoids bottlenecks in production
− Trade payables can be very costly
– Classical arrangement: “2/10 net 30”
– 2% discount if paid within 10 days, else full price paid in 30 days

13
Working capital

• In general: low WC is considered as good.

− WC analysis is a classic tool to detect anomalies &
management quality

• But keep in mind that:

− WC depends on the industry
− WC depends on the business cycle
− WC may have strong seasonal patterns

14
Capital expenditures

• Capital expenditures (capex), i.e., the acquisition of fixed assets.

• Compare capex and depreciation:

− If capex are higher than depreciation, the firm is building assets
(capacity, productivity)
− If depreciation is higher than capex, the firm is living on its past. It
might generate high cash flows in the short term but runs the risk of its
assets being worn out

• Equivalent to looking at change in fixed assets.

• Growth in fixed assets vs. sales growth

− This benchmarking can only be done over a long period of time
because capex do not provide immediate returns

15
Step # 3: Financing analysis

• This part of the analysis focuses on on:

• Cash flows: Are cash flows large enough to pay interest on debt ?
— Compare operating cash flows & financial expenses

• Debt: Are debt levels to high?

— Analyze different leverage ratio over time. Compare to industry peers.

• Liquidity: Is there a liquidity risk?

— Compare working capital & short-term liabilities

16
Cash Flows

• Look at all components of “change in excess cash” and their

evolution:

− Operating cash flow

− Cash flow from investment
− Cash flow from debt and equity financing

• Basic idea: in the long run, operating CF must pay for

− Reinvestment
− Interest payments
− Dividends

17
Debt ratios

• Financial leverage is important in a financial analysis.

• There are numerous different definitions of leverage out there… for
example:

Total Liabilities
Debt/Equity Ratio =
Total Equity [Sometimes, the Debt/… ratio is
computed with interest-bearing debt
instead of total liabilities]
Total Liabilities
Debt / Capital Ratio =
Total Assets

Reflects the firm’s ability to pay

EBIT
Interest Coverage Ratio = interest out of its operating profit.
Interest expenses Sometimes EBITDA is used instead
of EBIT.

18
Net Debt-to-EBITDA

• An important ratio is the Net Debt-to-EBITDA ratio.

• Analysts sometimes take EBITDA as a proxy for operating cash
flow.
• “Net Debt” is total interest-bearing debt – excess cash.

Net Debt
Debt Service Coverage =
EBITDA

Indicates the time (number of years) the firm

needs to repay all its debt (net of cash)
taking current operating cash flows (EBITDA)
as given.

19
Net Debt-to-EBITDA

• What should Net Debt / EBITDA be worth ?

• Standards:
<= 3 years : Healthy situation
4 years : Critical (but also LBOs)
5,6 years : Debt becomes « junk », distress likely

• Beware !
 stable industries may tolerate ratios of 4,5 or 6
 firms with « good collateral » (land) also !
 private equity typically takes 6

20
Liquidity risk

• Another risk is liquidity mismatch

− Even if short-term assets > short-term liabilities
− Assets mature in the long run (investment)
− Liabilities mature in the short run (short term debt)

• In theory, not a problem if rollover is possible

• But in practice: « Rollover risk »

− Creditors have doubts, they want to cash in & run
− Cheap short run credit can dry up suddenly (crisis)

21
Liquidity risk – ratios

• Some ratios to measure maturity mismatch are:

Current assets The number of times the current

Current ratio = assets cover short-term
Current liabilities
obligations

Cash + Trade accounts receivable «Acid test»: The number of times

Quick ratio = the liquid assets cover short-term
Current liabilities
obligations

22
Step # 4: Profitability analysis
ROA = NetIncome/ Total assets

• Is EBIT high enough? Compute Return on assets (or return on

capital employed (ROCE)):

EBIT
Return on Assets ROA =
Book value of assets

NOPLAT
or
EBIT × (1 − τ)
Return on Assets ROA = = ROCE
Book value of assets

where τ = corporate income tax rate

• Intuition:
− Start with NOPLAT = (1-τ) x EBIT
− Normalize by the capital invested by those who receive the NOPLAT
(shareholders + debtholders)
23
Profitability analysis

• Is Net Income high enough? Compute Return on Equity:

Net income
Return on Equity ROE =
Book value of equity

• Intuition:
− Normalize Net Income by the capital invested by those who
receive it (shareholders only)

• Other important profitability ratios are:

Net Sales − COGS EBIT Net Income

Gross margin = EBIT margin = Net margin =
Net Sales Sales Sales

24
Profitability analysis

40%
High
margins
35%
BHP Billiton
ROCE = NOPLAT/Total assets ( captital employed)
= NOPLAT/ sales * sals/total assets

30%
Maroc Télécom

Eutelsat
25% Microsoft Infosys
Sanofi-Aventis
After tax EBIT / Sales

Google

20%
Petrochina
Swatch
Intel
LVMH
15%
Holcim
Burberry
Disney
Zara
Danone L’Oréal
ArcelorMittal
10% M6
Porsche
Unilever
E.ON
Total

British Airways
5% Toyota

Tesco Wal-Mart Fiat

Adecco
Low
margins 0%
- 0,25 0,5 0,75 1 1,25 1,5 1,75 2 2,25 2,5 2,75 3 3,25 3,5 3,75 4 4,25 4,5 4,75 5 5,25 5,5
Low asset Sales / Capital employed High asset
turnover turnover

25
Profitability analysis - leverage

• Substitute debt for equity:

− Reduces shareholders’ investment
− Reduces Net Income (pay more interest)

• Often, interest rates are low compared to ROA

− Net income decreases, but equity decreases MORE

 The leverage increases the ROE

this is the leverage effect

26
Profitability analysis - example

Suppose a project costs 100 and pays 110:

It has an operating return (ROA) = 10%

100 110

If there is no debt:
ROE =(110 – 100)/100 = 10/100
=10%

27
Profitability analysis - example

Suppose Entrepreneur borrows 50,

with interest rate 2%

59
50

50
51

ROE =(110 – 50 – 50*(1+0.02))/50 = 9/50

= 18% !!!!

28
Profitability analysis - example

Bad luck hits your project: the project is not profitable (ROA=0%)
It costs 100 and generates 100 only :

100 100

When there is no debt:

ROE =(100 – 100)/100 = 0
=0%

29
Profitability analysis - example

Entrepreneur has borrowed 50, with interest rate 2%

50 49

50 51

ROE =(100 – 50 – 50*(1+0.02))/50 = -1/50

= -2% !!!!

30
Profitability analysis - example

You have very bad luck: the project only makes ROCE = - 10%
It costs 100 and generates 90 only :

100 90

When there is no debt:

ROE =(90 – 100)/100 = -10/100
=-10%

31
Profitability analysis - example

Entrepreneur has borrowed 50, with interest rate 2%

50 39

50 51

ROE =(90 – 50 – 50*(1+0.02))/50 = -11/50

= -22% !!!!

32
Profitability analysis - leverage

• Leverage makes ROE much more volatile

− Debtholders are always senior to shareholders

− First dollars of EBIT are pledged to debtholders
– In exchange for their contribution to capital
– In exchange for low interest rate

• If success, shareholders get big profit for small investment.

• If failure, shareholders absorb all the loss.

33
Profitability analysis – ROE
decomposition
• We can decompose ROE into its three components:
— Profitability
— technical efficiency
— financial leverage

Net income Sales Assets

ROE
= × ×
Sales Assets Equity

Profitability Technical (1 + Debt/Equity ratio)

efficiency

34
Overview

• Financial analysis – overview

• Performing a financial analysis

• Market information

35
Market information

• The market is forward looking.

• Stock price = PV of expected future dividends (cash flows).
• Three important ratios:

− P/E-ratio: stock price scaled by earnings

− Price-to-Book ratio: stock price scaled by book equity
− Dividend Yield: dividends scaled by stock price

• All three ratios serve to measure market expectations of future

growth.

36
Market information

• Price Earnings ratio (or « P/E ratio »)

P/E ratio = Stock Price / Earnings Per Share

• We can interpret the ratio using the Gordon-Shapiro formula

P/E ratio = b / (re – g)

− re = cost of equity
− g = expected (constant) growth rate
− b = payout ratio = Dividends / Net Income

• High P/E means «low risk» or «high growth»

37
Market information

• Price to Book:

PB = Stock Price / Equity per share

• Price to book is related to P/E ratio:

PB = P/E ratio x ROE

38
Market information

• Dividend Yield:

DY = Dividend per Share / Stock Price

39
Advanced Valuation
Forecasting cash flows

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Where are we?

• We now know how to work with financial statements and how

to calculate the relevant (free) cash flows.
• Next, we need to think about how we can forecast cash
flows.

(2) Make them comparable across time (discounting)

Today Year 1 Year 2 Year 3 …

(1) Determine the relevant cash flows

(3) Value

2
Overview

• Estimating growth

• Forecasting cash flows

• Estimating terminal value

Explicit forecast horizon

0 T=5

3
Value of growth

• When valuing a company, it is easy to get caught up in the

details of estimating growth and start viewing growth as
“good”, i.e., that higher growth translates into higher value.

• Growth, though, is a double-edged sword

− The good side of growth is that it pushes up revenues and
operating income, perhaps at different rates (depending on how
margins evolve over time).
− The bad side of growth is that you must set aside money to
reinvest to create that growth.
− The net effect of growth is whether the good outweighs the bad.

4
Ways of estimating growth in earnings

• Look at the past

− The historical growth in earnings per share is usually a good
starting point for growth estimation.

• Look at what others are estimating

− Analysts estimate growth in earnings per share for many firms.
It is useful to know what their estimates are.

• Look at fundamentals
− Ultimately, all growth in earnings can be traced to two
fundamentals - how much the firm is investing in new projects,
and what returns these projects are making for the firm.
5
Historical growth

• Historical growth rates can be estimated in different ways

− Arithmetic versus Geometric Averages

• Historical growth rates can be sensitive to

− The period used in the estimation (starting and ending points)

• In using historical growth rates, you have to wrestle with the

following:
− How to deal with negative earnings
− Deal with the effects of scaling

6
Analyst estimates

• While the job of an analyst is to find under and over valued

stocks in the sectors that they follow, a significant proportion
of an analyst’s time (outside of selling) is spent forecasting
earnings per share.
− Most of this time, in turn, is spent forecasting earnings per share
in the next earnings report.
− While many analysts forecast expected growth in earnings per
share over the next 5 years, the analysis and information
(generally) that goes into this estimate is far more limited.

• Analyst forecasts of earnings per share and expected growth

are widely disseminated by services such as Thomson
Reuters and IBES, at least for U.S companies.
7
Analyst estimates

• Analyst forecasts may be useful in producing a predicted

growth rate for a firm. But there is a danger to blindly
following consensus forecasts.

• Analysts often make significant errors in forecasting earnings

− Partly because they depend on the same data sources.

− Partly because they sometimes overlook significant shifts in the

fundamental characteristics of the firm.

8
Fundamental growth rates

• With both historical and analysis estimates, growth is an

exogenous variable that affects value but is divorced from the
operating details of the firm.

• The soundest way of incorporating growth into value is to

make growth endogenous, i.e., tie it in more closely to the
actions that the business takes to create and sustain that
growth.

9
Fundamental growth rates

• Growth, return on invested capital (ROIC), and the (re-)

investment rate are tied together mathematically with the
following relationship:
Growth = Investment rate × ROIC
g = IR × ROIC

• Invested capital:
− Cumulative amount the business has invested in its core
operations, including fixed assets and working capital.

• Return on invested capital (ROIC):

NOPLAT
ROIC =
Invested capital

10
Fundamental growth rates

• Net investments =
− 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑡𝑡 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑡𝑡−1

• Investment rate: This is the portion of the NOPLAT invested

back into the business.

𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐼𝐼𝐼𝐼 =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁

11
Fundamental growth rates

• We can further define the free cash flow as:

− 𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 – 𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
= 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 – 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 × 𝐼𝐼𝐼𝐼
= 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 × (1 − 𝐼𝐼𝐼𝐼) g = IR * ROIC

• We can replace IR with g/ROIC and write the free cash flow
as:
𝑔𝑔
𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 × 1 −
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
• Hence, the value of the firm becomes:

𝑔𝑔
𝐹𝐹𝐹𝐹𝐹𝐹1 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁1 × 1 −
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 = = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔 (𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔)
12
Overview

• Estimating growth

• Forecasting cash flows

• Estimating terminal value

13
Forecasting cash flows

• T-Account method:

− Explicitly model each account (e.g., sales, COGS, investments)

separately and use that information to derive the cash flows

− Method of choice for «extraordinary» activities (e.g., large

investments)

− Often, we do not have enough information. Moreover, many

accounts (e.g., accounts receivable) are likely to be a function of
other accounts (e.g., sales)

14
Forecasting cash flows

• Percentage of sales method:

− Identify the main driver(s) of the firm’s business activities
− In many industries, sales are the main driving force. In other
industries (e.g., wealth management) it could also be assets
under management
− Find out how the other positions are related to sales. For
example, operating cash could be 5% of sales, on average.
 Express «all» other positions as a percentage of sales
− Other positions (e.g., taxes) could be a function of a position
that is related to sales
− Forecast sales. By doing so, you implicitly also forecast «all»
other positions
• It could also make sense to combine the two approaches.
15
Forecasting cash flows

• Suggested procedure:
− Forecast the balance sheet and income statement using the
percentage of sales method
− For those positions that are not directly related to sales, use the T-
Account method
− Once we have estimated the future balance sheets and income
statements, we can derive the cash flows
• Keep in mind that the balance sheets and income statements must
be consistent! (Assets = Debt + Equity, etc.)
− We will assume that the firm pays out all excess cash
 This allows us to keep non-operating assets out
 Dividend payments are set such that Δ Excess cash = 0
− That is, dividend payments are not modeled explicitly and as a
consequence, retained earnings (Δ Reserves) aren’t either
16
Example

• The firm’s historical balance sheets and income statement:

20x-1 20x0 Income statement 20x0
Excess cash 0.00 0.00 Sales 1'300.0
Operating cash 200.0 260.0 - Operating expenses 1'048.0
Accounts receivable 300.0 325.0 - Depreciation 65.0
Other assets 50.0 50.0 EBIT 187.0
Fixed assets 540.0 597.0 - Interest expenses 27.0
Total assets 1'090.0 1'232.0 EBT 160.0
- Taxes (40%) 64.0
Accounts payable 143.0 156.0 Net income 96.0
Short-term debt 70.0 90.0
Other liabilities 50.0 70.0
Long-term debt 270.0 282.0
Share capital 100.0 100.0
Retained earnings 457.0 534.0
Total liabilities and equity 1'090.0 1'232.0

17
Example – Assumptions

• You want to forecast the firm’s cash flows for the following 5 years.
• Income statement:
− Based on historical data, industry reports, analyst forecasts, and
discussions with management, you assume that the firm’s sales
will grow at 10% in the first year, 8% in the second year, 6% in
the third year, 4% in the fourth year, and 2% in the fifth year
− Operating expenses are 80% of sales
− Depreciation will be 15% of the book value at the beginning of
the year plus investments
− Interest expenses will be 5% on the amount of debt at the
beginning of the year
− The tax rate is 40%

18
Example – Assumptions

• Balance sheet:
− Operating cash drops from 18% of sales in 20x1 by 2% each year to 10%
− Accounts receivable are 25% of sales (90 days of grace…)
− Other assets remain constant at 50
− Fixed assets: Book valuet-1 + Investments – Depreciation
− Accounts payable: 12% of sales
− Short-term debt: Repayment of 10 each year
− Other liabilities: 5% of sales
− Long-term debt: constant
− Share capital: constant

19
Example – Assumptions

• Cash flow statement:

− Investments of 150 in 20x1 and 100 thereafter
− All excess cash will be paid out to shareholders

20
 Example – Assumptions

Assumptions (% of sales) E20x1 E20x2 E20x3 E20x4 E20x5

Sales growth 10% 8% 6% 4% 2%
Operating expenses (% sales) 80% 80% 80% 80% 80%
Operating cash (% sales) 18% 16% 14% 12% 10%
Accounts receivable (% sales) 25% 25% 25% 25% 25%
Accounts payable (% sales) 12% 12% 12% 12% 12%
Other liabilities (% sales) 5% 5% 5% 5% 5%

Assumptions (T-Account and others) E20x1 E20x2 E20x3 E20x4 E20x5

Investments 150 100 100 100 100
Cost of debt (% Book debt t-1) 5%
Depreciation (% BV + Investments) 15%
Other assets Constant
Short-term debt (annual change) -10
Long-term debt Constant
Share capital Constant
Dividend payments Excess cash
Tax rate 40%

21
Example – Expected sales

• We use the growth assumptions from the previous table:

Income statement 2013
20x0 E2014
E20x1 E2015
E20x2 E2016
E20x3 E2017
E20x4 E2018
E20x5
Sales 1,300.0 1,430.0 1,544.4 1,637.1 1,702.5 1,736.6

×1.1 ×1.08 ×1.06 ×1.04 ×1.02

• Once we have sales, we can project all the positions that are
directly related to sales (everything that’s in the %-sales table):
− Operating expenses (80%)
− Operating cash (18% to 10%); Accounts receivable (25%), accounts
payable (12%), other liabilities (5%).

22
Example – Projections

• Using these assumptions, we get:

Income statement 20x0 E20x1 E20x2 E20x3 E20x4 E20x5
Sales 1,300.0 1,430.0 1,544.4 1,637.1 1,702.5 1,736.6
- Operating expenses 1,048.0 1,144.0 1,235.5 1,309.7 1,362.0 1,389.3 80% of Sales
- Depreciation 65.0
EBIT 187.0
- Interest expenses 27.0
EBT 160.0
- Taxes (40%) 64.0
Net income 96.0

Balance sheet 20x-1 20x0 E20x1 E20x2 E20x3 E20x4 E20x5

Excess cash 0.0 0.0
Operating cash 200.0 260.0 257.4 247.1 229.2 204.3 173.7
Accounts receivable 300.0 325.0 357.5 386.1 409.3 425.6 434.1
Other assets 50.0 50.0
Fixed assets 540.0 597.0
Total assets 1,090.0 1,232.0

Accounts payable 143.0 156.0 171.6 185.3 196.4 204.3 208.4

Short-term debt 70.0 90.0
Other liabilities 50.0 70.0 71.5 77.2 81.9 85.1 86.8
Long-term debt 270.0 282.0
Share capital 100.0 100.0
Retained earnings 457.0 534.0
Total liabilities and equity 1,090.0 1,232.0

23
Example – T-Account method

• We also assume that the firm will make an annual repayment

of short-term debt of 10. Long-term debt remains constant.
− This allows us to forecast debt outstanding…
− as well as interest expenses.

• Moreover, we assume that share capital will remain constant

at 100.
− This allows us to forecast share capital

• Moreover, we assume that other assets remain constant

24
Example – Projections

• Using the T-account method, we get additional positions:

Income statement 2012
2014
2013
20x0 E2013
E2015
E2014
E20x1 E2014
E2016
E2015
E20x2 E2015
E2017
E2016
E20x3 E2016 E2017
E2018 E20x5
E2017
E20x4 E2019
E2018
Sales 1'300.0 1'430.0 1'544.4 1'637.1 1'702.5 1'736.6
- Operating expenses 1'048.0 1'144.0 1'235.5 1'309.7 1'362.0 1'389.3 372 * 0.05
- Depreciation 65.0
EBIT 187.0
- Interest expenses 27.0 18.6 18.1 17.6 17.1 16.6 5% of debt (short-
EBT 160.0 and long-term) at
- Taxes (40%) 64.0
the beginning of
Net income 96.0
the year
Balance sheet 20x-1
2011
2012
2013 20x0
2012
2013
2014 E20x1
E2013
E2014
E2015 E20x2
E2014
E2015
E2016 E20x3
E2015
E2016
E2017 E20x4
E2016
E2017
E2018 E20x5
E2017
E2018
E2019
Excess cash 0.0 0.0
Operating cash 200.0 260.0 257.4 247.1 229.2 204.3 173.7
Accounts receivable 300.0 325.0 357.5 386.1 409.3 425.6 434.1
Other assets 50.0 50.0 50.0 50.0 50.0 50.0 50.0 constant
Fixed assets 540.0 597.0
Total assets 1'090.0 1'232.0

Accounts payable 143.0 156.0 171.6 185.3 196.4 204.3 208.4

Short-term debt 70.0 90.0 80.0 70.0 60.0 50.0 40.0 Repayment of
Other liabilities 50.0 70.0 71.5 77.2 81.9 85.1 86.8
Long-term debt 270.0 282.0 282.0 282.0 282.0 282.0 282.0
10 p.a.
Share capital 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Retained earnings 457.0 534.0 constant
Total liabilities and equity 1'090.0 1'232.0

25
Example – T-Account method

• All we need to incorporate now is the firm’s investment policy to get:

− Depreciation charges
− Book value of fixed assets
− Investment activities
• Here, we assume that:
− Investments will be 150 in the first year and 100 thereafter.
− New investments and the book value of assets is depreciated at 15%
per year.
− Hence, in the first year, depreciation is:
Depreciation20x1 = (Book valueFixed
20x0 + Investments20x1)×0.15
assets

= (597 + 150) ×0.15 = 112.05

− Therefore, the 20x1 book value of assets will be:
Book value20x1 = Book value20x0 + Investments20x1 - Depreciation20x1
= 597 + 150 – 112.05 = 634.95
26
Example – Projections

• Based on this information, we can now (almost) finish our pro

forma balance sheets and income statements
Income statement 2014
2013
2012
20x0 E2015
E2014
E2013
E20x1 E2016
E2015
E2014
E20x2 E2017
E2016
E2015
E20x3 E2018 E20x5
E2017
E2016
E20x4 E2019
E2018
E2017
Sales 1'300.0 1'430.0 1'544.4 1'637.1 1'702.5 1'736.6
- Operating expenses 1'048.0 1'144.0 1'235.5 1'309.7 1'362.0 1'389.3
- Depreciation 65.0 112.1 110.2 108.7 107.4 106.3
EBIT 187.0 174.0 198.6 218.7 233.1 241.0
- Interest expenses 27.0 18.6 18.1 17.6 17.1 16.6
EBT 160.0 155.4 180.5 201.1 216.0 224.4
- Taxes (40%) 64.0 62.1 72.2 80.4 86.4 89.8
Net income 96.0 93.2 108.3 120.7 129.6 134.7

Balance sheet 20x-1

2012
2011
2013 20x0
2014 E20x1
2013 E2013
2012 E2015 E20x2
E2015 E20x3
E2014 E2014
E2016 E20x4
E2016 E2016
E2015
E2017 E20x5
E2017 E2017
E2018 E2018
E2019
Excess cash 0.0 0.0
Operating cash 200.0 260.0 257.4 247.1 229.2 204.3 173.7
Accounts receivable 300.0 325.0 357.5 386.1 409.3 425.6 434.1
Other assets 50.0 50.0 50.0 50.0 50.0 50.0 50.0
Fixed assets 540.0 597.0 635.0 624.7 616.0 608.6 602.3
Total assets 1'090.0 1'232.0 1'299.9 1'307.9 1'304.5 1'288.5 1'260.1

Accounts payable 143.0 156.0 171.6 185.3 196.4 204.3 208.4

Short-term debt 70.0 90.0 80.0 70.0 60.0 50.0 40.0
Other liabilities 50.0 70.0 71.5 77.2 81.9 85.1 86.8
Long-term debt 270.0 282.0 282.0 282.0 282.0 282.0 282.0
Share capital 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Retained earnings 457.0 534.0
Total liabilities and equity 1'090.0 1'232.0

27
Example – Forecasting cash flows

Cash Flow Statement 20x0 20x1 20x2 20x3 20x4 20x5

EBIT 187.0 174.0 198.6 218.7 233.1 241.0
- Taxes 74.8 69.6 79.5 87.5 93.2 96.4
NOPLAT 112.2 104.4 119.2 131.2 139.9 144.6
+ Depreciation 65.0 112.1 110.2 108.7 107.4 106.3
- Increase Operating cash 60.0 -2.6 -10.3 -17.9 -24.9 -30.6
- Increase Accounts receivable 25.0 32.5 28.6 23.2 16.4 8.5
- Increase Other assets 0.0 0.0 0.0 0.0 0.0 0.0
+ Increase Accounts payable 13.0 15.6 13.7 11.1 7.9 4.1
+ Increase Other liabilities 20.0 1.5 5.7 4.6 3.3 1.7
Operating cash flow 125.2 203.6 230.6 250.4 266.9 278.8
- Capital expenditures 122.0 150.0 100.0 100.0 100.0 100.0
Free Cash Flow 3.2 53.6 130.6 150.4 166.9 178.8
+ Increase short-term debt 20.0 -10.0 -10.0 -10.0 -10.0 -10.0
+ Increase long-term debt 12.0 0.0 0.0 0.0 0.0 0.0
- Interest expenses (after taxes) 16.2 11.2 10.9 10.6 10.3 10.0
Residual cash flow 19.0 32.5 109.7 129.9 146.7 158.9
+ Increase Share capital 0.0 0.0 0.0 0.0 0.0 0.0
- Dividend 19.0 32.5 109.7 129.9 146.7 158.9
Change in Excess cash 0.0 0.0 0.0 0.0 0.0 0.0

All excess cash is paid out to the shareholders. Hence, Dividends = RCF + Capital increase.
Note that these dividend payments also make sure that ΔRetained earnings = Net income – Dividends.
Hence, the balance sheet is in fact balanced. Excess cash remains at zero.
28
The forecasted balance sheets and
income statements
Income statement 2012
2013
2014
20x0 E2013
E2014
E2015
E20x1 E2014
E2015
E2016
E20x2 E2015
E2016
E2017
E20x3 E2016
E2017
E2018
E20x4 E2017
E2018
E2019
E20x5
Sales 1'300.0 1'430.0 1'544.4 1'637.1 1'702.5 1'736.6
- Operating expenses 1'048.0 1'144.0 1'235.5 1'309.7 1'362.0 1'389.3
- Depreciation 65.0 112.1 110.2 108.7 107.4 106.3
EBIT 187.0 174.0 198.6 218.7 233.1 241.0
- Interest expenses 27.0 18.6 18.1 17.6 17.1 16.6
EBT 160.0 155.4 180.5 201.1 216.0 224.4
- Taxes (40%) 64.0 62.1 72.2 80.4 86.4 89.8
Net income 96.0 93.2 108.3 120.7 129.6 134.7

Balance sheet 2011

2012
2013
20x-1 2012
2013
2014
20x0 E2013
E2014
E2015
E20x1 E2014
E2015
E2016
E20x2 E2015
E2016
E2017
E20x3 E2016
E2017
E2018
E20x4 E2017
E2018
E2019
E20x5
Excess cash 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Operating cash 200.0 260.0 257.4 247.1 229.2 204.3 173.7
Accounts receivable 300.0 325.0 357.5 386.1 409.3 425.6 434.1
Other assets 50.0 50.0 50.0 50.0 50.0 50.0 50.0
Fixed assets 540.0 597.0 635.0 624.7 616.0 608.6 602.3
Total assets 1'090.0 1'232.0 1'299.9 1'307.9 1'304.5 1'288.5 1'260.1

Accounts payable 143.0 156.0 171.6 185.3 196.4 204.3 208.4

Short-term debt 70.0 90.0 80.0 70.0 60.0 50.0 40.0
Other liabilities 50.0 70.0 71.5 77.2 81.9 85.1 86.8
Long-term debt 270.0 282.0 282.0 282.0 282.0 282.0 282.0
Share capital 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Retained earnings 457.0 534.0 594.8 593.4 584.2 567.1 542.9
Total liabilities and equity 1'090.0 1'232.0 1'299.9 1'307.9 1'304.5 1'288.5 1'260.1

Retained earningst = Retained earningst-1 + Net incomet – Dividendst

29
Summary table

Cash Flow
Flow Summary
Summary 2013
2014
20x0
2016 E2014
E2015
E20x1
E2017 E2015
E2016
E20x2
E2018 E2016
E2017
E20x3
E2019 E2017
E2018
E20x4
E2020 E2018
E2019
E20x5
E2021
Operating cash flow 125.2 203.6 230.6 250.4 266.9 278.8
+ Cash flow from investments -122.0 -150.0 -100.0 -100.0 -100.0 -100.0
Free cash flow 3.2 53.3 130.6 150.4 166.9 178.8
+ Cash flow from debt financing 15.8 -21.2 -20.9 -20.6 -20.3 -20.0
Residual cash flow 19.0 32.5 109.7 129.9 146.7 158.9
+ Cash flow from equity financing -19.0 -32.5 -109.7 -129.9 -146.7 -158.9
Change in excess cash 0.0 0.0 0.0 0.0 0.0 0.0

30
Overview

• Estimating growth

• Forecasting cash flows

• Estimating terminal value

31
Terminal value

• A publicly traded firm potentially has an infinite life-time.

The value is therefore the present value of cash flows
forever.

• Since we cannot estimate cash flows forever, we estimate

cash flows for a “growth period” and then estimate a
terminal value, to capture the value at the end of the period:

32
Terminal value

• There are various ways to compute the terminal value.

1. Liquidation value: Most useful when assets are separable
and marketable.

2. Multiple approach: Easiest approach but makes the

valuation a relative valuation.

3. Stable growth model: Technically soundest but requires

that you make judgements about when the firm will grow at a
stable rate which it can sustain forever, and the excess
returns (if any) that it will earn during that period.

33
Liquidation value

• In some valuations, we can assume that the firm will cease

operations at a point in time in the future and sell the assets it
has accumulated to the highest bidder.
• The estimate that emerges is called liquidation value. There
are several ways how we can compute this:
Ex. BV of assets of 2bn CHF; average life 5 years, 3% exp. inflation rate

− Based on book value of assets: adjust book value of assets by

expected inflation
Exp. liquidation value = 2 * 1.03^5 = 2.319bn CHF

− Based on earnings power: estimate PV of after-tax cash flows

until liquidation 10% discount rate

400m in after-tax CFs for 15years. Exp liq value = 400 * PV of an annuity = 400 * 1/0.1 * (1 - 1/1.1^15) = 3.0426bn

34
Multiple approach

• The value of a firm in a future year is estimated by applying a

multiple to the firm’s earnings or revenues in that year.

• For instance, a firm with expected revenues of CHF 6 billion,

10 years from now will have an estimated terminal value in
that year of CHF 12 billion, if a value-to-sales ratio of 2 is
used.
from peers

• Careful: it becomes a mix between relative and DCF

valuation.

35
Stable growth model

• When a firm’s cash flows grow at a “constant” rate forever,

the present value of those cash flows can be written as:

𝐹𝐹𝐹𝐹𝐹𝐹𝑇𝑇+1 𝐹𝐹𝐹𝐹𝐹𝐹𝑇𝑇 × (1 + 𝑔𝑔)

Terminal Value 𝑇𝑇 = =
(𝑟𝑟 − 𝑔𝑔) (𝑟𝑟 − 𝑔𝑔)

𝑔𝑔
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑇𝑇+1 × (1 −
Terminal Value 𝑇𝑇 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 )
(𝑟𝑟 − 𝑔𝑔)
where,
− r = Discount rate (Cost of Capital (WACC))
− g = Expected growth rate
− RONIC: Expected rate of return on new invested capital

36
Stable growth model

• The stable growth rate cannot exceed the growth rate of the
economy, but it can be set lower.
− If you assume that the economy is composed of high growth
and stable growth firms, the growth rate of the latter will
probably be lower than the growth rate of the economy.
− The stable growth rate can be negative. The terminal value will
be lower, and you are assuming that your firm will disappear
over time.
− If you use nominal cash flows and discount rates, the growth
rate should be nominal in the currency in which the valuation is
denominated.
• One possible proxy for the nominal growth rate of the cash
flows is the risk-free rate or the nominal GDP growth rate.

37
Stable growth model

• Assume that you are valuing a young, high growth firm with
great potential, just after its initial public offering. How
long would you set your high growth period?
− < 5 years
− 5 years
− 10 years
− >10 years
• While analysts routinely assume very long high growth
periods (with substantial excess returns during the periods),
the evidence suggests that they are much too optimistic.
Most growth firms have difficulty sustaining their growth for
long periods, especially while earning excess returns.

38
Stable growth model

• Recapping a key lesson about growth, it is not growth per se

that creates value but growth with excess returns. For
growth firms to continue to generate value creating growth,
they have to be able to keep the competition at bay.

• The stronger and more sustainable the competitive

advantages, the longer a growth company can sustain “value
creating” growth.

• Growth companies with strong and sustainable

competitive advantages are rare.

39
Advanced Valuation
Cost of capital

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Where are we?

• We know now how to forecast the relevant (free) cash flows.

• Now, we must think about how to make these cash flows
comparable across time.
• How do we estimate the discount rate (cost of capital)?

(2) Make them comparable across time (discounting)

Today Year 1 Year 2 Year 3 …

(1) Determine the relevant cash flows

(3) Value

2
Overview

• Introductory remarks

• Risk-free rate

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

3
 The “market value” balance sheet

• The value of an asset corresponds to the PV of the net cash

flows the owner expects to receive from owning that asset.
The PV is obtained by discounting the cash flows with a risk-
adjusted discount rate.
ASSETS LIABILITIES
Firm value: PV of cash Value of Debt: PV of cash
flows that are available for flow from debt financing
DEBT
debt and equity holders (discounted at the cost of
(discounted at a cost of debt).
capital that reflects the cost ASSETS
of debt and the cost of Value of Equity: PV of the
equity). EQUITY cash flows that are available
to equity holders (discounted
FCF
at the cost of equity).
market capitalization

4
Capital structure

• Capital structure
− Debt (Bonds, bank debt, senior/junior, secured/unsecured, etc.)
 All “interest bearing” financial claims
− Mezzanine (we mostly ignore this here)
− Equity

• CONTRACTUAL rights of debt holders

− Regular interest payment
− Repayment of nominal amount
− If secured: underlying asset in the case of bankruptcy

• Rights of shareholders
− Claim on residual cash flows; voting right
5
Capital structure – Modigliani and Miller

• Capital structure and firm value

− Modigliani and Miller show that in the absence of market
imperfections (= perfect capital markets, which means no taxes,
no transactions, fixed investment policy, competitive capital
markets) the value of the firm is independent of capital structure.

• The implication is that the cost of capital is also

independent of capital structure in perfect capital markets.

• We will call this cost of capital 𝒓𝒓𝑼𝑼 , 𝒓𝒓𝑨𝑨 , or pre-tax WACC.

6
Cost of capital

• Overall cost of (unlevered) assets/capital, rU (or rA)

− Required (expected, average) rate of return on assets

− This is the weighted average of the pre-tax cost of debt and

equity (whereas the WACC is the resulting weighted after-tax
average)

− rA = rU = cost of equity if debt = 0 (therefore it is sometimes

referred to as unlevered cost of capital)

• Remember: The required rate of return on a given asset or

investment project equals the expected rate of return on
alternative investment opportunities with the same risk
characteristics.

7
Cost of debt and cost of equity

• Cost of debt, rD
− Required (expected, average) rate of return on debt

− If the firm has various types of debt outstanding, the cost of debt
is the weighted average required rate of return on the various
types of debt

• Cost of equity, rE
− Required (expected, average) rate of return on equity

8
Overview

• Introductory remarks

• Risk-free rate

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

9
Risk-free rate

• On a risk-free asset, the actual return is equal to the

expected return. Therefore, there is no variance around the
expected return.
• For an investment to be risk-free, it must have
− No default risk
− No reinvestment risk
• Time horizon matters: The risk-free rates in valuation will
depend upon when the cash flow is expected to occur and
will vary across time.
• Not all government securities are risk-free: Some
governments face default risk and the rates on bonds issued
by them will not be risk-free.
10
Risk-free rate

• For most developed markets, the government can be viewed

as a default-free entity, at least when it comes to borrowing in
the local currency. Hence:
− When doing investment analysis on longer-term projects or
valuations, the risk-free rate should be the long-term
government bond rate.
− If the analysis is shorter-term, the short-term government
security rate can be used as the risk-free rate.

• Use the same risk-free rate for the calculation of the equity
risk premium as the one used as a proxy for the risk-free rate
(consistency).

11
Risk-free rate and cash flows

• If cash flows are estimated in nominal Swiss Franc terms, the

risk-free rate will be the Swiss Government bond rate.
• It is not where the firm is domiciled that determines the
choice of a risk-free rate, but the currency in which the
cash flows of the firm are estimated.
• When we are in conditions of high and unstable inflation,
we should do valuation in real terms.
• To be consistent, the discount rates used in these cases
have to be real discount rates.

12
Term structure of interest rates

13
Spot interest rates in Switzerland

14
Risk-free rate when there is no default-free
entity

• If the government issues long-term bonds denominated in the

local currency and these bonds are traded, we can use the
interest rates on these bonds as a starting point:
• Example:
− The Indian government had 10-year Rupee bonds outstanding,
with a yield to maturity of about 8.5% on January 1, 2012.
− In January 2012, the Indian government had a local currency
sovereign rating of Baa3. The typical default spread (over a
default-free rate) for Baa3 rated country bonds in early 2012
was 2%.
− The risk-free rate in Rupee = YTM on the 10-year bond –
default spread = 8.5% - 2%.

15
Overview

• Introductory remarks
Equity Risk Premium (ERP)
Market Risk Premium (MRP)
• Risk-free rate
CAPM : Re = Rf + BetaE * (Rm - Rf)

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

16
Equity risk premium

• The notion that risk matters, and that riskier investments

should have a higher expected return than safer investments,
is intuitive.
• The expected return on any investment can be written as the
sum of the risk-free rate and an extra return to compensate
for the risk.
• Disagreement remains on:
− How to measure the risk.
− How to convert the risk measure into an expected return that
compensates for risk.

17
Equity risk premium

• Typically, the expected return on any investment is written as

Re = Rf + BetaE * (Rm -Rf)

Expected return = Risk − free rate + � βj Risk premiumj

j=1

• βj is the beta of the investment relative to factor j

• Risk premiumj for factor j

• Assuming the risk-free rate is known, we need as additional

inputs the risk premiums and the betas.

18
Historical equity risk premium

• The historical premium is the premium that stocks have

historically earned over risk-free securities.

• While the users of historical risk premiums act as if it is a fact

(rather than an estimate), it is sensitive to:
− How far back you go in history…
− Whether you use short-term or long-term government rates…
− Whether you use geometric or arithmetic averages…

19
Historical equity risk premium

• For example, looking at the US:

(Rm -Rf)

Arithmetic Average Geometric Average

Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2021 8.49% 6.71% 6.69% 5.13%
Std Error 2.05% 2.17%
1972-2021 8.04% 5.47% 6.70% 4.47%
Std Error 2.44% 2.76%
2012-2021 16.47% 14.39% 15.89% 14.00%
Std Error 3.88% 4.59%

Source: Damodaran

20
Historical equity risk premium

• Noisy estimates: Even with long time periods of history, the

risk premium that you derive will have substantial standard
error. For instance, if you go back to 1930 (about 90 years of
history) and you assume a standard deviation of 20% in
annual stock returns, you arrive at a standard error of greater
than 2%:

− Standard Error in Premium = 20%/√90 = 2.1%

− (And aside: The implied standard deviation in equities rose to
almost 50% during the last quarter of 2008. Think about the
consequences for using historical risk premiums, if this volatility
persisted)

21
Historical equity risk premium

• For less developed markets, it will be even more difficult to

estimate a precise historical equity premium.
− Shorter and more volatile time-series data

22
Implied equity premiums

• We can use the information in stock prices to back out

how risk averse the market is and how much of a risk
premium it is demanding.

Source: Damodaran

• If you pay the current level of the index, you can expect to
make a return of 8.39% on stocks (which is obtained by
solving for r in the following equation)

23
Implied equity premiums

• Expected ret. on stocks - Treasury bond rate = Implied ERP

8.39% − 4.02% = 4.37%

24
Implied equity premiums

Source: Damodaran
25
Implied equity premiums

Source: Damodaran
26
Equity premiums – implicit assumptions

• Historical Risk Premium: When you use the historical risk

premium, you are assuming that premiums will revert back to
a historical norm and that the time period that you are using
is the right norm.
• Current Implied Equity Risk premium: You are assuming
that the market is correct in the aggregate but makes
mistakes on individual stocks. If you are required to be
market neutral, this is the premium you should use.
• Average Implied Equity Risk premium: The average
implied equity risk premium between 1960-2011 in the United
States is about 4%. You are assuming that the market is
correct on average, but not necessarily at a point in time.

27
Overview

• Introductory remarks

• Risk-free rate

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

28
Cost of equity and betas

• The cost of equity is the required (expected, average) rate of

return on equity.
• There exist several methods to determine the cost of equity.
• Here, we look at two popular approaches:
− The cost of equity from the Dividend Discount Model (DDM)
− Capital Asset Pricing Model (CAPM)
• There are several other methods, including:
− Arbitrage pricing theory
− Consideration of additional risk factors (i.e., growth
opportunities)

29
The Dividend Discount Model (DDM)

• Let’s define the stock price as (Gordon-Shapiro model):

Div0 × (1 + g)
P0 =
(rE − g)

with P0 = current share price, Div0 = last year’s dividend, g =

expected (dividend-)growth rate, and rE = cost of equity.

• To find the implied cost of equity, solve the above equation

for rE:

𝐷𝐷𝐷𝐷𝐷𝐷0 ×(1+𝑔𝑔) 𝐷𝐷𝐷𝐷𝐷𝐷1

𝑟𝑟𝐸𝐸 = + 𝑔𝑔 or 𝑟𝑟𝐸𝐸 = + 𝑔𝑔
𝑃𝑃0 𝑃𝑃0

30
Example

• Assumptions/market data:
− On October 5, 2020 , Novartis shares trade at CHF 81 (P0)
− The company payed out a dividend of CHF 2.95 per share for the year
2019 (Div0)
− The expected growth rate (g) of the future dividend payments is around
2.37% (historical three year average).
• If the assumptions are «correct» and the market values Novartis’
shares with the Gordon-Shapiro model, the numbers would imply a
cost of equity of 6.1% for Novartis:

Div0 × 1+g 2.95×1.0237

• 𝑟𝑟E = +g= +0.0237 = 0.06098 = 6.1%
P0 81

31
The Dividend Discount Model (DDM)

• Easy to use, easy to understand, and the required data are

(more or less) readily available.
• Potential problems:
− Does the market really use such a simple model to set prices?
− What’s the expected growth rate?  Not easy to make the
«right» assumptions
• Possible workarounds:
− Use a more sophisticated DDM (various growth rates, etc.)
− Determine possible intervals for the implied rE

32
The Capital Asset Pricing Model (CAPM)

• The most commonly used approach to estimate the cost of

equity is the Capital Asset Pricing Model (CAPM). The
expected return, rj , on firm j’s stock is given by:

rj = rF + βj × E[rM − rF ]

• rF: Risk-free rate

1%

• E rM − rF : Market risk premium

Beta = 1
1%

• βj : The firm’s beta, its systematic risk

33
«Standard» way of estimating betas

• The standard procedure for estimating betas is to regress

stock returns (rj,t ) on market returns (rM,t ):
rj, t = aj + bj × rM, t + ej, t

− where:
rj,t continuously compounded stock return of firm j
measured from time (t-1) to t;
rM,t, continuously compounded market return measured
from time (t-1) to t;
aj, bj regression coefficients;
ej,t error term.
34
 Novartis: The beta

15%
Slope ≈ 0.38
CONTINUOUSLY COMPOUNDED)
NOVARTIS (MONTHLY RETURN,

10%

5% Regression of Novartis stock returns in

USD (y-axis) on MSCI World index returns
0% in USD (x-axis). To estimate the regression
coefficients, we used continuously
-5% compounded monthly total returns (capital
gains plus dividends) over a period of 5
-10% years (weekly data and shorter horizons
yield very similar results).
-15%
-15% -10% -5% 0% 5% 10% 15%
MSCI WORLD (MONTHLY RETURN,
CONTINUOUSLY COMPOUNDED)

• Our estimate for Novartis’ beta is 0.38 as of October 5, 2020.

35
«Standard» way of estimating betas

• There are many choices associated with this type of

regression:

− Length of the estimation period

− Return interval (monthly vs. weekly vs. daily data)
− Choice of the market index (local or world index)

36
Problems of estimated betas

• This regression beta has other problems:

− It has high standard error
− It reflects the firm’s business mix over the period of the
regression, not the current (or future) mix
− It reflects the firm’s average financial leverage over the period
rather than the current (or target/future) leverage.

• Another way to estimate betas is to look at the fundamentals

of the business.
• For this, we can first look at the determinants of betas.

37
Determinants of betas
BetaE

unlevered return

Re = Ru + D/E * (Ru - Re)

BetaE = BetaU + D/E *(Betau -Betad)

Source: Damodaran
38
Fundamental betas

• Ideally, we start with the beta of the business that the firm is
in.
• We assume that the operating leverage of firms within a
business (industry) is similar and use the same unlevered
beta for every firm.
• We use the financial leverage of the firm to estimate the
(levered) equity beta for the firm

Debt
Levered beta = Unlevered beta(1 + 1 − τ )
Equity

39
Fundamental betas – financial leverage

• Conventional approach:
• If we assume that debt carries no market risk (i.e., debt has
a beta of zero), the beta of equity alone can be written as a
function of the unlevered beta and the debt-equity ratio

βL = βu (1 + ((1 − 𝜏𝜏)D/E))
Be=

Hamada's equitation

− In some versions, the tax effect is ignored and there is no (1 −

𝜏𝜏) in the equation.

40
Fundamental betas – financial leverage

• Debt Adjusted Approach:

• If beta carries market risk and you can estimate the beta of
debt, you can estimate the levered beta as follows:

𝛽𝛽𝐿𝐿 = 𝛽𝛽𝑢𝑢 (1 + ((1 − 𝜏𝜏)𝐷𝐷/𝐸𝐸)) − 𝛽𝛽𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 (1 − 𝜏𝜏) (𝐷𝐷/𝐸𝐸)

− While the latter is more realistic, estimating betas for debt can
be difficult to do.

41
Bottom-up betas

• Breaking down betas into their business risk and financial

leverage components provides us with an alternative way of
estimating betas.

• We do not need past prices on an individual firm or asset to

estimate its beta.

• We can estimate the beta for a firm in five steps:

1. Find the business (industry) or businesses that your firm

operates in.
42
Bottom-up betas

2. Find publicly traded firms in each of these businesses

and obtain their regression betas. Compute the simple
average across these regression betas to arrive at an
average beta for these publicly traded firms. Unlever this
average beta using the average debt to equity ratio across
the publicly traded firms in the sample.
− Unlevered beta for business = Average beta across publicly
traded firms/ (1 + (1-𝜏𝜏) (Average D/E ratio across firms))
3. Estimate how much value your firm derives from each of the
different businesses it is in.
− If values are not available, use operating income or revenues as
weight.

43
Bottom-up betas

4. Compute a weighted average of the unlevered betas of

the different businesses (from step 2) using the weights from
step 3.

− Bottom-up unlevered beta for your firm = Weighted average of

the unlevered betas of the individual business

5. Compute a levered beta (equity beta) for your firm, using the
market debt to equity ratio for your firm:
Debt
Levered beta = Unlevered beta(1 + 1 − τ )
Equity
Be -> CAPM

44
Bottom-up betas

• The bottom-up beta can be adjusted to reflect changes in the firm’s

business mix and financial leverage. Regression betas reflect the
past.

• You can estimate bottom-up betas even when you do not have
historical stock prices for the firm you are interested in. This is
the case with initial public offerings, private businesses or divisions
of companies.

45
Which betas to use?

• Bottom-up betas seem to provide the best estimates

− They allow us to consider changes in business and financial

mix, even before they occur.

− They use average betas across a large number of firms.

− They allow us to calculate betas by area of business for a firm.

46
Cost of equity recap

Source: Damodaran
47
Overview

• Introductory remarks

• Risk-free rate

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

48
Cost of debt

• Why is rD eventually ≥ rF ?
− Credit or default risk: “Chance that the borrower will not be able to
make the promised payments, either on time or in full”.
• What transforms this inequality into an equality?
rD = rF + risk premium
− To bear the credit risk, debtholders require a risk premium. This is the
so-called credit spread (CS)
• There are several methods to determine the cost of debt (or the
credit spread). Here, we look at three possible approaches:
− Market prices
− CAPM
− Credit ratings

49
Cost of debt – market prices

• The debt cost of capital is the cost of capital that a firm

must pay on its debt.

• For bonds, the yield to maturity is the IRR an investor will

earn from holding the bond to maturity and receiving its
promised payments.

• If there is little risk the firm will default, yield to maturity is a

reasonable estimate of investors’ expected rate of return.

• If there is significant risk of default, yield to maturity will

overstate investors’ expected return.

50
Cost of debt – market prices

• Consider a one-year bond with YTM of y. For each CHF 1

invested in the bond today, the issuer promises to pay CHF
(1 + y) in one year.
• Suppose the bond will default with the probability p, in which
case bond holders receive only CHF (1 + y – L), where L is
the expected loss per CHF 1 of debt in the event of default.

• The expected return of the bond is:

rd = (1 – p)y + p(y – L) = y – pL
= Yield to maturity – Prob(default) × expected loss rate

• The importance of the adjustments depends on the riskiness

of the bond.
51
Promised and expected cash flows

• Consider a 1-year, zero coupon government bond with a

YTM of 4%.

1000 1000
𝑃𝑃 = = = 𝐶𝐶𝐶𝐶𝐶𝐶 961.54
1 + 𝑌𝑌𝑌𝑌𝑌𝑌1 1.04

• Suppose now that the bond issuer defaults with certainty

and will pay 90% of the obligation.
900 900
𝑃𝑃 = = = 𝐶𝐶𝐶𝐶𝐶𝐶 865.38
1 + 𝑌𝑌𝑌𝑌𝑌𝑌1 1.04

52
Promised and expected cash flows

• When computing the yield to maturity for a bond with certain

default, the promised rather than the expected cash flows
are used.

FV 1000
YTM= − 1= − 1= 15.56%
P 865.38

• The yield to maturity of a certain default bond is not equal to

the expected return of investing in the bond. The yield to
maturity will always be higher than the expected return of
investing in the bond.

53
Promised and expected cash flows

• Consider a one-year, CHF 1000, zero-coupon bond. Assume

that the bond payoffs are uncertain.
− There is a 50% chance that the bond will repay its face value in
full and a 50% chance that the bond will default and you will
receive CHF 900. Thus, you would expect to receive CHF 950.
− Because of the uncertainty, the discount rate is 5.1% (assuming
a risk premium of 1.1%).

• The price of the bond will be

950
𝑃𝑃 = = 𝐶𝐶𝐶𝐶𝐶𝐶 903.90
1.051
54
Promised and expected cash flows

• The yield to maturity will be

FV 1000
YTM= − 1= − 1= .1063
P 903.90

• A bond’s expected return will be less than the yield to

maturity if there is a risk of default.

• A higher yield to maturity does not necessarily imply that a

bond’s expected return is higher.

55
Cost of debt – CAPM
Rd = Rf + BetaD * (Rm - Rf)

Risk premium
• Alternatively, we can estimate the debt cost of capital using
the CAPM.
• Debt betas, however, are difficult to estimate because
corporate bonds are traded infrequently.
• One approximation is to use estimates of betas of bond
indices by rating category.

56
Credit rating categories

• Credit rating categories and their interpretation:

57
Cost of debt – credit ratings

• Let us consider Novartis. From the corporate website, we

know that its ratings are:

• Credit ratings of Novartis AG:

Moody’s Investors Service S&P Global Ratings

Short term P-1 A-1+

Long term A1 AA-

Outlook Stable Stable

58
Cost of debt – example

• According to Damodaran, an AA (A1) rating (long-term) is

associated with a credit spread of approximately 1% (1.25%).

Source: Damodaran

59
Cost of debt – example

• The yield on a 10-year Swiss government bond is -0.8%.

• Hence, we can write:

rD ≈ rF + Credit Spread

rD ≈ 1.5% + 1% = 2.5%

• Based on these numbers, we estimate a rD of 2.5% for

Novartis.

60
Cost of debt for firms without a credit rating

• Only a minority of all firms – the big ones usually - have an

official credit rating.
• Workaround: Compute your own rating to derive the cost of
debt of a non-rated firm, a so-called synthetic rating.
• To do so, identify factors that are closely related to the firm’s
creditworthiness.
• Commonly used factors/proxies that drive a firms synthetic
credit rating are (risk profile):
− Size
− Interest coverage ratio
− Leverage or debt ratio

61
Cost of for firms without a credit rating

• Credit rating, firm characteristics and probability of default:

Interest Cumulative proability of default
Rating Debt ratio (D/A)
coverage ratio 1 year 5 years 10 years
AAA 12% 23.8 0.00% 0.11% 0.61%
AA 28% 19.5 0.01% 0.28% 1.06%
A 38% 8.0 0.05% 0.71% 2.10%
BBB 43% 4.7 0.36% 3.53% 7.60%
BB 54% 2.5 1.47% 14.77% 26.61%
B 76% 1.2 6.72% 31.99% 44.59%
CCC 114% 0.4 30.95% 56.77% 62.92%

EBITt
Interest coverage ratiot =
interest expenset

62
Interest coverage ratios and synthetic ratings

• Interest coverage ratio and credit rating according to

Damodaran

Source: Damodaran

63
Cost of debt for firms without a credit rating
Example

• Suppose a firm has interest expenses of CHF 1 million, EBIT

of CHF 5 million and market cap that amounts to roughly
CHF 250 million.

• Hence, its interest coverage ratio is 5.

• According to the previous table, this implies a synthetic rating

of A-, which is associated with a credit spread of 156 basis
points (1.56%).
Rd = Rf + credid spread
= 1.5% + 1.56% = 3.06%

64
Overview

• Introductory remarks

• Risk-free rate
Rd = Int. exp/ Financ. debt

• Equity risk premium

• Cost of equity

• Cost of debt

• Cost of capital

65
Cost of capital

• Once we have all the ingredients, we can compute the firm’s

cost of capital as

Equity Debt
𝑟𝑟𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = cost of equity × + cost of debt × (1 − τ) ×
(Equity + Debt) (Equity + Debt)

• Use the marginal tax rate

• Use market value weights (or expected proportions).
• Compute the cost of equity based on bottom-up betas (if
possible)

66
Cost of capital and firm value

Source: Berk and DeMarzo

67
Cost of capital – hybrid securities

• When dealing with hybrids (convertible bonds, for instance),

break the security down into debt and equity and allocate the
amounts accordingly. Thus, if a firm has $125 million in
convertible debt outstanding, break the $125 million into
straight debt and conversion option components. The
conversion option is equity.
• When dealing with preferred stock, it is better to keep it as a
separate component. The cost of preferred stock is the
preferred dividend yield. (As a rule of thumb, if the
preferred stock is less than 5% of the outstanding market
value of the firm, lumping it in with debt will make no
significant impact on your valuation).

68
Cost of capital – convertible debt

• Assume that the firm that you are analyzing has $125 million
in face value of convertible debt with a stated interest rate of
4%, a 10-year maturity and a market value of $140 million. If
the firm has a bond rating of A and the interest rate on a A-
rated straight bond is 8%, you can break down the value of
the convertible bond into straight debt and equity portions.

− Straight debt = (4% of $125 million) (PV of annuity, 10 years,

8%) + 125 million/1.0810 = $91.45 million
− Equity portion = $140 million - $91.45 million = $48.55 million

69
Advanced Valuation
Firm Valuation

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Where are we?

• We know how to forecast the relevant (free) cash flows.

• We know how to estimate the relevant cost of capital.
• How can we estimate the value of the firm (equity)?

(2) Make them comparable across time (discounting)

Today Year 1 Year 2 Year 3 …

(1) Determine the relevant cash flows

(3) Value

2
Overview

• Dividend Discount Models

• FCFE (residual cash flow) discount models

• Discounted cash flow (DCF) model

• Adjusted Present Value

• (Excess) cash

3
Dividend Discount Model

• What are the future cash flows shareholders are entitled to?
− Ordinary dividends
− Share repurchases
− Liquidation dividend

• Stock prices should equal the PV of future dividends plus the

future selling price:

T
E(Divt ) E(PT )
P0 = � +
(1 + rE )t (1 + rE )T
t=1

4
Dividend Discount Model

• In fact, stock prices should equal the PV of all future

dividends
T
E(Divt ) E(PT )
P0 = � +
(1 + rE )t (1 + rE )T
t=1

T 2T
E(Divt ) E(Divs ) E(P2T )
=� + � +
(1 + rE )t (1 + rE )s (1 + rE )2T
t=1 s=T+1

=⋯
∞
E(Divt )
=�
(1 + rE )t
t=1

5
Dividend Discount Model

• This model requires the projection of dividends until infinity.

• We can make several simplifying assumptions.

Assumption Dividend discount model

Constant dividends Zero-growth model
Constantly growing dividends Constant-growth model

6
Zero-growth model

• Assumption:

Div1 = Div2 = ... = Div

• Share price equals the present value of a constant perpetuity

of dividend payments (assuming the first dividend is
distributed in 1 year):

Div
P0 =
rE

7
Zero-growth model – Example

• Suppose that the Swiss National Bank’s share price is CHF

1’120. It pays an annual dividend of CHF 15, the maximum
dividend according to the NBG (Law of the Swiss National
Bank).

• If the market values the SNB stock as a zero-growth

perpetuity, the implied cost of equity is 1.34%:

Div1 Div1 15
P= → rE = = = 1.34%
rE P 1′ 120

8
Roche’s dividend history

9
Constant-growth model

• Empirically, many firms pay dividends. In fact, firms go to

great pains to avoid cutting them.

• If we assume that the expected future dividends grow at a

constant rate of 𝑔𝑔, we get the constant growth model:

Div0 × (1 + g) Div1
P0 = =
(rE − g) (rE − g)

10
Constant-growth model – Example

• Based on analyst forecasts, we expect Roche to distribute

the following dividends:

Year current 2022 2023 2024 2025

Dividend 9.30 9.65 9.94 10.41 NA

• What is the fair share price at the end of 2022, if you know
that Roche’s beta is 0.82, the current risk-free rate is 1.5%
and the expected market risk premium is 5.5%.

• We know:
− Div1 = 9.65
− rE = rF + β×MRP = 0.015 + 0.82×0.055 = 6.01%
11
Constant-growth model – Example

• The growth rates in dividend payments are:

Year current 2020 2021 2022 2023

Dividend 9.30 9.65 9.94 10.41 NA
Growth rate 3.76% 3.01% 4.72% NA

• The expected average growth rate is:

0.0376+0.0301+0.0472
g= = 3.83%
3

• Hence, the theoretical share price is:

Div1 9.65
P0 = = = 443.13.
rE −g 0.0601 −0.0383

12
Constant growth model

• Use the forecasted dividends (like the explicit forecast period)

and only then apply a constant growth.

• Use historical dividend growth rates to estimate 𝑔𝑔 (make sure

that inflation did not change too much…).

• In the (very) long run, expected dividend growth rates should

not exceed the expected GDP growth rate.

13
The Gordon-Shapiro model

Payout ratio

Div0 × (1 + g) b × EPS0 × (1 + g) b × EPS1

• P0 = = =
(rE − g) (rE − g) (rE − g)

• The Gordon-Shapiro model is a special version of the

constant growth dividend discount model. It assumes:
− Constant growth in EPS
− Constant payout ratio

14
Overview

• Dividend Discount Models

• FCFE (residual cash flow) discount models

• Discounted cash flow (DCF) model

• Adjusted Present Value

• (Excess) cash

15
Free cash flow to equity

• The free cash flow to equity (FCFE), or residual cash

flow, is the cash flows left over after meeting all financial
obligations, including debt payments, and after covering
capital expenditure and working capital needs.

• See the earlier slides on how we can estimate the free cash
flow to equity.

• Because the FCFE goes to shareholders, we need to

discount this cash flow with the cost of equity, 𝒓𝒓𝑬𝑬 .

16
Constant growth FCFE model

• The constant growth FCFE model is designed to value

firms that are growing at a stable growth rate and are hence
in steady state.

FCFE1
Equity value =
rE − g

• FCFE1 : Expected FCFE next year

• rE : Cost of equity of the firm
• g: Growth rate in FCFE for the firm forever

17
 r E, st

Two-stage FCFE model steady state

FCFE

hg R E,hg T st

• The two-stage FCFE model is designed to value a firm that is

expected to grow much faster that a stable firm in the initial
period and at a stable rate after that.

Equity value = PV of FCFE + PV of terminal value

t=T
FCFEt PT
=� +
(1 + rE,hg )t (1 + rE,hg )T
t=1

− FCFEt : FCFE in year t

FCFET+1
− PT : Price at the end of the extraordinary growth period: PT =
rE,st − g
− rE : Cost of equity in high growth (hg) and stable growth (st)
− g: Growth rate in FCFE after the terminal year forever

18
Three-stage FCFE model

• The three-stage FCFE model is designed to value a firm that goes

through three stages of growth – an initial phase of high growth, a
transitional period in which the growth rate declines, and a steady-
state growth period.
t=n1 t=n2
FCFEt FCFEt Pn2
Value = � + � +
(1 + rE )t (1 + rE )t (1 + rE )n2
t=1 t=n1+1

− FCFEt : FCFE in year t

FCFEn2+1
− Pn2 : Price at the end of transition period: Pn2 =
rE − g
− rE : Cost of equity
− n1: end of initial growth period; n2: end of transition period
− g: Growth rate in FCFE after the transition period forever

19
Three-stage FCFE model

• Important that assumptions about other variables are

consistent with the different assumptions about growth.

• Capital spending and depreciation: As the firm goes from

high growth to stable growth, the relationship is likely to
change.

• Risk: As the growth characteristics of a firm change, so do

its risk characteristics.
− In the context of the CAPM, as the growth rate declines, the
beta of the firm can be expected to change, too. Over time, as
firms get larger and more diversified, the average betas move
toward 1.
20
FCFE model and dividend discount model

• Difference in definition of cash flow:

− Dividend discount model uses strict definition of cash flow, i.e.
expected dividends
− FCFE model uses an expansive definition of cash flow as the
residual cash flow after meeting all financial obligations and
investment needs.

• FCFE are often different from dividends

− Firms often do not pay out to their stockholders all they can
afford.

• Value from the FCFE model often provides the better

estimate of value compared to dividend discount model.
21
Overview

• Dividend Discount Models

• FCFE (residual cash flow) discount models

• Discounted cash flow (DCF) model

• Adjusted Present Value

• (Excess) cash

22
Firm valuation – Discounted Cash Flow

• We can value the entire firm either with the Discounted

Cash Flow (DCF) or the Adjusted Present Value (APV)
approach.

• These two approaches make different assumptions about the

role of capital structure.

1. DCF: Discounting the free cash flows (cumulated cash

flows to all claimholders) with the weighted average cost of
capital, 𝑟𝑟𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 .
− We assume a constant proportion of debt to capital in the
future.

23
Firm valuation – Adjusted Present Value

2. APV: Discounting the free cash flows (cumulated cash

flows to all claimholders) with the unlevered cost of capital,
𝑟𝑟𝑈𝑈 = 𝑟𝑟𝐴𝐴 . This will yield an unlevered firm value.

We then add the marginal impact of debt on firm value to the

unlevered firm value.
𝑉𝑉𝐿𝐿 = 𝑉𝑉𝑈𝑈 + PV tax shield − PV(bankruptcy costs)

− Using this approach, we value the tax shield based on a

nominal amount of debt outstanding (in CHF, USD, EUR, etc.)
in the future (potentially assuming constant debt forever).

24
Firm valuation

• When we compute firm value by discounting future cash

flows, we value the firm’s underlying business, or its
operating assets.
− The free cash flows correspond to the cash flows that the firm
generates out of its operations (and investment), i.e., out of its
underlying business.
• When the firm does not have other non-operating assets,
such as large excess cash holdings, the value of the firm’s
underlying business will correspond to the overall firm value.
• When the firm has large non-operating assets (e.g., excess
cash), we must add these assets to the firm’s underlying
business value to get the overall firm value.

25
Stable growth model

• We denote the value of the firm’s underlying business as

𝑽𝑽𝟎𝟎 .
• A firm with free cash flows to the firm growing at a stable
growth rate can be valued using:

FCF1
𝑉𝑉0 =
WACC − g

• FCF1 : Expected FCF next year

• WACC: Weighted average cost of capital
• g: Growth rate in FCF for the firm forever

26
General version of the FCF model

• More generally, the value of the firm can be written as the

present value of expected free cash flows to the firm:

∞
FCFt
𝑉𝑉0 = �
(1 + WACC)t
t=1

• FCF1 : Expected FCF next year

• WACC: Weighted average cost of capital

27
General version of the FCF model

• If the firm reaches steady state after T years and starts

growing at a stable growth rate g after that, we can write firm
value as:

t=T
FCFt FCFT+1 /(WACCst − g)
𝑉𝑉0 = � t
+
(1 + WACChg ) (1 + WACChg )T
t=1

• FCFt : Free cash flow in year t

• WACC: Weighted average cost of capital, high growth (hg)
and stable growth (st)

28
General version of the FCF model

• There are several problems with this model:

1. The FCF is a rather hypothetical concept: What would the

firm’s cash flow be if it had no debt?

2. The focus is on pre-debt cash flows. It may hide problems if

the firm must make large debt payments.

3. By using the cost of capital, we are making implicit

assumptions about leverage that might not be feasible or
reasonable.

29
Overview

• Dividend Discount Models

• FCFE (residual cash flow) discount models

• Discounted cash flow (DCF) model

• Adjusted Present Value

• (Excess) cash

30
Adjusted present value (APV)

• In the adjusted present value approach, the value of the

firm is written as the sum of the value of the firm without debt
(the unlevered firm) and the effect of debt on firm value.

𝑉𝑉𝐿𝐿 = 𝑉𝑉0 = 𝑉𝑉𝑈𝑈 + PV tax shield − PV(bankruptcy costs)

• The optimal CHF (or USD, EUR, etc.) debt level is the one
that maximizes firm value.

31
Implementing the APV approach

• Step 1: Estimate the value of the unlevered business. That

is, discount the expected FCFs at the unlevered cost of
capital, 𝐫𝐫𝐔𝐔 .

• The unlevered cost of capital correspond to the pre-tax

WACC, i.e., to 𝑟𝑟𝑈𝑈 .

Equity Debt
𝑟𝑟𝑈𝑈 = 𝑟𝑟𝐸𝐸 × + 𝑟𝑟𝐷𝐷 ×
(Equity + Debt) (Equity + Debt)

32
Implementing the APV approach

• Step 2: Calculate the expected present value of tax

benefits from a given level of debt.

• It is a function of the tax rate and interest payments, and is

discounted at the cost of debt, 𝑟𝑟𝐷𝐷 , to reflect the risk of this
cash flow.

• If the tax savings are viewed as a perpetuity,

Present value of tax benefit = Tax rate × Debt = τ × D

33
Implementing the APV approach

• Step 3: Calculate the expected present value of

bankruptcy costs.

• The present value of expected bankruptcy costs is a function

of the probability of bankruptcy and the bankruptcy costs.

PV of expected bankruptcy cost =

Prob. of bankruptcy × PV of bankruptcy costs = π × BC

34
Implementing the APV approach

• Step 3: Challenge is that neither the probability of bankruptcy

nor the bankruptcy costs can be estimated directly.
− Probability of Bankruptcy
– Estimate the synthetic rating that the firm will have at each level of
debt.
– Estimate the probability that the firm will go bankrupt over time, at
that level of debt.
− Cost of Bankruptcy
– The direct bankruptcy cost is the easier component. It is generally
between 5-10% of firm value, based upon empirical studies.
– The indirect bankruptcy cost is much tougher to get. It should be
higher for sectors where operating income is affected significantly
by default risk (like airlines) and lower for sectors where it is not
(like groceries).

35
WACC versus APV approach

• Debt:
− The WACC approach assumes a constant debt-capital proportion
going forward.
− The APV approach assumes a (fixed) Swiss Franc (or EUR, USD, etc.)
debt value.
• Tax benefits:
− The WACC approach incorporates the tax benefits through the
discount rate.
− The APV approach models them explicitly.
• Bankruptcy costs:
− The WACC approach incorporates these costs into the levered beta
and cost of debt.
− The APV approach models them explicitly.

36
Overview

• Dividend Discount Models

• FCFE (residual cash flow) discount models

• Discounted cash flow (DCF) model

• Adjusted Present Value

• (Excess) cash

37
Non-operating assets

• So far, we have (implicitly) focused on the valuation of

operating assets.

• But most firms have assets on their books that can be non-
operating.
− Cash holdings
− Investments in equities and bonds of other firms
− Holdings in other firms, which are categorized in a variety of
ways by accountants
− Other assets such as undeveloped land or overfunded pension
plans

38
How much cash do firms hold?

Source: Bates, Kahle, Stulz (Journal of Finance 2009)

39
Cash and near cash investments

• Every firm has investments in cash and near cash

investments (treasury bills, commercial paper etc.). firms hold
cash for a multitude of reasons:
− Operations: Some cash may be needed for operations
(transactions) - a retail firm will have cash in its cash registers
− Precautionary motive: Firms hold cash just in case they may
need to draw on it in the event of a crisis
− Future capital investments: Just in case a great investment
opportunity comes along
− Strategic cash holdings: Strategic weapon to be an effective
competitor
− Management interests: Perks consumption and risk reduction

40
Dealing with cash in valuation

• Since cash is so different from other operating assets in

terms of risk and returns, valuing it becomes a challenge.

• The simplest and most direct way of dealing with cash and
marketable securities is to keep it out of the valuation.
− The cash flows should be before interest income from cash and
securities.

• Once the firm has been valued (using operating cash flows),
we can add back the value of cash and marketable
securities. The value of the firm thus becomes:
FCF1
Firm value = + Excess cash Ov. pension plans
WACC − g

41
Gross debt versus net debt

Net debt = Finance. debt - Excess cash

• In much of Latin America and Europe, analysts net cash

balances out against debt outstanding to estimate a net
debt value, which is used in computing the debt ratios and
costs of capital.
• In firm value calculations, the differences between using the
gross and net debt approach will show up in the following
places:
− Cost of capital computation: assuming the same cost of debt,
more weight is put on the equity cost of capital, which will partly
compensate the lower equity cost of capital.
− Cash flows to the firm are the same under the two approaches.
• The value of equity will generally not be the same.

42
Gross debt versus net debt

• The reason why the two approaches will yield different values
lies in the difference in the costs of capital obtained with
the two approaches.

• But why is there a difference?

− Consider a firm with a value of non-cash assets of CHF 1.25bn

and a cash balance of CHF 250m.
− The firm has CHF 500m in debt outstanding, with a pre-tax cost
of debt of 5.9% and CHF 1bn in market value of equity.
− The cost of debt equals the risk-free rate.

43
Gross debt versus net debt

• Gross debt approach:

− We assume that the gross debt-to-capital ratio (500/1500=1/3)
is used to fund both its operating and cash assets.

• Net debt approach:

− We assume that cash is funded with risk-free debt (and no
equity).
− The operating assets of the firm are funded using the remaining
debt (CHF 250m) and all the equity.
− The resulting lower debt ratio (250/1250=20%) will usually result
in a slightly higher cost of capital and a lower value for the
operating assets and equity.

44
 Gross debt versus net debt

Entire firm

Operating assets 1250 Debt 500

Cash 250 Equity 1000

Gross debt Net debt approach

approach
Operating assets Operating assets

Operating 1250 Debt 416.67 Operating 1250 Debt 250

assets assets
Equity 833.33 Equity 1000

Cash Cash

Cash 250 Debt 83.33 Cash 250 Debt 250

Equity 166.67 Equity 0

45
Advanced Valuation
Estimation Bias

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Measurement error

• Scenario analysis

• Sensitivity analysis

• Monte Carlo Simulation

• Break-even analysis

2
Valuation and assumptions

• Valuation is the result of many assumptions.

• Given the many assumptions we have to make, does it really make
sense to conduct a formal valuation?
• The answer is YES.
− This is how the market works (forward looking)
− The valuation framework forces us to explicitly formulate our
expectations
− Correctly applied, the valuation framework allows us to identify the
relevant value drivers
− Correctly applied, the valuation framework allows us to come up with
an interval estimate of the firm value
• To be able to do so, we need to reflect measurement error in our
estimates.

3
Sources of measurement error

• Popular sources of measurement error when estimating firm

value include:

WACC Free cash flows

Risk-free rate Future capital expenditures

Beta Revenues

Market risk premium Costs

Cost of debt Liquidation proceeds

Growth rate of cash flows

4
Uncertainty vs. measurement error

• We know that forecasts are subject to uncertainty. This is why we

use risk-adjusted discount rates.
• The higher the uncertainty, the higher the discount rate.
• However, because of uncertainty, we measure the various
ingredients of firm value with error.
• As a result, we cannot claim that firm value is, say, 85.37 million.
All we can claim is that firm value lies in an interval between, say,
80 and 90 million (with a certain probability).
• Consider throwing a dice:
− Uncertainty (risk): We know that the number of pips will be between 1
and 6.
− Measurement error: If we can’t observe the number of pips directly
but instead have to rely on a visually impaired old person.

5
Dealing with measurement error

• There are several ways we can deal with measurement error:

− Scenario analysis

− Sensitivity analysis

− Monte Carlo simulation

− Break-even analysis

6
Overview

• Measurement error

• Scenario analysis

• Sensitivity analysis

• Monte Carlo Simulation

• Break-even analysis

7
Scenario analysis

• In a scenario analysis, we can focus on the important value

drivers, i.e.,
− Cost of equity rE
− Operating expenses
− Long-term growth rate of cash flows

• For each value driver, we can define worst, base, and best
case values.
• Redo valuation for the three scenarios, and then take
weighted average as a potentially more precise estimate of
value.

8
Scenario analysis – example

• Let us assume a base case valuation, where we have a rE of

12%, operating expenses of 66.9% of sales, and a growth
rate of cash flows of 2.5%.

• In what follows, we assume that:

− rE can be 11%, 12%, or 13%
− Operating expenses can be 64.9%, 66.9%, or 68.9%
− Growth rate of cash flows can be 2%, 2.5%, or 3%

9
Scenario analysis – example

• Based on the information provided, we could create the

following three scenarios:
Worst case Base case Best case
rE 13% 12% 11%
Operating expenses 68.9% 66.9% 64.9%
Growth rate CFs 2% 2.5% 3%
Firm Value 1’331 2’033 3’019
Probability 0.25 0.5 0.25

• Average Value = 0.25 × 1’331 + 0.5 × 2’033

+ 0.25 × 3’019 = 2’104

10
Scenario analysis

• The main advantage is that the scenario analysis is simple

and intuitive.

• People often think in scenarios. Hence, they are easy to

communicate.

• Drawbacks:
− Only 3 scenarios?

− Correlation between variables?

− Which are the value drivers?

11
Overview

• Measurement error

• Scenario analysis

• Sensitivity analysis

• Monte Carlo Simulation

• Break-even analysis

12
Sensitivity of firm value

• We change one variable at a time and measure by how

much firm value changes.
• Let’s use the values from the pessimistic and optimistic
scenarios from before.

Optimistic Pessimistic Difference % of Base case

Cost of equity 2'260.4 1'846.3 414.1 20.4%
Operating expenses 2'511.7 1'554.8 957.0 47.1%
Growth rate 2'180.8 1'907.7 273.1 13.4%

Base case valuation 2'033.0

• By dividing the difference in the resulting value estimates by

the value of the base case, we get the sensitivity of firm value
to changes in the variable in question.
13
Sensitivity analysis – drawbacks

• Specifying the range of possible outcomes.

• Deciding how a given variable changes over time.

• Changing only one variable at a time (in scenario analysis,

we change a set of variables at the same time).

• What is the interval estimate of firm value?

14
Overview

• Measurement error

• Scenario analysis

• Sensitivity analysis

• Monte Carlo Simulation

• Break-even analysis

15
Simulation with @RISK

16
The 5 steps to simulated value interval

1. Create the base case valuation

2. Identify potential measurement errors

3. Try to quantify the measurement error

4. Draw random variables and estimate 1 potential outcome

5. Repeat this procedure many times (e.g., 10’000 times) and

derive the distribution of firm value.

17
Key variables: Distribution assumptions

• Operating expenses: Uniform distribution with min. 64.9% and

max. 68.9%.

• Growth rate of cash flows: Normal distribution with mean 2.5%

and standard deviation of 0.3%.

• Cost of equity: Normal distribution with mean of 12% and

standard deviation of 0.5%.

• Feel free to add other potential value drivers.

18
 Defining distributions: Operating
expenses
1) Click on cell D14
2) On the @RISK tab, click on “Define Distributions”
3) Double-click on the distribution “Uniform”. Now, you should see:

4) Enter the
parameters of
the distribution
(Min = 0.649;
Max = 0.689;
Static Value =
0.669)

5) Click “OK”
19
Defining the other distributions

• Repeat this procedure for the other variables which you

identified to be potentially affected by measurement error.

• Now your Excel cells should read:

− D14: =RiskUniform(0.649;0.689;RiskStatic(0.669))
− M16: =RiskNormal(0.025;0.003;RiskStatic(0.025))
− M11: =RiskNormal(0.12;0.005;RiskStatic(0.12))

20
Defining the output

> Finally, we have to tell @RISK which cells contain the output
of our analysis. In our case, this is the Firm Value in L25 (note
that we can define multiple output cells).
— Click on Cell L25
— In the @RISK tab, click on “Add Output”

21
Defining the output

> Now we are ready to run the simulation. In the middle of the
@RISK tab, we can set the number of iterations to, say,
10’000. This means that:
— @RISK draws random numbers from the distributions
— Plugs them into our valuation
— Measures the resulting firm value
— Repeats this procedure 10’000 times.
 we end up with 10’000 possible firm values.

22
The resulting value distribution

Firm Value
1'597 2'600

5.0% 90.0% 5.0%

0.0012

0.0010

0.0008
Average over the last 5 years / Firm Value

@RISK Course Version Minimum 1'360.84

0.0006 Maximum 3'268.83

Universitat Bern Mean 2'082.38
Std Dev 315.76
Values 10000
0.0004

0.0002

0.0000
1'200

1'800
1'600
1'400

2'200
2'000

3'200
2'800
2'600

3'000
2'400

3'400
> 90% of the simulated firm values are between 1’597 and 2’600.
This is the 90% confidence interval of our valuation.
> Because of measurement error, we are unable to produce a point
estimate of the firm value. However, we are able to say that with
high probability, the firm value is somewhere between 1’597 and
2’600.
23
Alternative output style

> In some situations, we may want to know the probability with which the firm
value exceeds a specific number.
> Example: The current owners are willing to sell the firm for 1’800. We are
potential buyers and want to know how likely it is for us to make money
with this deal.
> In the @RISK output, we can 1'800
Firm Value
+∞

shift the lower bound of the

22.1% 77.9%
0.0012

confidence interval to 1’800 0.0010

(or type 1’800 into the respective 0.0008

Average over the last 5 years / Firm Value

field).
@RISK Course Version Minimum 1'360.84

0.0006 Maximum 3'268.83

Universitat Bern Mean 2'082.38
Std Dev 315.76
Values 10000

22.1% of the simulated firm values

0.0004

>
are below 1’800.
0.0002

0.0000

> Hence, the probability that the take-

1'200

1'800
1'600
1'400

2'200
2'000

3'200
2'800
2'600

3'000
2'400

3'400
over @ 1’800 is a NPV>0
project is 77.9%.

24
Identifying value drivers

> We can also use @RISK to identify the relevant value drivers. To
do so, click on the “Tornado” in the output window and select
“Regression – mapped values”.

> The resulting graph shows you by how much firm value changes if
the variables at risk increase by one standard deviation.

25
The relevant value drivers

Firm Value
Regression - Mapped Values

A 1 standard deviation
increase in kE reduces firm
% Sales / Fixed value -282.39 value by approximately 106.

@RISK Course Version Similarly, a 1 standard

rE / Cost of capital

deviation increase in the

-106.32
Universitat Bern

growth rate increases firm

wth (g) / Cost of capital 89.306 value by 89.

50

100
-50
-300

-250

-200

-150

-100

Average over the last 5 years / Firm Value

> This analysis helps managers identify the dimensions, which they
should monitor very closely.

26
Overview

• Measurement error

• Scenario analysis

• Sensitivity analysis

• Monte Carlo Simulation

• Break-even analysis

27
Break-even analysis

• Quantifying the value of an investment project is often difficult.

• Alternative: judge whether the project is likely to have a positive
value.
• Let’s go back to the hypothetical takeover situation from before:
− We assume that we could buy the firm for 1’800
− We are confident concerning our cash flow projections.
− However, we have no idea what the relevant cost of equity (to compute
WACC) could be
• Instead of spending a lot of time on the estimation of rE, we try to
figure out which value of rE would justify an acquisition. Then, we
ask whether the resulting rE is reasonable.

28
Break-even analysis

• We could use Excel’s “Goal Seek” function.

• We find a firm value of approximately 1’800 if the cost of

equity is 13.5%.

• Interpretation: As long as rE does not exceed 13.5% (and the

other assumptions are “correct”), an acquisition @1’800 is
NPV > 0.
• We then have to assess how reasonable it is to assume that
rE < 13.5%.

29
Take away

• Each valuation is the result of many assumptions. Because these

assumptions are potentially affected by measurement error, we should
NOT focus on point estimates of firm value.
• Instead, we should try to look at the possible distribution of firm value.
• To do so, we have used various tools:
− Scenario analysis
− Sensitivity analysis
− Monte Carlo simulation
• All three approaches have their advantages and disadvantages. The
simulation seems to be the most powerful tool, as it allows us to change
various variables at the same time and is not restricted to only a few
scenarios.
• IMPORTANT: Be careful when defining the distributions of your random
variables!!!

30
Advanced Valuation
Relative Valuation and Multiples

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Introductory remarks

• Principles of relative valuation

• Using multiples

• P/E multiple

• Other multiples

2
Example

3
Principles of relative valuation

• In DCF valuation, the objective is to find the intrinsic value

of assets, given their cash flows, growth, and risk
characteristics.

• In relative valuation, the objective is to value assets based

on how similar assets are currently priced in the market.

• While multiples are intuitive and easy to use, they are also
easy to misuse.

4
Principles of relative valuation

• To do relative valuation,
− We need to identify comparable assets and obtain market
values for these assets.
− Convert these market values into standardized values, since
the absolute prices cannot be compared. This process of
standardizing creates price multiples.
− Compare the standardized value or multiple for the asset being
analyzed to the standardized values for comparable asset,
controlling for any differences between the firms that might
affect the multiple.

• Idea: «Let others (= the market) do the job»

5
Relative valuation – intuition

• Example:
− The market value of a comparable firm’s equity is 150 million.
− The value indicator is net income. The comparable firms’ net
income is 10 million. Your company’s net income is 3 million.
− What’s the expected value of your company’s equity?

 For each dollar of net income, the market pays 15 dollars

[=150/10].

 Your company’s net income is 3 million. Hence, the market value

of your company’s equity should be 45 million [= 3×15].

6
The prevalence of relative valuation

• Damodaran:
− 85% of equity research reports are based upon multiples
− 50% of all acquisitions are based upon multiples
− Rules of thumb based on multiples are often the basis for final
valuation judgements

• Why?
− Relative valuation is simple and requires few explicit assumptions
− Easy to communicate
• Beware:
− Equity valuation vs. firm valuation
− Historical vs. forward-looking valuation indicators
− Choosing the «right» comparable firms
− Bad model problem / Black box
7
Relative valuation and market moods

• Relative valuation is much more likely to reflect market

perceptions and moods than DCF valuation. This can be an
advantage when it is important that the price reflects these
perceptions as is the case when:
− The objective is to sell a security at that price today (as in the case of
an IPO)
− Investing on “momentum” based strategies
• With relative valuation, there will always be a significant proportion
of securities that are under valued and over valued.
• Since portfolio managers are judged based upon how they perform
on a relative basis (to the market and other money managers),
relative valuation is more tailored to their needs.
• Relative valuation generally requires less information than DCF
valuation.

8
Overview

• Introductory remarks

• Principles of relative valuation

• Using multiples

• P/E multiple

• Other multiples

9
The “theory” of multiples

• Multiples measure the amount the market is willing to pay

for one unit of sales, earnings, book value of equity, etc.
• In general, the market value of the asset you want to value
(MVT) can be estimated with the following equation:
 MVC 
MVT 
=  × VIT
 VIC 
Market value multiple
− MVC = Market value of the comparable assets (or peer-group)
− VIC = Valuation indicator for the comparable assets (or peer-
group)
− VIT = Valuation indicator of the asset you want to value

10
A simple example

• You are a shareholder of an unlisted financial services boutique. The

firm has issued 100’000 shares and last year’s earnings were CHF 1
million. Hence, the firm’s earnings per share (EPS) were 10. You
would like to know the fair share price of the company. What can
you do?

• You know that, on average, the market pays an earnings multiple

of 13 for financial services firms. That is, for each Swiss Franc of
earnings, the market is willing to pay 13 CHF.

• Valuation:
− Equity value = Earnings × multiple = 1 million × 13 = 13 million
− Share price = EPS× multiple = 10 × 13 = CHF 130

• According to this valuation, the fair share price is CHF 130.

11
Popular valuation multiples

EBITDA

Source: Damodaran

12
What is «enterprise value?»

• The Enterprise Value (EV) is the market value of the operating

assets of a firm.

• Enterprise value = MV debt + MV equity

– Excess cash + MV minority interests

• Excess cash: Since the interest income from the cash is not
counted as part of the EBITDA, not netting out the cash will result in
an overstatement of the EV-to-EBITDA multiple.

13
What is «enterprise value?»

• Enterprise value = MV debt + MV equity

– Excess cash + MV minority interests

• Minority interests:
− The numbers in the denominator of the multiples (sales, assets, EBIT,
etc.) are fully consolidated. That is, even if the firm owns only, say,
75% of a subsidiary, the financial statements fully (@100%) reflect the
subsidiary’s sales etc.
− The share price (MV equity), however, is not «consolidated».  adjust
the numerator, add the MV of the minority interests.
− Alternative: Use unconsolidated data and value the company without
cross-holdings (usually, we do not have the data for this approach).
− But generally, this adjustment is complicated.

14
Enterprise value (EV)
EV = MV(Market Value) equity + Net Debt

• EV is an estimate for what you have to pay in an acquisition

to get full control over the assets (and the value indicator):
− Buy the equity (including the minority shareholdings)
− Assume the firm’s debt
− After the acquisition, use the (excess) cash to repay debt
Debt – (Excess) cash = Net debt

• Keep in mind that using multiples based on enterprise value

will give you an estimate for the value of the firm without
(excess) cash and marketable securities. To get equity value:

MV Equity = EV – Debt – Minority interest + Excess cash

15
Another simple example

• We want to value Mars, Inc. With total sales of approximately

$30 billion in 2016, Mars is the third largest private company
in the U.S. Because the company is not listed on a stock
exchange, it does not have to disclose financial information to
the public. Suppose the 2016 sales figure of $30 billion is the
only available piece of financial information about the
company. Can we still gauge its potential enterprise value as
well as its potential stock price?

16
Comparable: Mondelez International
(formerly Kraft Foods)

• Suppose we have the following information about Mondelez:

− Sales of 35 billion
− 1.75 billion shares outstanding
− Current share price of USD 35
− Cash and equivalents of 3.7 billion
− Debt of 20 billion
− No minority interests
• Compute Mondelez’s EV and use this number to value Mars.
• Additional question: What’s the theoretical share price of
Mars if you assume that Mars has:

− 5 billion in cash, debt of 10 billion, minority interests of 1 billion,

and 2 billion shares outstanding?

17
Another simple example

• Solution: EVmon = 1.75 * 35 + 20 -3.7 = 77.55 bn dollar

MV of equity Debt Cash

EVmon/ Salesmon = 77.55/35 = 2.216

EVmars = 30 * 2.216 = 66.5bn dollar

MV of equity mars = 66.5 - 10 + 5 - 1 = 60.5bn dollar

Pmars = 60.5bn/2bn = 30.25 dollar

18
Forward vs. trailing multiples

• Valuation indicators are typically based on accounting data.

• (Publicly available) accounting data are not continuously updated.

− Historical data (for example from the annual report)
− Forward-looking data (for example from analyst forecasts)

• Valuation multiples based on (the most recent) historical data are

called trailing multiples (trailing ratios).

• Valuation multiples based on forward-looking data are called

forward multiples (forward ratios).

• It is important to be consistent! If you compute a trailing (forward)

multiple for the comparable company, you should apply it to the
historical (forward-looking) valuation indicator of your firm!!!
19
Four steps to using multiples

1. Define the multiple

− The same multiple can be defined in different ways by different

users. When comparing and using multiples, estimated by
someone else, it is critical that we understand how the multiples
have been estimated.

2. Describe the multiple

− Too many people who use a multiple have no idea what its
cross sectional distribution is. If you do not know what the
cross sectional distribution of a multiple is, it is difficult to look at
a number and pass judgment on whether it is too high or low.

20
Four steps to using multiples

3. Analyze the multiple

− It is critical that we understand the fundamentals that drive

each multiple, and the nature of the relationship between the
multiple and each variable.

4. Apply the multiple

− Defining the comparable universe and controlling for differences

is far more difficult in practice than it is in theory.

21
1. Define the multiples

• Is the multiple consistently defined?

− Both the value (the numerator) and the standardizing variable
(the denominator) should be to the same claimholders in the
firm. In other words, the value of equity should be divided by
equity earnings or equity book value, and firm value should be
divided by firm earnings or book value.

• Is the multiple uniformly estimated?

− The variables used in defining the multiple should be estimated
uniformly across assets in the “comparable firm” list.
− If earnings-based multiples are used, the accounting rules to
measure earnings should be applied consistently across assets.
The same rule applies with book-value based multiples.

22
2. Describe the multiples

• What is the average and standard deviation for this multiple,

across the universe (market)? What is the median for this
multiple?
− The median multiple is often a more reliable comparison point.
• How large are the outliers to the distribution, and how do we
deal with the outliers?
− Throwing out the outliers may seem like an obvious solution, but
if the outliers all lie on one side of the distribution (they usually
are large positive numbers), this can lead to a biased estimate.
• Are there cases where the multiple cannot be estimated? Will
ignoring these cases lead to a biased estimate of the
multiple?
• How has this multiple changed over time?
23
Distribution of P/E ratios by region

Source: Damodaran

24
Distribution of EV/EBITDA multiples

Source: Damodaran

25
3. Analyze the multiples

• What are the fundamentals that determine and drive these

multiples?
− Embedded in every multiple are all of the variables that drive
every discounted cash flow valuation
– Growth
– Risk
– Cash flows

• How do changes in these fundamentals change the multiple?

− The relationship between a fundamental (like growth) and a
multiple (such as P/E) is almost never linear.
− It is impossible to properly compare firms on a multiple, if we do
not know how fundamentals and the multiple move.
26
4. Apply multiples

• When identifying comparable firms, look for firms of similar:

− Line of business (similar operating risk)
− Margins (measure of competition)
− Size (in terms of sales, market capitalization, number of
employees)
− Growth
− Capital structure (similar financial risk)
− Age (similar stage in the life cycle)
− Etc.

• Because the valuation depends solely on the comparable

firm(s), make sure that the comparable(s) really is (are)
comparable.
27
Overview

• Introductory remarks

• Principles of relative valuation

• Using multiples

• P/E multiple

• Other multiples

28
 Example: Paktech

• You want to value the firm Paktech International, a specialized

paper producer. The firm’s debt is 50 million and it has no excess
cash. You have collected the following data on Paktech:
Paktech financials ($M) last year expected
Sales 213.6 213.7
EBITDA 29.9 32.4
Net income NA 9.0

• You have also collected information on five comparable companies:

Comparable firms Market Historical financials Expected financials
(specialized paper product, $M) value Equity Net debt Sales EBITDA Net income Sales EBITDA Net income
Caraustar Inc. 262 476 932 88 -4 960 113 14
Fibermarket Inc. 49 302 394 57 4 410 67 10
Glatfelter Co. 589 203 544 125 44 622 142 55
Rock-Tenn Company 467 466 1'437 174 27 1'489 170 40
Wausau-Mosinee Paper Co. 581 159 954 108 23 1'028 149 49

• We ignore minority interests.

29
Paktech

• Assignments
− Compute the trailing and forward PE-ratio of Caraustar Inc
− Compute the trailing and forward EV/EBITDA-ratio of Caraustar Inc
− Use these numbers to estimate Paktech’s firm value
− How could you improve the reliability of your valuation?
− Is it possible to use multiples to estimate the equity value of a firm with
negative earnings?
• Using the information on all comparables, compute the following
median trailing and forward multiples:
− EV/Sales
− EV/EBITDA
− P/E
• Use these multiples to estimate Paktech’s firm value.

30
Paktech – valuation multiples

• Based on the information on the previous slide, we can compute

valuation multiples for the comparable firms. To do so, we ignore
minority interests and assume that EV = MVE + Net Debt.
Comparable firms Trailing multiples Forward multiples
(specialized paper products) EV/Sales EV/EBITDA P/E EV/Sales EV/EBITDA P/E
Caraustar Inc. 0.79 8.39 0.77 6.53 18.71
Fibermarket Inc. 0.89 6.16 12.25 0.86 5.24 4.90
Glatfelter Co. 1.46 6.34 13.39 1.27 5.58 10.71
Rock-Tenn Company 0.65 5.36 17.30 0.63 5.49 11.68
Wausau-Mosinee Paper Co. 0.78 6.85 25.26 0.72 4.97 11.86
Average 0.91 6.62 17.05 0.85 5.56 11.57
Median 0.79 6.34 15.34 0.77 5.49 11.68

• Note that firm and equity value cannot be negative. Therefore, we

exclude firms/years with negative valuation indicators (Carustar’s
trailing P/E ratio). Example: Fibermarket’s forward EV/EBITDA
multiple
− EV = MVE + Net Debt = 49 + 302 = 351
EV/EBITDA = 351/67=5.24
− Expected EBITDA = 67 31
 Valuing Paktech

• Now we can apply the multiples to Paktech’s valuation indicators.

Because the median is less affected by outliers than the mean,
relative valuation should be based on the median multiple:
Valuation using median multiples
Trailing multiples Forward multiples
EV/Sales EV/EBITDA P/E EV/Sales EV/EBITDA P/E
Packtech's VI (Sales, EBITDA, Net inc.) 213.6 29.9 213.7 32.4 9.0
Median industry multiple 0.79 6.34 15.34 0.77 5.49 11.68
Estimated equity value n.a. 105.1
Net debt 50
Estimated firm value 169.1 189.4 n.a. 164.3 177.8 155.1

• Example: Based on a median forward EV/EBITDA ratio of 5.49 and

Paktech’s expected EBITDA of 32.44 million, Paktech’s estimated
enterprise value is 178 million [5.49×32.44].

32
Overview

• Introductory remarks

• Principles of relative valuation

• Using multiples

• P/E multiple

• Other multiples

33
P/E multiple: The Gordon-Shapiro model

Payout ratio

Div0 × (1 + g) b × EPS0 × (1 + g) b × EPS1

• P0 = = =
(rE − g) (rE − g) (rE − g)

• Under this model, we can write the P/E ratio, defined as

current stock price divided by current EPS:
P0 b × (1 + g)
=
EPS0 (rE − g)

• Or divided by expected EPS:

P0 b
=
EPS1 (rE − g)

34
P/E multiple: Interpretation
cash
Re = Rf + BetaE * (Rm -Rf)
P0 b
=
EPS1 (rE − g)
risk
growth
• The P/E-ratio is a function of:
− The firm’s payout policy (high payouts (lower reinvestment)  high
P/E ratio)
− The firm’s growth rate (high growth  high P/E ratio)
− The risk of the firm’s equity (which drives the cost of equity, rE): high
risk  lower P/E ratio.
• P/E ratio and financing policy? rE is higher for firms with high
leverage.  Highly levered firms should have lower P/E ratios.
• Note: these are partial effects, we keep everything else the same
(high-growth firms may have high leverage and low payout ratios)
 net effect is not clear.

35
Overview

• Introductory remarks

• Principles of relative valuation

• Using multiples

• P/E multiple

• Other multiples

36
Other multiples

• Many other popular multiples are directly related to the

P/E ratio. This could explain why the P/E is so popular.

1 P0
• Price / Dividends = ×
Payout ratio EPS0

P0
• Price / Book = ROE ×
EPS0
P0
• Price / Sales = Net profit margin ×
EPS0

• These relations also show us the implicit assumptions we

make when using other multiples. In the case of the P/B
ratio, for example, we assume that the firm’s return on equity
is comparable to that of the industry.
37
EBITDA multiple

Enterprise value MV of equity + MV of debt − Cash + MV MI

=
EBITDA EBITDA

• The multiple can be computed even for firms that are

reporting net losses, since earnings before interest, taxes
and depreciation are usually positive.

• For firms in certain industries, such as cellular, which require

a substantial investment in infrastructure and long gestation
periods, this multiple seems to be more appropriate than the
P/E ratio.

38
Reasons for use of EBITDA multiple

• In leveraged buyouts, where the key factor is cash

generated by the firm prior to all discretionary expenditures,
the EBITDA is the measure of cash flows from operations
that can be used to support debt payment at least in the short
term.

• By looking at cash flows prior to capital expenditures, it may

provide a better estimate of “optimal value”, especially if the
capital expenditures are unwise or earn substandard returns.

• By looking at the value of the firm and cash flows to the firm it
allows for comparisons across firms with different financial
leverage.
39
Concluding remarks

• Multiples are very popular valuation instruments

− Easy to use (all you need is a group of comparable firms)
− Easy to understand
− Easy to communicate

• They measure the amount the market is willing to pay for one
unit of sales, earnings, book value of equity, etc.
− Trailing multiples
− Forward multiples
• Limitations:
− Choosing the right multiple and the right peer group
− Treating the firm as a black box
− Relatively inaccurate
• Use both multiples and DCF
40
Advanced Valuation
EVA and other valuation methods

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Introduction

• The DCF model provides for a rich and thorough analysis of

all the different ways in which a firm can increase value.
• But it can become complex…
• When it comes to management compensation, firms are not
necessarily willing to rely on DCF, which depends on many
assumptions.
• Nevertheless, firms are becoming more focused on value
creation, so they need tools that measure value creation
and do not require a lot of estimation.
• Two such tools are residual income and EVA.

2
Overview

• Residual Income Valuation

• Economic Value Added (EVA)

• Other (traditional) valuation methods

3
Residual income valuation

• Idea: The firm has two sources of value:

− The current value of the assets in place (book value, B0)
− The economic value added that can be earned in the future by
managing the assets in place.

• What is the “economic value added?”

− Present value of the firm’s residual income (RI)
− Residual income = Net income - $ cost of equity

∞
RIt
• The value of the firm’s equity (P0) is: P0 = B0 + �
(1 + rE )t
t=1

4
Residual Income Valuation – Example

Variable Value
EBIT 500′000
Book value of interest bearing debt (D) 2′000′000
Book value of equity (B0) 3′000′000
Cost of debt (rD) 5%
Cost of equity (rE) 10%
Tax rate (𝜏𝜏C) 35%

• Using this information, we can compute the firm’s net profit:

Position Value
EBIT 500′000
– Interest payments [= D × rD] 100′000
Earnings before taxes (EBT) 400′000
– Taxes [= EBT × τC] 140′000
Net profit 260′000

5
Residual Income Valuation – Example

• What’s the residual income?

• The firm generates a net profit of 260’000. This is the money
that “belongs” to the shareholders.
• The shareholders’ opportunity costs are:
− Invested capital (original contribution plus retained earnings, B0)
= 3’000’000
− Cost of equity (rE) = 10%

 Required compensation = 3’000’000×0.1 = 300’000

• Hence, the firm’s residual income is:

Residual income = 260’000 – 300’000 = −40’000

6
Residual Income Valuation – Example

• The firm has earned a positive profit. However, it is not

enough to cover the shareholders’ opportunity costs!

• The equity value is (assuming the firm lives one period):

∞ ′ 000
RIt ′ 000′ 000 −
40 ′ 963′ 636
P0 = B0 + � = 3 = 2
(1 + rE )t 1.1
t=1

• Interpretation:
− The profit the firm generates is unable to cover the
shareholders’ opportunity costs.
− If the residual income is systematically negative, the firm should
probably be liquidated (or the management should be replaced).

7
Overview

• Residual Income Valuation

• Economic Value Added (EVA)

• Other (traditional) valuation methods

8
Economic Value Added (EVA)

• EVA is a measure of surplus value created on an investment.

− Define the return on capital (ROC) to be the “true” cash flow
return on capital earned on an investment.
− Define the cost of capital as the weighted average of the costs
of the different financing instruments used to finance the
investment.

EVA = (Return on capital – Cost of capital) × Invested

capital

EVAt = Operating income after taxt – Invested Capital(t-1) ×

WACC

9
EVA – Inputs

• Capital Invested: Many firms use the book value of capital invested
as their measure of capital invested. To the degree that book value
reflects accounting choices made over time, this may not be true. In
addition, the book capital may not reflect the value of intangible
assets such as research and development.
• Operating Income: Operating income has to be cleansed of any
expenses which are really capital expenses or financing expenses.
• Cost of capital: The cost of capital for EVA purposes should be
computed based on market values.
• Bottom line: If you estimate return on capital and cost of capital
correctly in DCF valuation, you can use those numbers to compute
EVA.

10
Calculation of EVA

• EVA tries to capture the firm’s economic profit, i.e., the

difference between the earnings and the costs of all input
factors.
EBIT
– Adjusted taxes [= EBIT × τC]
NOPLAT
– (Net) Invested Capital(t-1) × WACC Capital charge

EVA

• What’s new…? In particular:

− We subtract a charge for the invested capital (D+E)

11
Economic Value Added (EVA)

• EVA is a measure of dollar (or Swiss Franc) surplus value,

not the percentage difference in returns.

• It is closest in both theory and construct to the net present

value of a project in capital budgeting, as opposed to the IRR.

• The value of a firm, in DCF terms, can be written in terms of

the EVA of projects in place and the present value of the EVA
of future projects.

12
EVA and firm valuation

∞
EVA t
• Firm value = (Net) invested capital + ∑ (1 + WACC )
t =1
t

Market Value Added (MVA)

• In reality: We have seen that accounting numbers could be

biased. Since EVA is mostly based on accounting numbers,
the proponents of EVA suggest > 160 adjustments…
− Depreciation
− R&D expenses
− Transfer prices
− Overhead
− …
13
EVA – Example

• We want to estimate the value of the fictitious firm

Greenwood.

• So far, we have estimated its WACC and forecasted its

balance sheets and income statements.

− Cost of debt (𝑟𝑟𝐷𝐷 ): 5%

− Cost of equity (𝑟𝑟𝐸𝐸 ): 13.33%
− Tax rate: 𝜏𝜏𝐶𝐶
− Target debt ratio (D/(D+E))
− WACC: 9.40%

14
Forecasted balance sheets and income
statements
Balance sheet
0 1 2 3 4 5
Excess cash 0.0 0.0 0.0 0.0 0.0 0.0
Net working capital 8.0 10.0 12.0 14.0 16.0 0.0
PPE 100.0 80.0 110.0 65.0 20.0 0.0
Total assets 108.0 90.0 122.0 79.0 36.0 0.0

Interest-bearing Debt 72.0 63.1 70.6 53.1 31.1 0.0

Equity 36.0 26.9 51.4 25.9 4.9 0.0
Total liabilities and equity 108.0 90.0 122.0 79.0 36.0 0.0

Income statement
1 2 3 4 5
Sales 100.0 120.0 140.0 160.0 180.0
– COGS 50.0 60.0 70.0 80.0 90.0
– Depreciation 20.0 20.0 45.0 45.0 20.0
EBIT 30.0 40.0 25.0 35.0 70.0
– Interest payments (5%) 3.6 3.2 3.5 2.7 1.6
Earnings before taxes (EBT) 26.4 36.8 21.5 32.3 68.4
– Taxes (30%) 7.9 11.1 6.4 9.7 20.5
Net profit 18.5 25.8 15.0 22.6 47.9
– Dividends 27.6 1.3 40.5 43.6 52.8
Retained earnings -9.2 24.5 -25.4 -21.0 -4.9

15
EVA valuation

• We know that:
EVAt = NOPLATt – (Net) Invested Capital(t-1) × WACC

• What’s the (Net) Invested Capital?

− Actual amount of money, which has been invested by the firm’s
debt- and equity holders (net of repayments)
− According to today’s balance sheet:
– Interest bearing debt = 72
– Equity (share capital + retained earnings) = 36
– Hence, as of today, the providers of capital have invested 108.
– Therefore, given the WACC of 9.4%, the opportunity cost of the
invested capital is 108 × 0.094 = 10.2
– Interpretation: A NOPLAT of 10.2 would imply that the firm just
managed to cover the opportunity cost of the input factors.
16
EVA valuation

• Next, we have to compute the firm’s expected NOPLAT. We

have all the relevant information in the previous slides:
1 2 3 4 5
EBIT 30.0 40.0 25.0 35.0 70.0
– Adjusted taxes (30%) 9.0 12.0 7.5 10.5 21.0
NOPLAT 21.0 28.0 17.5 24.5 49.0
– (Net) Invested capital t–1 × WACC 10.2 8.5 11.5 7.4 3.4
EVA 10.8 19.5 6.0 17.1 45.6
At the beginning of year 2, the firm’s (Net)
invested capital is 90 (= 63.1 + 26.9). Hence, the
capital charge is 90×0.094 = 8.5

• The present value of all future EVAs is:

10.8 19.5 6.0 17.1 45.6

MVA = + 2
+ 3
+ 4
+ 5
= 71.9
1.094 1.094 1.094 1.094 1.094
17
Firm value using EVA

• Hence, the value of the firm is:

Firm value = (Net) invested capital + MVA

= 108.0 + 71.9 = 179.9

• To find the value of the firm’s equity, we can now subtract the
current value of the debt outstanding (72). Therefore:

Equity value = Firm value – Debt = 179.9 – 72.0 = 107.9

18
Residual income valuation (equity)

> We said that:

Residual income = Net income - $ cost of equity

• We already know all the ingredients!

1 2 3 4 5
Net profit 18.5 25.8 15.0 22.6 47.9
– (Net) invested equity t–1 × rkEEK 4.8 3.6 6.8 3.5 0.7
Residual income 13.7 22.2 8.2 19.2 47.3
At the beginning of year 2, the firm’s (Net)
invested equity is 26.9. Hence, the shareholders
$ opportunity cost is 26.9×0.1333= 3.6

13.7 22.2 8.2 19.2 47.3

Equity value =
36 + + + + + 107.9
=
1.1333 1.13332 1.13333 1.1333 4 1.13335

19
What about DCF?

• Using the forecasted balance sheets and income statements,

we can derive the projected free cash flows:
1 2 3 4 5
EBIT 30.0 40.0 25.0 35.0 70.0
– Adjusted taxes 9.0 12.0 7.5 10.5 21.0
NOPLAT 21.0 28.0 17.5 24.5 49.0
+ Depreciation 20.0 20.0 45.0 45.0 20.0
– Investments NUV
NWC 2.0 2.0 2.0 2.0 -16.0
Operating cash flow 39.0 46.0 60.5 67.5 85.0
– Investments 0.0 50.0 0.0 0.0 0.0
Free Cash Flow 39.0 -4.0 60.5 67.5 85.0

39 4.0 60.5 67.5 85.0

Firm value = − + + + = 179.9
1.094 1.0942 1.0943 1.0944 1.0945

Equity value = 179.9 – 72 = 𝟏𝟏𝟏𝟏𝟏𝟏. 𝟗𝟗

20
Problems with EVA

• Managers may have no incentives to invest. Investments

increase the capital charge and decrease EVA.

• EVA depends heavily on the accounting standards used.

• EVA can lead to “power games” within the firm: allocation of

costs of capital across divisions, leasing instead of buying
equipment (to decrease the capital charge), etc.

21
Which approach to use?

• In the simple example, the two valuation approaches yield the

same result because they are based on the same
assumptions.

• When it comes to EVA, the tricky part is how to measure the

(net) invested capital and how to adjust the NOPLAT (net
profit).

• We prefer the DCF approach, because it is relatively easy

to identify cash in- and outflows.

22
Overview

• Residual Income Valuation

• Economic Value Added (EVA)

• Other (traditional) valuation methods

23
Other (traditional) valuation methods

• There are some other valuation methods that are sometimes

used in practice. These are, among others,

− Net Asset Value (NAV)

− Capitalized earnings

− The practitioner’s approach

24
The (net) asset value (NAV)

• Historically, the so called (net) asset value was a popular

valuation approach among practitioners (at least in
Switzerland).

• Asset value = Book assets + Hidden reserves – Deferred taxes

• Net asset value = Asset value – Liabilities

= Book equity + Hidden reserves – Deferred taxes

25
Net asset value – example

• Consider a firm with the following balance sheet.

Assets Liabilities and equity

Cash 2,000 Bank overdraft 500
Securities 5,000 Accounts payable 1,500
Accounts receivable 1,500 Long-term debt 9,000
Office equipment 800 Common stock 7,000
Machines 10,000 Retained earnings 2,000
Other assets 700
Total assets 20,000 Total L & E 20,000

• Total assets = 20’000

• Book equity = Common stock + Retained earnings
= 7’000 + 2’000 = 9’000.

26
Net Asset Value – Example

• Suppose the firm has the following hidden reserves:

Market value Book value Hidden reserves

(1) (2) (1) – (2)
Securities 7,000 5,000 2,000
Office equipment 1,100 800 300
Machines 15,000 10,000 5,000
Total hidden reserves 7,300
Deferred taxes (20%) 1,460

• Asset value = 20,000 + 7,300 – 1,460 = 25,840

• Net asset value = 9,000 + 7,300 – 1,460 = 14,840

• Alternatively:
− Net asset value = Asset value – Liabilities = 25,840 – 11,000 = 14,840

27
Net asset value

• The method is based on book values (historical).

• In particular, it is not clear how the asset value should be measured.

− Replacement value: How much you would have to pay to construct an
identical firm
− Liquidation value: What you get when you sell the firm’s assets
(depends on how quickly you liquidate and how specific the assets are)
− How to quantify the hidden reserves?

• Bottom line:
− Can be useful when a buyer only wants parts of the company
− For a going concern valuation, however, the buyer probably wants to
know more about the prospects of the company

28
Net asset value

• In this course, we are typically interested in a going concern

valuation. Therefore, we will mostly ignore book values.

• There are some exceptions:

− Exception (1): Debt valuation in the firm’s capital structure. We
use the book value of the interest-bearing debt as a proxy for
the market value of debt
− Exception (2): Cash and other (non-operating) assets that
appear in the balance sheet at (or close to) market value

29
The capitalized earnings method

• Assumption: The assets generate a constant and sustainable

stream of earnings (normalized earnings).
Normalized future earnings
• Equity value =
Cost of capital

• Suppose the firm we considered before will generate future

earnings of 4.5 per year and the relevant discount rate is 10%

4.5
Equity value
= = 45
0.1

• Firm value = Capitalized earnings + Book Debt

= 45 + 9 = 54
30
The capitalized earnings method

• Correct mindset: Focus on the firm’s future, not its past.

• Several limitations:
− What are the «normalized» earnings?
− Constant earnings (e.g., what about inflation)?
− Do firms live forever?
− Earnings ≠ Cash flows
− Earnings = f(Accounting practices)
− What’s the discount rate?

31
The practitioners’ approach

• Idea: Both the firm’s substance and its earnings power

contribute to firm (or equity) value.

 Equity value = weighted average of NAV and capitalized

earnings. Practitioners often use 1/3 NAV and 2/3 cap. earn.
Net asset value + 2 × Capitalized earnings
Equity value =
• 3

• In the above example:

14.84 + 2 × 45
Equity value = 34.95
=
3

• Firm value = Equity value + Debt = 34.95 + 9 = 43.95

32
Remarks: Traditional valuation methods

• The «traditional» valuation techniques we considered are:

− (Net) asset value
− Capitalized earnings method
− The practitioner’s approach

• The techniques are easy to understand and easy to use.

• They rarely produce a reliable estimate of the market value of

equity (or the market value of assets), at least for a going
concern valuation.

• They treat the firm as a black box  Not a management tool.

33
Advanced Valuation
Valuation of real options

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
The setting

• Roche, a global pharmaceutical company, spent CHF 11

billion (approx. 20% of its revenues) on R&D in 2018.
• Only small number of projects ultimately reach the market.
• But those that reach market can be highly successful.
• How does Roche manage its R&D expenses to maximize
value?
• Investing in R&D is like purchasing a call option.
• By selectively investing in technologies that prove to be the
most promising, Roche exercises its option to develop a
product.

2
Overview

• Introduction and preliminaries

• The value of a real option – a simple example

• Example: Valuing a mine with a shutdown option

• Example: Options to postpone, abandon, and to default

3
DCF valuation

• Four steps in DCF valuation

− Estimation of cash flows: These are unlevered cash flows.
− Estimation of the discount rate: Should reflect a risk premium as
well as the financing structure of the project/firm.
− Estimation of the terminal value.
− Calculation of the PV of the cash flows.

4
DCF valuation – limitations

• One of the limitations of DCF analysis is that it is static and

does not do a good job of capturing the options embedded in
investment.
• The approach presents a number of additional limitations
− It ignores the flexibility in the timing of investment.
− It ignores the value of the option that might become available in
the future.
− It relies on a difficult estimation of an appropriate discount rate.

5
Options and corporate finance

• In practice the firm:

− Has a right to invest
− Can postpone the investment decision

• The traditional DCF approach also ignores the options

available to the firm in the future:
− Growth options (R&D, land, …)
− Contraction options (Reduce scale temporarily)
− Flexibility options (Switch uses, location, …)
− Option to default (on debt)
− …

6
Real options

• Real options may arise naturally in a firm due to competitive

advantages:
− Early capture of market share, high entry costs, technical
expertise, advertising, brand names, etc...

• Real options may also be purchased:

− Patents, production flexibility, rights to develop natural
resources, and various contractual real options such as
warranties, leases, or options to purchase equipment

7
Financial options vs. real options

• Real options are the right to make a particular business

decision, such as capital investment.
• Real options, and the underlying assets on which they are
based, are often not traded in competitive markets.
• However, many of the principles of financial options also
apply to real options.
− Real options allow a decision maker to choose the most
attractive alternative after new information becomes available.
− The presence of real options adds value to the investment
opportunity.
− This value can be substantial if there is a great deal of
uncertainty.

8
Overview

• Introduction and preliminaries

• The value of a real option – a simple example

• Example: Valuing a mine with a shutdown option

• Example: Options to postpone, abandon, and to default

9
Decision tree analysis – example

• EXAMPLE: Megan wants to finance part of her education by

running a small business.
• She purchases goods on eBay and resells the merchandise
at farmers’ markets.
− Farmers’ markets typically charge her CHF 500 in advance to set
up her booth.
− Ignoring the costs of the booth, if she goes to the market every
time, her average profit on the goods that she sells is CHF 1100
per meet.

10
Decision tree analysis – example

• The following decision tree represents Megan’s options:

CHF 1100 - 500 = 600

go

stay home

CHF 0

11
Decision tree analysis – example

• The attendance at the farmers’ markets depends on the

weather.
− In good weather, her profits are much higher (CHF 1500).
− In bad weather, occurring 25% of the time, business is slow, and
she makes on average a small loss of CHF 100.

• The booth fee is paid in advance; i.e., the cash flow is

incurred before Megan finds out about the weather.

12
Decision tree analysis – example

• Megan’s decision tree including the weather:

CHF 1500
sun (75%)

go
rain(25%)

CHF -100

stay home
0 CHF

13
 Decision tree analysis – example

• Megan’s decision tree when she can observe the weather

before making the decision to go to the market:
CHF 1500
go

CHF 0
stay home
sun (75%)

CHF -100
go

rain(25%)
CHF 0

NPV = 1100 - 500 = 600 CHF

Megan commits to go: 0.75 * 1500 + 0.25 * (-100) = CHF 1100 value of the real option is CHF 25

Megan participates when sun shining: 0.75 * 1500 +0.25 * 0 = 1125

NPV = 1125 - 500 = 625 14

Overview

• Introduction and preliminaries

• The value of a real option – a simple example

• Example: Valuing a mine with a shutdown option

• Example: Options to postpone, abandon, and to default

15
Valuing a mine with a shutdown option

• Consider a mine that will produce 75’000 pounds of copper

one year from now if economic conditions are favorable.

• Two possible outcomes for copper prices then:

− $0.40 per pound if demand is low
− $0.90 per pound if demand is high

• The current copper price is $0.60 per pound.

16
Valuing a mine with a shutdown option

• Suppose that:
− The risk free one year interest rate is 5%
− Extraction costs are $0.80 per pound
• What is the value of the mine:

Year 0 Year 1

Scenario 1:
Cash flow? = 75'000 * (0.9 - 0.8) = 7500
Value
Scenario 2:
Cash flow? = 0

17
Replicating portfolio

• Replicating portfolio composed of

− Copper: x pounds
− Risk-free zero coupon bonds: y dollars

• Scenario 1: 0.90𝑥𝑥 + 1.05𝑦𝑦 = $7’500 (= 75’000($0.90 − $0.80)

• Scenario 2: 0.40𝑥𝑥 + 1.05𝑦𝑦 = $0

18
Value of the mine

• Solving Yields
x = 15’000 pounds of copper
y = -$5’714.29 - extraction costs

• The value of the mine is equal to the value of the replicating

portfolio or:

𝑉𝑉 = 𝑥𝑥𝑥𝑥 + 𝑦𝑦 = 15’000 × 0.6 – 5’714.29 = 3’285.71

19
Valuing a mine: More general setup

• We have
security that mimicks the copper price

u×S = Su

S u = 1/d

d×S = Sd
and
CFu = Su * x + y(1+r)
Value?

CFd = Sd * x + y (1+r)

20
Replicating portfolio: More general setup

• Tomorrow the portfolio replicates the cash flows of the mine

𝑥𝑥𝑥𝑥𝑢𝑢 + 𝑦𝑦(1 + 𝑟𝑟) = 𝐶𝐶𝐶𝐶𝑢𝑢 𝑎𝑎𝑎𝑎𝑎𝑎 𝑥𝑥𝑥𝑥𝑑𝑑 + 𝑦𝑦(1 + 𝑟𝑟) = 𝐶𝐶𝐶𝐶𝑑𝑑

• Solving

CFu − CFd CFu − CFd 1 uCFd − dCFu

x= = , and y =
Su − Sd S(u − d ) 1+ r u−d

P=x*S+y

21
Replicating portfolio: More general setup

• Value of the portfolio today: 𝑃𝑃 = 𝑥𝑥𝑥𝑥 + 𝑦𝑦

• Therefore

1  (1 + r ) − d u − (1 + r )
Value = CFu + CFd 
1 + r  u − d u−d 

• With the correct risk neutral probabilities, the expected

cash flows of traded assets, discounted at the risk-free
rate, equals the observed market price of the traded asset.

22
 S*u

0.9

Value of the mine

u = 3/2

0.6
S*d
d = 2/3
0.4

• What are the risk-neutral probabilities in the previous

example?

P(up) = ( 1 +r -d)/(u - d) = (1.05 - 2/3)/ (3/2 - 2/3) = 0.46

P(down) = 1 - 0.46 = 0.54

• What is the value of the mine?

Value = 1/ 1+ 0.05 * (0.46*7500 + 0.54*0) = (0.46 * 7500)/ 1.05 = 3285.71

23
Overview

• Introduction and preliminaries

• The value of a real option – a simple example

• Example: Valuing a mine with a shutdown option

• Example: Options to postpone, abandon, and to default

24
Valuation of a risky project

• You can invest I = CHF 96 million in a copper project. The

present value of the cash flows from the project is currently
CHF 100 million and moves linearly with the copper price.
• In each year the copper price can move up by 25% or down
by 20%. There is an equal historical probability 𝑞𝑞 = 0.5 that
the price of copper goes up.
• The risk free one-year interest rate is 7%.
• What is the NPV of this project?

NPV = -96 +100=4

25
Option to postpone the investment
u = 1.25 d = 0.8

p(up) = (1.07 -0.8)/1.25 - 0.8 = 0.6

• Suppose that you can postpone the decision for a maximum of two
years. If you postpone, the investment expenditures increase by 8%
per year. What is the value of the project?
max( S - K,0)

don't invest
156.25
max(156.25 - 96 * 1.08^2;0) = max(44.28;0)

* 1.25 125

100
max(100 - 96 * 1.08^2 ; 0) = 0
100

80

64 max(64 - 96 * 1.08^2;0) = 0

: max(125 - 96*1.08; (44.28 * 0.6)/1.07) =0

= max(21.32; 24.83) = 24.83 : max(100 - 96; (24.83 * 0.6)/1.07) = max ( 4; 13.92) = 13.92

26
Option to abandon the project

• Suppose now that your only option is to abandon the project

during construction.
• That is, you are required to invest I₀ = CHF 16 million now
(out of the CHF 96) as a start-up cost for infrastructure and
you put the balance in an escrow account planned to be paid
as a I₁= CHF 85.6 (= CHF 80×1.07) follow up outlay for
constructing the plant.
• Next year you will then pay the installment cost only if
profitable to do so.

27
Option to abandon the project

• What is the value of the option to abandon during construction?

125 max(K - S; 0 )
max(85.6 - 125; 0)

100

80 max(85.6 - 80 ; 0 ) = 5.6
option to get rid of the project

Value of option = (5.6 * 0.4)/1.07 = 2.093

28
Option to abandon the project

• What is the value of the project with the option to abandon?

Value of project = 4 + 2.093 = 6.093

Value of project = PV of exp. CFs

= -16 + (0.6 + (125 - 85.6) +0.4 * (80-85.6))/1.07 = 6.093

29
Option to default on the firm’s debt

• Suppose that you must invest at time 0. You have issued

debt to finance the project, and your only option is to default
on the debt contract.
• Specifically, to finance the investment, you issue coupon
paying debt with face value F = 75 to be repaid at t = 2.
• Every year you make coupon payments at the rate c. At
maturity you will default if the value of assets is less than F.
• If you default on the debt contract, the debt holders get the
value of the firm's assets minus bankruptcy costs, which are
assumed to represent 50% of the value of the firm's assets.
• What is the yield on corporate debt if debt is issued at par?

30
 Option to default on the firm’s debt

• Solution:

156.25
F = 75M

0.6
84%

125
0.6

100

100

0.4

0.4
64 Default : 16%
75 = 75 * c/1.07 + (75*(1+c) * 0.84)/1.07^2 + (64 * 0.5 *0.16)/ 1.07^2

no default default
c = 12.39% 31
Valuation of the firm

• Suppose that the firm pays taxes at the rate of = 35% (and the
value of unlevered assets net of taxes is $100 million). What is the
value of the levered firm? What is the value of equity?

• Solution: Vl = Vu + PV(tax shield) - PV(BC)

100M

32
Valuation of the firm

• Solution:
PV(tax shield) = (0.1239 *75 * 0.35)/1.07 + (0.1239 * 75 * 0.35 * 0.84)/ 1.07^2 = 5.426m

PV(BC) = (64 * 0.5 * 0.16)/1.07^2 = 4.472m

Vl = 100 + 5.426 - 4.472 = 100.954m

E = Vl - D = 100.954 - 75 = 25.954m

33
Risk-neutral probabilities p = (1 + r - d)/u - d

• What happens to the risk neutral probabilities if the

underlying asset delivers a cash flow (e.g., dividend)?

E(return) = 1 +r = capital gains + dividends

S*u S*d
dividend yield
=> 1 + r = (p * Su + (1-p) * Sd)/S + delta

p = (1 + r-d - delta)/u - d

34
Advanced Valuation
Pricing of debt and equity as options

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Pricing of debt and equity

• Subordinated debt

2
Model assumptions

• Consider a firm that has assets in place with value V = (Vt)t≥0

that evolves according to the stochastic differential equation

dVt = r Vt dt + σ Vt dBt, V0 > 0

• For simplicity, assume that the firm produces no cash flows

before some fixed horizon T

• In this specification
− r is the risk-free interest rate
− σ is the constant volatility of returns on the firm’s assets
− B is a standard Brownian motion

3
Model assumptions

• Assume that the capital markets are perfect (no taxes, no

contracting costs, competitive markets, and fixed investment
policy).

• The firm has a simple capital structure with common stock

and a single debt issue outstanding.

• The debt contract

− is a zero-coupon bond
− has maturity date T
− promises a single payment F at maturity

4
Firm, equity, and debt values

• In the absence of market frictions, the market value of the

firm is V and equals the sum of equity E and debt D

E D
V =E+D

5
Payoffs to equity and debt

• The payoff of claimholders at the maturity date of the debt

contract depends on the value of the firms’ assets at that
date.

• If VT ≥ F at maturity, then the firm is worth more than the face

value of its debt. In this case, debtholders receive the full
payoff and shareholders receive the residual.

• If VT < F at maturity, then the firm is worth less than the face
value of its debt. In this case, the firm defaults and
debtholders receive the remaining asset value.

6
Payoffs to equity and debt

D
debt holders

V
F

E equity holders

V
F
7
Graphical Representation

Distribution of
asset value at
E(VT) horizon

Asset
Value

Default Point: F

Probability of default
Time
T

8
Call options

• There are other securities that have the same payoff

structure as the equity of a levered firm.

• One such security is called a call option.

• A call option gives the buyer the right, but not the obligation:
− To purchase a specific asset
− On a specified date
− At a specified price

9
Black and Scholes

• The Black and Scholes formula gives the price of a European

option prior to maturity.

• It expresses the value of a call option as a function of

− The current price of the underlying asset: S
− The exercise price of the option: K
− The time to maturity of the option: T
− The risk free interest rate: r
− The standard deviation of the return on the underlying asset: σ

10
 Black and Scholes

• The price of the option is given by the payoff of the option

discounted at the risk-free rate:

c0 = EQ [e-rT max(ST – K ; 0)F0]

with
dSt = r St dt + σ St dBt, S0 > 0

and where Q is the risk-neutral pricing measure.

11
 Black and Scholes

• When stock prices are governed by the above stochastic

differential equation, the formula for the pricing of European
options is

c0 = S N(d1) – K e-rT N(d1-σ√T)

ln(S / K ) + r × T 1
with d1 = + σ T
σ T 2

12
Value of equity

• The value of equity in a levered firm is equivalent to a call

option on the firm’s assets:

E = V N(d1) – F e-rT N(d1-σ√T)

ln(V / F ) + r × T 1
with d1 = + σ T
σ T 2

13
Value of equity: Application

• Assume that
− Firm value is V = CHF 100
− The face value of corporate debt is F = CHF 77
− The maturity of corporate debt is T=1 year
− The volatility of returns is σ = 40%
− No dividend is expected
− The risk-free rate is r = 9.54%

• The value of equity is 33.37.

14
Corporate debt

• Credit risk exists as long as the probability of default (VT<F) is

greater than zero.

• This implies that at time 0, the market value of debt is below

the discounted face value of debt:

D < Fe −rT

• This also implies that the yield to maturity on corporate debt,

YT, is higher than the risk free rate r

YT = r + risk premium

15
Value of debt

• The value of the firm’s assets is equal to the value of its

liabilities or
V=E+D

• This implies that the value of corporate debt satisfies

D=V-E
or probability of no default

D = V [1 - N(d1)] + F e-rT N(d1-σ√T)

16
Yields and spreads

• What is the yield on corporate debt?

time
Today the value is D T: Payment is F

• The market value of corporate debt is D; its face value is F;

its time to maturity is T. Therefore the yield solves
D eYT = F YTln(D) = ln(F)
Y = 1/T * ln(F)/ln(D)

• What is the credit spread on corporate debt?

CS = Y-r

17
Yields and spreads

• The default/credit spread can be computed exactly as a

function of:
− the leverage ratio
− the volatility of returns on the underlying asset
− the debt maturity T

• Using the above numerical example we find

− A credit spread equal to CS = 4.9%
− A value for equity of E = 33.37
− A value for corporate debt of D = 66.63

18
Default probabilities

• The risk-neutral default probability is given by

Pr (VT < F) = 1 - N(d1-σ√T)

• Again, this probability can be computed as a function of:

− the firm’s leverage ratio
− the volatility of returns on the underlying asset
− the debt maturity T

• Using the above numerical example we find a value of

24.45%.
19
Changing environment

Default line
V=
D buiten de eerste alles omgekeerd

D(V,F,T,σ,r)
V
F
+
E

E(V,F,T,σ,r)
V
F more time to be in the money hoe meer volatilty, meer waarde voor
call optie

20
Bond covenants

• In theory, there is no conflict of interests between

shareholders and bondholders.

• In practice: Shareholders may maximize their wealth at the

expense of bondholders
− Dividend payout: Increasing dividends significantly
− Claim dilution: Borrowing more on the same assets
− Asset substitution: Taking riskier projects than those agreed to
at the outset
− Underinvestment: Rejecting positive NPV projects and
increasing the probability of default

21
Bond covenants

• How can firms solve these problems?

• Use of bond covenants

− Dividend payout: Limits on dividends
− Claim dilution: Restrictions on financing, Security provisions
(i.e. mortgage loans)
− Asset substitution: Limitations on financial assets, Max.
leverage ratio or Min. interest coverage ratio, convertible debt
− Underinvestment: Restrictions on financing (e.g. allow the firm
to issue high seniority claims)

22
Overview

• Pricing of debt and equity

• Subordinated debt

23
Subordinated debt

• Suppose the firm has two debt issues outstanding with equal
maturity T: A senior debt with face value FS and a junior debt
with face value FJ.
• The priority structure refers to the cash flows of claimholders
in default.
• At the maturity date, we have

Claims V< FS FS <V< FS + FJ V>FS + FJ

Senior bonds V FS FS
Junior bonds 0 V- FS FJ
Stock 0 0 V- FS - FJ

24
Subordinated debt

• Payoff of the senior bond

FS

VT
FS
25
Subordinated debt

• Payoff of the junior bond

FJ

VT
FS FS +FJ
26
Subordinated debt

• Payoff of the total debt

FS +FJ

VT
FS FS +FJ
27
Subordinated debt

E
V = E (V, FS, FJ, T, σ², r)

V
FS FS+FJ

DJ
+ DJ (V, FS, FJ, T, σ², r)

V
FS FS+FJ
DS
+ DS (V, FS, FJ, T, σ², r)
V
FS FS+FJ
28
Subordinated debt

• The price of senior debt is given by

DS = V [1 - N(d1)] + FS e-rt N(d1-σ√T)
where
ln(V / FS ) + r × T 1
d1 = + σ T
σ T 2

• The price of total debt is given by

TD = V [1 - N(d3)] + (FS+FJ) e-rt N(d3-σ√T)
where  V 
ln  + r ×T
 FS + FJ  1
d3 = + σ T
σ T 2
• The price of junior debt is given by: DJ = TD – DS.
29
Subordinated debt

• Assume that:
− Firm value is V = CHF 100 and no dividend is expected
− The face value of corporate debt is FJ = CHF 27 and FS = CHF
50,
− The maturity of corporate debt is T = 1 year,
− The volatility of returns is σ = 40%
− The risk-free rate is r = 9.54%

• The value of
− Junior debt is DJ = CHF 21.42 and its yield is YJ = 23.16%
− Senior debt is DS = CHF 45.21 and its yield is YS = 10.07%
− Total debt is TD = CHF 66.63 and its yield is Y = 14.47%

30
Valuation
Venture Capital

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Venture capital valuation

• Young firms often raise equity from venture capitalists.

• How does a venture capitalist asses the value of these
firms?
• They would typically use what is called the “VC method”.
− Earnings of the private firm are forecast in a future year when
the company can be expected to go public.
− These earnings, in conjunction with a multiple based on publicly
listed firms in the same business, are used to assess the value
at the time of IPO: this is the exit or terminal value.
− Discount the value back using a “target” or discount rate.

2
VC method – example

• A startup wants to raise CHF 6.7 million from a venture

capitalist to market a novel vaccine against the hay fever.
• Both parties agree that the firm will be able to earn a net
income of CHF 15 million within 5 years. They also know that
profitable pharmaceutical companies currently trade at a
forward P/E-ratio of 12.
• What’s the value of the company if the venture capitalist
requires an annual rate of return of 40%?
• Which share in capital will the VC require?
• How many shares will the company issue if there are
currently 100’000 shares outstanding? And what’s the fair
share price?

3
Summary of the relevant information

Capital requirements 6.7 million

Exit date 5 years from now
Expected net income year 5 15 million
P/E-Ratio of comparable firms (Forward) 12
The VC’s cost of capital (p.a.) 40%
Shares outstanding 100'000

4
The VC’s valuation

• Based on this information, we can estimate the firm’s exit

value:
Exit value5 = Net income5 × P/E-Ratio (forward)
= 15 × 12 = 180

• Interpretation: The VC thinks that the firm’s value will be 180

million 5 years from now.
Exit value 180
= T
= 33.5 million.
• PV(Exit value) = (1 + Required Return ) 1.4 5

• This is the VC’s so-called post-money valuation: The value

can only be achieved if the VC actually invests the 6.7 million.

5
Pre- and post-money valuation

• The pre-money valuation is the post-money valuation net of

the required investment:

Pre-money valuation = Post-money valuation – Capital needs

= 33.5 – 6.7 = 26.8

• Interpretation: The pre-money valuation is positive. In

principle, the company seems to be a good investment.

• According to the VC-method, the pre-money valuation is the

current value of the company.

6
The required share in capital

• The VC has to invest 6.7 million. Which share of capital will she
request in return?

• She wants to make sure that the NPV is positive:

Capital invested ≤ %share in capital × PV(post-money valuation)

• That is: %Share in capital ≥ Capital invested 6.7

= 0.2 =
= 20%
PV ( post-money valuation ) 33.5

• Interpretation: If the VC receives a share of capital of 20%, the

PV of the expected payoff at maturity is equal to the capital
invested (NPV-zero project with r = 40%).

7
The relevant number of shares

• Given that the number of shares outstanding is 100’000, how many

shares should the VC receive?
• Note that the 100’000 shares are not owned by the company, but by
its shareholders.
• The company has to increase its capital, it has to issue new shares.
The VC wants to control 20% of all the shares outstanding:

New shares = Share in capital × (Shares outstanding + New shares)

Share in capital × Shares outstanding 0.2 × 100 '000
New shares
= = = 25 '000
1 − Share in capital 1 − 0.2

• The firm issues 25’000 new shares. The number of shares

outstanding grows to 125’000 and the VC controls 20% [=25/125].

8
The fair share price

• Now we know that the VC will invest 6.7 million and receive
25’000 shares in return. This implies a share price of:

Capital invested 6 '700 '000

• Share
= Price = = 268.
New shares 25 '000

9
Are we done?

• Not quite…

• What happens if the firm has to raise additional capital or hire

new employees (who require an equity stake) over the next
five years?

• As soon as the firm issues new shares, the VC’s share in the
capital declines. This is the so-called dilution.

• The VC wants protection against dilution.

− Contractual clause
− Higher share in capital
10
Example (revised)

• Let’s go back to our pharmaceutical company. The VC and

the entrepreneur still think that it is reasonable to expect a net
income of 15 million in year 5 (and, hence, an exit value of
180 million).

• However, the VC thinks that the firm will have to launch a

major marketing campaign to actually reach this ambitious
target. To this end, it will have to:
− Hire a marketing guru, who wants a share of 10%;
− Raise additional capital for an additional 20%

• How does this information affect the VC’s claims?

11
Solution

• From before, we know that the VC wants a share in the capital

of 20% at the time of exit. An additional 10% and 20% will be
controlled by the marketing guru and the new investor,
respectively.

• Hence, the incumbent shareholders will only control 50% at

the time of exit.

• Currently, they own 100’000 shares. This implies, that the

company will have 200’000 shares outstanding 5 years from
now.

• Knowing this, the VC will ask for 40’000 shares [0.2×200’000].

12
Solution (cont’d)

• Step 1: The firm issues 40’000 shares and sells them to the
VC for a total of 6.7 million. This implies a share price of:
Capital invested 6 '700 '000
Share
= Price = = 167.5.
New shares 40 '000

Initially, the VC will control 28.57% of the firm [= 40/140].

• Before entering the market, the firm will issue another 60’000
shares to the marketing guru (20’000) and the new investor
(40’000).

• Hence, the number of shares outstanding goes up to 200’000.

13
Solution (cont’d)

• At maturity, the value of the company will be 180 million (see

before).

• Given 200’000 shares outstanding, the share price will be

900 [=180’000’000/200’000].

• Hence, the VC’s investment went up from 167.5 to 900 in 5

years. This increase corresponds to an annual rate of return
of 40%:

167.5 × 1.45 = 900.

14
VC method

• Obviously, the VC-method per se is pretty straightforward

(computing the required stakes and protecting against dilution
is a bit more complicated).

• It is therefore not surprising that this method is very popular.

• Potential problems:
− The way we used the approach, we applied a current multiple to
an expected net income (5 years from now!). What if the market
conditions change?
− We still need to forecast the balance sheets and income
statements…
− How can discount rates of 40% or more be justified???
15
Valuation
Valuing private firms

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Latest statistics on corporate Switzerland (2019
data, updated Nov. 2021)

Size cluster (employees) # of establishments % of total # of employees % of total

Micro enterprises (up to 9) 539'604 89.73% 1'168'809 25.57%

Small enterprises (10 to 49) 50'758 8.44% 979'464 21.43%
Medium enterprises (50 to 249) 9'324 1.55% 920'856 20.15%
Total SME (up to 250) 599'686 99.72% 3'069'129 67.15%
Large firms (251 and more) 1'706 0.28% 1'501'541 32.85%
Total 601'392 100.00% 4'570'670 760.02%
Source: Federal Statistical Office
Overview

• What makes private firms different?

• Estimating the cost of capital for a private firm

• Estimating cash flows for a private firm

• Illiquidity discounts

• Valuation motives

3
What makes private firms different

• The process of valuing private companies is not different

from the process of valuing public companies. You estimate
cash flows, attach a discount rate based upon the riskiness of
the cash flows and compute a present value. As with public
companies, you can either value
− The entire business, by discounting cash flows to the firm at
the cost of capital.
− The equity in the business, by discounting cash flows to equity
at the cost of equity.
• When valuing private companies, you face two standard
problems:
− There is no market value for either debt or equity.
− The financial statements are likely to go back fewer years,
have less detail and have more holes in them.
4
No market values

• Market values as inputs: Since neither the debt nor equity

of a private business is traded, any inputs that require them
cannot be estimated.
− For example, cost of capital calculation.

• Market value as output: When valuing publicly traded firms,

the market price operates as a measure of reasonableness.
In private company valuation, the value stands alone.

• Market price-based risk measures, such as beta and bond

ratings, will not be available for private businesses.

5
Cash flow estimation problems

• Shorter history: Private firms often have been around for

much shorter time periods than most publicly traded firms.
There is therefore less historical information available.
• Different Accounting Standards: The accounting
statements for private firms are often based upon different
accounting standards than public firms, which operate under
much tighter constraints on what to report and when to report.
• Intermingling of personal and business expenses: In the
case of private firms, some personal expenses may be
reported as business expenses.
• Separating “Salaries” from “Dividends”: It is difficult to tell
where salaries end and dividends begin in a private firm,
since they both end up with the owner.

6
Overview

• What makes private firms different?

• Estimating the cost of capital for a private firm

• Estimating cash flows for a private firm

• Illiquidity discounts

• Valuation motives

7
Discount rates

• The value of a private firm is the present value of expected

cash flows, discounted back at the appropriate discount rate.

• The fundamental definition of the cost of capital is the same

as for publicly traded firms.

• What may differ is how we estimate the inputs.

• With the absence of historical prices, we cannot estimate

betas based on historical returns.

• But for the cost of equity, we can still use bottom-up betas.

8
Cost of equity

• In the bottom-up beta calculation, we have to adjust the

unlevered betas for financial leverage.
bottom-up beta

𝐷𝐷
𝛽𝛽𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = 𝛽𝛽𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 × (1 + (1 − 𝜏𝜏) × )
𝐸𝐸

• The problem is that we do not observe a market debt-to-

equity ratio for the private firm.

• What can we do?

− (Use book value debt-to-equity ratio)
− Use the industry’s average market debt-to-equity ratio
− Use the private firm’s target debt-to-equity ratio
9
Cost of equity Re = Rf + beta * (Rm - Rf)

• We can adjust the beta computation to bring in non-

diversifiable risk.

• We define market beta as:

𝜌𝜌𝑗𝑗𝑗𝑗 𝜎𝜎𝑗𝑗
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 =
𝜎𝜎𝑚𝑚

− 𝜌𝜌𝑗𝑗𝑗𝑗 : correlation between stock return 𝑖𝑖 and index return 𝑚𝑚

− 𝜎𝜎𝑗𝑗 : standard deviation of stock 𝑖𝑖
− 𝜎𝜎𝑚𝑚 : standard deviation of market index

10
Cost of equity – total beta

• To measure exposure to total risk, as opposed to only

market risk, we divide the market beta by 𝜌𝜌𝑗𝑗𝑗𝑗 .

𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝜎𝜎𝑗𝑗

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = =
𝜌𝜌𝑗𝑗𝑗𝑗 𝜎𝜎𝑚𝑚

• The total standard deviation of the private firm’s equity value

is scaled against the market index’s standard deviation.

• Intuitively, the total beta scales the beta to reflect all risk in
the firm and not just the portion of the risk that is market risk.

11
Cost of equity – total beta

Source: Damodaran
12
Cost of equity – example

• Example: Chez Pierre is a privately held restaurant. The

unlevered beta of publicly traded restaurants is 1.21. The
average correlation coefficient for these publicly traded firms
with the market is 0.4841. Chez Pierre faces a marginal tax
rate of 40%, and the industry’s average debt-to-equity ratio is
22.08%.

• Estimate the total levered beta for Chez Pierre.

Total beta = 1.21/0.4841 = 2.5

Beta levered = 2.5 * (1 + (1-0.4) * 0.2208) = 2.83

Re = Rf + Beta levered * (Rm - Rf) + size premium + illiquidity premium

13
Cost of debt

• Private firms generally are not rated and do not have bonds
outstanding.
• So, we cannot rely on this information to compute the
firm’s cost of debt.
− If the firm has borrowed money recently, we can use the
interest rate on the borrowing as a cost of debt. Simply
computing interest expense/book debt is a poor approximation.
− If the firm is valued for an IPO, we can assume that the cost of
debt will move toward the average cost of debt for the industry.
− The firm typically has reported operating income and lease or
interest expenses. That is, we can compute the interest
coverage ratio and infer the rating and the corresponding
cost of debt from available tables.

14
Cost of debt – example

• Example: Chez Pierre has an operating income of $400’000

and its annual lease and interest expenses are $120’000.

• The interest coverage ratio therefore is 3.33.

• Suppose the risk-free rate is 3.5%, an interest coverage ratio

of 3.33 corresponds to a synthetic rating of BB, and the
spread for a BB rated bond is 4%.

• The after-tax cost of debt therefore is:

Rd = (0.035 + 0.04) * (1-0.4) = 4.5% + 2%

15
Cost of debt

• The approach of using the interest rate coverage may

underestimate the cost of debt if banks charge higher
interest rates for private firms than for otherwise similar
publicly traded firms.

• You could add an additional spread to reflect this difference

if you were valuing the firm for sale in a private transaction,
but not if you were valuing it for sale to a publicly traded firm
or an IPO.

16
Debt ratios

• For the cost of capital calculation, we need the market value

weights of debt and equity.

• For private firms, this is not available.

• Proceed as with the re-levering of betas:

− Use industry-averages for the debt and equity ratios
− Use a target capital structure

• It is important to be consistent – use the same approach that

you used to re-lever the beta.

17
Overview

• What makes private firms different?

• Estimating the cost of capital for a private firm

• Estimating cash flows for a private firm

• Illiquidity discounts

• Valuation motives

18
Cash flows

• The definitions of the cash flows to equity and cash flow to

the firm are identical for both private and publicly traded
firms.

• Three issues that affect the estimation of cash flows for

private firms:

− Salaries of owner-managers
− Intermingling of personal and business expenses
− Taxes

19
Owner salaries and equity cash flows

• Many owners do not distinguish between income that they

receive as dividends and income obtained as salaries.

• In valuation, we draw a simple distinction.

− Salaries: Compensation for professional services rendered to

the firm. Should be treated as operating expense.
− Dividends: Returns on equity capital invested.

• Owners often indifferent between receiving salary or dividend

because tax treatment is the same.

20
Owner salaries and equity cash flows

• For valuation purposes, we need to estimate the

appropriate compensation for the owner-manager, based
on the role she plays in the firm.

• If the owner of a firm plays several roles – accountant,

cashier, salesperson etc., the salary would have to include
the cost of hiring a person or outside entity to provide the
same services.

21
Mixing of personal and business expenses

• Because owners often have absolute power in small private

businesses, the mixing up of personal and business
expenses is a problem. E.g.:

− Office in their residence

− Car used for business and private purposes
− Family members are hired to fill phantom positions…

• Getting the correct information is not always easy…

22
Tax effects

• In valuing publicly traded firms, we centered around the

marginal corporate tax rate.

• The differences in tax rates across potential buyers of a

private firm can be substantial.
− Corporate tax rate if buyer is a corporation.
− Highest marginal tax rate for individuals if buyer is a private
wealthy individual.
− Zero if buyer is an individual with lower income or non-profit.

• The tax rate will affect both after-tax cash flows and the cost
of capital.

23
Cash flows – example

• Example: At Chez Pierre, the owner is not paying himself a

salary. We add $150’000 to wages to reflect this expense.

• We also convert the operating lease into financial expenses,

by capitalizing the lease commitments.
− $120’000 per year for the next 12 years
− PV of lease payments at 7.5% cost of debt: $928’233
− Imputed interest expenses: 928’233×0.075 = $69’617
− Imputed depreciation: Current year’s lease expense – imputed
interest expense = $120’000 - $69617 = $50’383

• The following table summarizes these changes.

24
Cash flows – example

• Chez Pierre’s adjusted operating and net income:

Stated Adjusted
Revenues 1200 1200
- Operating lease expenses 120 0 Leases are financial expenses
- Wages 200 350 Add the wage of the Chef
- Material 300 300
- Other operating expenses 180 180
- Imputed depreciation 0 50.38 Subtract imputed depreciation on leased asset
Operating income 400 319.62
- Interest expenses 0 69.62
Taxable income 400 250.0
- Taxes 160 100.0
Net income 240 150.0

Debt 0 928.23 PV of 120 million for 12 years @7.5%

25
Growth

• In estimating growth, there is again less information available

than for publicly traded firms.

• Therefore, we should rely more on fundamentals:

Expected growth rate = Reinvestment rate × Return on capital

• We can look at both histories of private firms and the industry

average for publicly traded firms in the same business.

26
Persistence of growth

• For publicly traded firms, we typically assume infinite lives.

• With private firms, this perpetual life assumption must be

made with more caution.

• The transition from an owner-manager to the next is much

more complicated than for a publicly traded company with a
professional management.

• The implication is that the terminal value will be lower than

for a publicly traded firm.
− If the owner-manager retires and business closes at that point in
time, we would use a liquidation value for the assets as
terminal value.
27
“Key person” effect on value

• Private firms sometimes heavily depend on one or a few

“key” people.
− E.g., well known chef/owner of a restaurant

• If this key person leaves, the value of a business can change

significantly.

• To assess a key person discount in valuations, we can

first value the firm with the status quo (including key people),
and then value again with the loss built into the revenues,
earnings, and expected cash flows.
− E.g., 20% drop in expected operating income when the chef
departs, drop in adjusted operating income from 319.6k to
255.7k.
28
Assumptions about the fundamentals

• To complete valuation, we need to assume an expected growth

rate. We need to make sure that these assumptions are consistent
with the reinvestment assumptions.
• In the long term,

− Reinvestment rate = Expected growth rate/Return on capital

• We assume a 2% growth rate in perpetuity and a 20% return on

capital.

− Reinvestment rate = g / ROIC = 2%/ 20% = 10%

• Even if the restaurant does not grow in size, this reinvestment is

what you need to make to keep the restaurant both looking good
(remodeling) and working well (new ovens and appliances).

29
Valuing the restaurant

• Inputs to valuation
− Adjusted EBIT = $ 255,700
− Tax rate = 40%
− Cost of capital = 13.25%
− Expected growth rate = 2%
− Reinvestment rate (RIR) = 10%

• Value of the restaurant = Expected FCFF next year / (r – g)

= 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 × 1.02 × (1 − 𝑡𝑡𝑡𝑡𝑡𝑡) × (1 − 𝑅𝑅𝑅𝑅𝑅𝑅)/ (𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 – 𝑔𝑔)

= 255,700 × (1.02) (1 − 0.4) (1 − 0.10)/ (0.1325 − 0.02)

= $1.252m
30
Overview

• What makes private firms different?

• Estimating the cost of capital for a private firm

• Estimating cash flows for a private firm

• Illiquidity discounts

• Valuation motives

31
Illiquidity discounts

• Try selling paintings, vintage cars, and rare coins.

• Try selling illiquid stocks.

32
How high is the illiquidity discount?

• In private company valuation, illiquidity is a constant

theme. All the talk, though, seems to lead to a rule of thumb.
The illiquidity discount for a private firm is between 20-30%
and does not vary much across private firms.
• But illiquidity should vary across:
− Companies: Healthier and larger companies, with more liquid
assets, should have smaller discounts than money-losing
smaller businesses with more illiquid assets.
− Time: Liquidity is worth more when the economy is doing badly,
and credit is tough to come by than when markets are booming.
− Buyers: Liquidity is worth more to buyers who have shorter time
horizons and greater cash needs than for longer term investors
who don’t need the cash and are willing to hold the investment.

33
Estimation of an illiquidity discount

• Restricted stock: These are stock issued by publicly traded

companies to the market that bypass the official registration
process, but the stock cannot be traded for one year after the
issue.
• Pre-IPO transactions: These are transactions prior to initial
public offerings where equity investors in the private firm buy
(sell) each other’s stakes.
• In both cases, the discount is estimated to be the difference
between the market price of the liquid asset and the observed
transaction price of the illiquid asset.
− Discount Restricted stock = Stock price – Price on restricted
stock offering
− Discount IPO = IPO offering price – Price on pre-IPO
transaction
34
Evidence on the illiquidity discounts

• Evidence from aggregate discount studies:

− Maher examined restricted stock purchases made by four

mutual funds and concluded that they traded an average
discount of 35.43% on publicly traded stock in the same
companies.
− Moroney reported a mean discount of 35% for acquisitions of
146 restricted stock issues by 10 investment companies.
− In a study of restricted stock offerings Silber finds that the
median discount for restricted stock is 33.75%.

35
The bid-ask spread

• In the case of limited liquidity market makers require a

larger compensation in the form of a wider bid-ask spread.
• SIX stocks and their recent bid-ask spreads (daily average):

Smallest average bid-ask spreads Highest average bid-ask spreads

ROCHE GS 0.088% WALTER MEIER I 3.352%
NOVARTIS N 0.089% COS I 3.495%
NESTLE N 0.094% BIG STAR I 3.888%
SWISS RE N 0.123% LOEB PS 3.963%
UBS N 0.124% SCHLATTER N 4.001%
ZURICH ALLIED N 0.187% NETSTAL I 4.031%
CS GROUP N 0.191% VETROPACK I 4.070%
ABB LTD N 10 0.196% GAVAZZI -B- I 5.441%
HOLDERBK I 0.223% AGEFI N 6.259%

Average 0.153% 4.419%

Standard Deviation 0.054% 0.999%

36
The bid-ask spread

• All traded assets are illiquid. The bid-ask spread, measuring

the difference between the price at which you can buy and
sell the asset at the same point in time, is the illiquidity
measure.
• An investor who buys an asset, changes his or her mind, and
decides to sell the asset immediately will pay the bid-ask
spread.
• While the bid-ask spread might only be CHF 0.25, it looms as
a much larger cost when it is stated as a percent of the price
per unit.
− For a stock that is trading at CHF 2, with a bid-ask spread of
CHF 0.25, this cost is 12.5%.

37
The bid-ask spread

• We can regress the bid-ask spread (as a percent of the price)

against variables that can be measured for a private firm
(such as revenues, cash flow generating capacity, type of
assets, variance in operating income) and are also available
for publicly traded firms.
• For example, regress the bid-ask spread against annual
revenues, a dummy variable for positive earnings (DERN: 0 if
negative and 1 if positive), cash as a percent of firm value
and trading volume (results for NASDAQ stocks):

Bid − Ask Spread

= 0.145 − 0.0022 ln Annual Revenues − 0.015 DERN
Cash
− 0.016 Value − 0.11 ($ Monthly trading volume/ Firm Value)
Firm

38
The bid-ask spread

• Example: What is the illiquidity discount for Chez Pierre?

Assuming revenues of $1.2 Mio., positive earnings, a cash-
to-firm value ratio of 3%, we can plug in the numbers into the
equation on the previous slide:

Bid − Ask Spread

= 0.145 − 0.0022 ln 1.2 − 0.015 1 − 0.016 0.03 − 0.11 0 = 0.1291
= 12.91%

39
Overview

• What makes private firms different?

• Estimating the cost of capital for a private firm

• Estimating cash flows for a private firm

• Illiquidity discounts

• Valuation motives

40
Motive matters

• You can value a private company for

− ‘Show’ valuations
– Curiosity: How much is my business really worth?
– Legal purposes: Estate tax and divorce court

− Transaction valuations
– Sale or prospective sale to another individual or private entity
– Sale of one partner’s interest to another
– Sale to a publicly traded firm

− As prelude to setting the offering price in an initial public offering

41
Motive matters

• You can value a division or divisions of a publicly traded firm

− As prelude to a spin off

− For sale to another entity

− To do a sum-of-the-parts valuation to determine whether a firm

will be worth more broken up or if it is being efficiently run.

42
Different valuation motives

• Private to private transactions: You can value a private

business for sale by one individual to another.

• Private to public transactions: You can value a private firm

for sale to a publicly traded firm.

• Private to IPO: You can value a private firm for an initial

public offering.

• Private to VC to Public: You can value a private firm that is

expected to raise venture capital along the way on its path to
going public.

43
Private to private transaction

• In private-to-private transactions, a private business is sold

by one individual to another. There are three key issues that
we need to confront in such transactions:
− Neither the buyer nor the seller is diversified. Consequently,
risk and return models that focus on just the risk that cannot be
diversified away will seriously underestimate the discount rates.
− The investment is illiquid. Consequently, the buyer of the
business will have to factor in an “illiquidity discount” to estimate
the value of the business.
− Key person value: There may be a significant personal
component to the value. In other words, the revenues and
operating profit of the business reflect not just the potential of
the business but the presence of the current owner.

44
Private to public transaction

• The key difference between this scenario and the previous

scenario is that the seller of the business is not diversified
but the buyer is (or at least the investors in the buyer are).
Consequently, they can look at the same firm and see very
different amounts of risk in the business with the seller seeing
more risk than the buyer.

• The cash flows may also be affected by the fact that the tax
rates for publicly traded companies can diverge from those of
private owners.

• Finally, there should be no illiquidity discount to a public

buyer, since investors in the buyer can sell their holdings in a
market.
45
Private to IPO transaction

• In an initial public offering, the private business is opened up

to investors who clearly are diversified (or at least have the
option to be diversified).

• There are control implications as well. When a private firm

goes public, it opens itself up to monitoring by investors,
analysts and market.

• The reporting and information disclosure requirements shift to

reflect a publicly traded firm.

46
Estimation inputs and valuation motives

Valuation for sale to Valuation for sale to

private entity publicly traded firm or
for an IPO
Cost of equity Based on total beta, with Based on market beta,
correlation reflecting since marginal investor
diversification of is diversified
potential buyer
Cost of debt May reflect additional Based on synthetic
spread for private firm rating
Operating cash flows Private business tax rate Corporate marginal tax
rate
Firm life Finite life terminal value Perpetual life when
or liquidation value estimating terminal
value
Illiquidity discount Value discounted for No illiquidity discount
illiquidity
47
Example

• Assume that you have a private business operating in a

sector, where publicly traded companies have an average
beta of 1 and where the average correlation of firms with the
market is 0.25. Consider the cost of equity at three stages
(risk-free rate = 4%; market risk premium = 5%):
− Stage 1: The nascent business, with a private owner, who is
fully invested in that business.
– Perceived Beta = 1/ 0.25 = 4
– Cost of Equity = 4% + 4 ×(5%) = 24%
− Stage 2: Angel financing provided by specialized venture
capitalist, who holds multiple investments, in high technology
companies. (Correlation of portfolio with market is 0.5)
– Perceived Beta = 1/0.5 = 2
– Cost of Equity = 4% + 2 (5%) = 14%

48
Example

− Stage 3: Public offering, where investors are retail and

institutional investors, with diversified portfolios:
– Perceived Beta = 1
– Cost of Equity = 4% + 1 (5%) = 9%

• Assume that this company will be fully owned by its current

owner for two years, will access the technology of the venture
capitalist at the start of year 3 and that is expected to either
go public or be sold to a publicly traded firm at the end of
year 5.

49
Example

Source: Damodaran
50
Wrap up

• The value of a private business will depend on the potential buyer.

• If you are the seller of a private business, you will maximize value, if
you can sell to
− A long-term investor
− Who is well diversified (or whose investors are)
− And does not think too highly of you (as a person)
• If you are valuing a private business for legal purposes (tax or
divorce court), the assumptions you use and the value you arrive at
will depend on which side of the legal divide you are on.
• Always keep in mind that the owner of a private business has the
option of investing his wealth in publicly traded stocks. There has to
be a relationship between what you can earn on those investments
and what you demand as a return on your business.

51
Advanced Valuation
Mergers & Acquisitions

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Background on mergers & acquisitions

• Acquisition motives

• Deal valuation

• Deal making

• Takeover defenses

2
Mergers & Acquisitions (1985 – 2021)

Source: imaa-institute.org
Background

• Mergers & Acquisitions are part of what is often referred to as

“the market for corporate control”.
• There are two primary mechanisms by which ownership and
control of a public corporation can change:
− A corporation (or a group of individuals) can acquire the target
firm
− The target firm can merge with another firm
• In both cases, the acquiring entity must purchase the stock
or existing assets of the target either for cash or for
something of equivalent value (such as shares in the
acquiring or newly merged corporation).

4
Stock returns around acquisition
announcements

Badly managed AG

CHF 30

Investor

restructuring
CHF70
Sell? Don't sell? At CHF 50? Every shareholder would want the restructering to take place, however you don't
Source: Damodaran want to sell your own share. If everyone thinks that way you have a problem
5
Types of mergers

• There are different types of mergers:

• Horizontal merger: The target and acquirer are in the same

industry.

• Vertical merger: The target‘s industry buys or sells to the

acquirer‘s industry

• Conglomerate merger: The target and acquirer operate in

unrelated industries (fallen out of favor).

6
Background: acquiring a listed company

• Once the acquirer has completed the valuation process, it is

in the position to make a tender offer – that is, a public
announcement of its intention to purchase a large block of
shares for a specified price.

• A bidder can use either of two methods to pay for the target:
cash or stock.
— In a cash transaction, the bidder simply pays for the target,
including any premium, in cash.
— In a stock-swap transaction, the bidder pays for the target by
issuing new stock and giving it to the target shareholders.

7
Background: acquiring a listed company

• For a merger to proceed, both the target and acquiring board

of directors must approve the deal and put the question to a
vote of the shareholders of the target.
− Friendly takeover: Target board of directors supports the
merger.
− Hostile takeover: The board of directors (together with upper-
level management) fights the takeover attempt. In such a case,
the acquirer is often called a raider.

• If shareholders of a target company receive a premium over

the current market value of their shares, why would a board
of directors ever oppose a takeover?

8
Overview

• Background on mergers & acquisitions

• Acquisition motives

• Deal valuation

• Deal making

• Takeover defenses

9
Acquisition motives

• Most acquirers pay a substantial acquisition premium (ca.

40% for all US deals between 1980 and 2020).
• At the same time, for most investors an investment in the
stock market is a zero-NPV investment.
• How, then, can an acquirer pay a premium for a target and
still satisfy the requirement that the investment is a positive
NPV- investment opportunity?

10
Acquisition motives

• Most acquirers pay a substantial acquisition premium (ca.

40% for all US deals between 1980 and 2020).
• At the same time, for most investors an investment in the
stock market is a zero-NPV investment.
• How, then, can an acquirer pay a premium for a target and
still satisfy the requirement that the investment is a positive
NPV- investment opportunity?

⇒ Acquirer might be able to add economic value, as a result of

the acquisition, that an individual investor cannot add.
⇒ Synergies: cost reduction and revenue enhancement

11
Acquisition motives

• Acquire undervalued firms?

• Economies of scale and scope? all valid

• Vertical integration?

• Expertise?

12
Acquisition motives

• Monopoly gains?

• Efficiency gains?

• Diversification?
not very good motive

• EPS growth? not very good motive

13
Acquisition motives: Example EPS

• Example:
− Consider two corporations that both have earnings of 5 EUR per
share.
− The first firm, OldWorld Enterprises, is a mature company with
few growth opportunities. It has 1 million shares outstanding,
priced at 60 EUR per share.
− The second company, NewWorld Corporation, is a young
company with much more lucrative growth opportunities.
Consequently, it has a higher value: Although it has the same
number of shares outstanding, its stock price is EUR 100 per
share.
− Assume NewWorld acquirers OldWorld using its own stock, and
the takeover adds no value.

14
Acquisition motives: Example EPS

• Example continued:
− In a perfect market, what is the value of NewWorld after the
acquisition?
Post-takeover value = 160m EUR

− At current market prices, how many shares must NewWorld

offer to OldWorlds‘ shareholders in exchange for their shares?

Issue 600 000 shares at 100 EUR. Each shareholder at OldWorld gets 0.6 share of NewWorld per share of Oldworld

15
Acquisition motives: Example EPS

• Example continued:
− What are NewWorld‘s earnings per share after the acquisition?
EPS = 10m/1.6m = 6.25 EUR

• The EPS of the merged company can exceed the premerger

EPS of either company, even when the merger itself
creates no economic value.

16
Acquisition motives

• Control?
majority shareholders extract value from minority interests

• Managerial motive to merge

− Conflicts of interest
Managers want to work for bigger companies -> slack creation

− Overconfidence
managers are quick to think another company is badly managed

17
Overview

• Background on mergers & acquisitions

• Acquisition motives

• Deal valuation

• Deal making

• Takeover defenses

18
Steps in a deal valuation

• Step 1: Stand-alone valuation of the acquirer and the target

− Assume that the firms will continue to operate the way they are
currently operating

• Step 2: Include expected synergies

− Estimate sources and destroyers of value as well as the
implementation costs
− Determine the value of the merged company, including
synergies.
− Estimate the value of net synergies:

Net synergies = Value of the merged companies (incl.

synergies) – Stand-alone values of acquirer and target

19
Steps in a deal valuation

• Step 3: Determine the initial offer price for the target firm
− Estimate the minimum and maximum purchase price range
− Determine the amount of synergy (in%) the acquirer is willing to
(or has to) share with the target shareholders
− Determine the appropriate composition of the offer price (cash,
stock or combination)

• Step 4: Determine the combined firm’s ability to finance

− Estimate the impact of alternative financing structures
− Select the appropriate financing structure

20
Steps in a deal valuation

• We know how to do step 1

− DCF, relative valuation, option pricing, etc.

• We also know how to value synergies (step 2):

− Either value them explicitly (in particular, map the expected
cash flows due to synergies and/or the impact on the cost of
capital)
− Or project the merged company

• In what follows, we will focus on how to set a price (amount

and structure) and how the market is expected to react.

21
Example

• Consider a very simplified case:

Acquirer Target
Stand-alone value ($M) 1’600 200
Shares outstanding ($M) 100 10
Share price 16 20

Moreover, we know that the parties expect (net) synergies of 500

from the merger.
• Are we done? Not quite:
− We need to know how much the acquirer actually has to pay
− We need to know how the price will be paid
− We need to know the impact of the transaction on the firm’s ownership
structure
− We need to know the impact of the transaction on the firm’s valuation
22
The purchase price range

• The range between the minimum price the target requires and the
maximum the acquirer is willing to pay.

• Minimum price:
− Based on the information we have: The current market value of the
target company, i.e., 200 million
− More generally, the minimum price is the best alternative the target can
get if there is no agreement with the acquirer
• Maximum price:
− The acquirer is not willing to pay more than 700 million, i.e., the target’s
stand-alone value (200) plus all expected synergies (500)

• Therefore, the purchase price range is 200 to 700 million. Inside

this range, the transaction creates value to both the acquirer and
the target!
23
The initial offer price

• Let’s assume that the acquirer is willing to share 50%, or 250

million, of the expected synergies with the target shareholders.
• Therefore, the offer price is 450 million
− 200 million from the stand-alone valuation (minimum price)
− 250 million in net synergy (50% of the 500 million)

• Put differently, the target shareholders will receive a takeover

premium of 125%.
• Upon the announcement of the transaction, the share price will
go up to 45 [= 450/10], assuming the market believes that the
transaction will take place.

24
The (expected) market reaction

• Next, the parties have to figure out how the price of 450
should actually be paid…
− Let’s assume that 300 million will be paid in cash, the rest (150)
in equity.

How does this affect the valuation:

1600 + 200 + 500
•
− Cash payment of 300 is a cash outflow to the shareholders:
It reduces the overall value of the firm:

Merged equity value after cash payment = 2’300 – 300 = 2’000.

− To “pay” the remaining 150 million, the acquiring firm has to

issue new shares.

25
Share exchange ratio

• What do the target shareholders get?

− We know that the merged equity value (after cash) is 2’000
− We also know that the target shareholders receive 150 in equity
− Hence, after the transaction, the target shareholders will control 7.5%
of the company [= 150/2’000]
• How many shares will be issued?
− Currently, the acquiring firm has 100M shares outstanding
0.075
New shares = 100 × 8.1
=
1 − 0.075

− Hence, after the transaction, there will be 108.1 million shares

outstanding.
• Given the structure of the transaction, we expect the acquirer’s
share price to go from 16 to 18.5 [= 2’000/108.1].
26
Share exchange ratio

• Share exchange ratio:

− The target company currently has 10 million shares outstanding
− We have just seen that the acquiring company will issue 8.1
million new shares to buy the target
− Hence, in our case, the share exchange ratio is 0.81: For
every share the target shareholders own, they receive 0.81
share of the acquiring company:
Shares issued to target shareholders 8.1
= = 0.81
Share exchange ratio = Shares acquired from target shareholders 10

− Alternatively:
Equity paid per target share 15
Share exchange ratio = = = 0.81
Price of the acquirer's share 18.5
27
Summary of the transaction

• Offer price to the target shareholders:

− 300 million cash ($30 per share)
− 150 million in equity ($15 per share)

• Equity Value of the merged companies

= Stand-alone acquirer + stand-alone target + Synergies – Cash payments
= 1’600 + 200 + 500 – 300 = 2’000

• Equity stake of the target shareholders in the merged

company = 150 / 2’000 = 7.5%

%T arg et 7.5%
• Shares issued = Shares outstanding ×
1 − %T arg et
100M ×
=
1 − 7.5%
8.1M
=

28
Summary of the transaction

• Expected stock price reactions:

− Target: from $20 to $45 (125% takeover premium)
− Acquirer: from $16 to $18.5 (see before)
• Value to target shareholders: 450 million
− 300 million in cash
− 150 million in equity: 8.1 million acquirer shares @ $18.5
• Valuation to acquirer shareholders:
− Before: 1’600 million: 100 million shares @ $16
− After: 1’850 million: 100 million shares @ 18.5
− Hence, the acquirer shareholders also get 250 million in synergies
• Ownership structure after the transaction:
− 7.5% owned by the target shareholders
− 92.5% owned by the acquirer shareholders

29
Extension

• Suppose the two firms announce the transaction as outlined

above. They announce that, for each share, the target
shareholders will get $30 in cash plus 0.81 shares of the
acquirer.

• Upon the announcement, the target’s share price goes up to

42 (instead of 45) and the acquirer’s share price drops to
14.8 (instead of an increase to 18.5).

• What happened???

30
Solution

• It could be that the market believes the companies

overestimate the synergy potential of the transaction.

• What does the market expect?

− New share price is 14.8
− Hence, the market thinks that the equity value of the company
after the merger will be:

Value after merger = Price × #shares = 14.8 × 108.1 = 1’600.

− From before, we know that: Value of the merged companies

= Stand-alone acquirer + stand-alone target + Synergies – Cash payments
= 1’600 + 200 + Synergies – 300 = 1’600
− Hence, the market expects that the transaction creates 100 in synergies
31
Interpretation

• According to the market’s expectations, the acquirer

overpays for the target firm.
− As a whole, the transaction makes sense (net synergy of 100)
− However, by offering a premium of $22 per share (42 – 20), the
acquirer pays 220 million to get 100 million in synergies
− Hence, the acquisition is an NPV-negative project: It destroys
120 in value
− Because the acquirer has 100 million shares outstanding
(before the transaction), the announcement of a 120 million
value destruction should reduce the share price by 1.2 (from 16
to 14.8)
− This is exactly what we observe…

32
Overview

• Background on mergers & acquisitions

• Acquisition motives

• Deal valuation

• Deal making

• Takeover defenses

33
Deal making

• We have seen that whether or not a deal creates value to the

parties involved depends on the details of the arrangement.

• So far, we have assumed that the parties will be able to agree on a

transaction price: The “minimum price required by the seller” was
always smaller than the “maximum price the buyer is willing to pay.”

• What if that’s not the case? Is the deal dead if the seller wants more
than the buyer is willing to pay (valuation gap)?

34
The valuation gap

• There are various reasons why the buyer’s and the seller’s
reservation prices could differ.

• Remember the many assumptions we made on the way to

the DCF-value of a company…
− Cash flow estimation
− Cost of capital
− Continuing value
− Valuation method
− Illiquidity discount
− …

35
Example

• Suppose the owner of a computer device manufacturer wants

to sell her company. Based on her assumptions, the DCF-
value of the company is 200 million.

• She approaches a potential acquirer, who comes up with his

own valuation, which is only 150 million.
Buyer’s reservation Seller’s reservation
price (maximum he price (minimum
is willing to pay): 150 price she requires): 200

Valuation gap: 50 million

Valuation
36
Bridging the valuation gap

• In principle, there are three ways to bridge the valuation gap:

− Find and correct the reasons for the gap.
– Go over the assumptions made in the computation of firm value by
both parties to make sure that there are no misunderstandings
− Find an ownership structure that respects the valuation gap.
– Strategic alliances
– Joint ventures
– Acquire stake and postpone full takeover
– Spin-offs
− Find a contractual solution that respects the valuation gap.
– Stage financing
– Earnout agreements
– Risk shifting

37
Contractual solutions

• Earnout agreements
− Example: 2005 acquisition of Skype
Technologies by eBay
− eBay paid a lump sum of about USD 2.6 billion and an earnout
of up to another USD 1.5 billion if it was able to exceed certain
revenue, gross profit and number of active-user targets between
2006 and 2009
− The actual earnout amounted to about USD 500 million

38
Earnouts in M&A

• The buyer takes over the target firm, but the total payment depends
on subsequent performance.

• Total payment = fixed payment (cash, shares, etc.)

+ payments depending on future performance

• For example: The parties could agree on an initial payment of 100

million as well as 20% of sales in 3 years.

• The target management has an incentive to perform. But:

− Earnout payment should be a function of easily observable accounting
numbers not subject to manipulation (f.ex., EBITDA or Sales);
− Agreement should avoid disincentives to invest (f.ex., Sales or EBITDA
are computed before depreciation…)

39
Example

• The private equity firm PEQUI is debating the acquisition of

Plastica. In total, PEQUI is willing to pay 8.8 million for
Plastica.

• Of course, PEQUI could offer 8.8 million in cash. However,

to avoid incentive problems with the target managers, PEQUI
thinks about three different types of earnout clauses:
− Regular earnout: Linear earnout as a function of future sales
− Earnout with threshold: To actually receive an earnout
payment, certain minimum performance goals have to be
reached
− Earnout with threshold and cap: There is an upper limit to the
earnout payment

40
Regular earnouts

• Acquisition offer:
− CHF 2 million in cash at closing
− CHF 1 million every year over the next three years, conditional
on the owner of ‹Plastica› staying on
− An earnout of 0.25 times Sales in three years

• Assumptions regarding ‹Plastica›

− Cost of capital = 10 percent
− Current sales = 20 million
− Expected annual growth rate in sales = 5%

• What’s the value of this offer to the current owner?

41
Valuation of the regular earnout

• Three components:
− 2 million in cash upfront (value of 2 million)
− 1 million in cash over each of the next 3 years (annuity)
− Earnout of 0.25 times sales of year 3

• The present value of the annuity is:

1 1 1
Annuity value = + 2 + 3 =2.5
1.1 1.1 1.1
• What about the earnout?
− Expected sales in 3 years are: 20×1.053 = 23.2
− Hence, the expected earnout in 3 years is: 0.25×23.2 = 5.8
− The PV of this earnout is: 5.8/1.13 = 4.3
• Total offer value = 2.0 + 2.5 + 4.3 = CHF 8.8 million

42
Regular earnouts: Payment in 3 years

43
Potential problem?

• There are at least two potential problems with this “regular”

earnout:
− Problem 1: It rewards managers for maintaining the status quo
(sales of 20 million) or even reducing sales
− Problem 2: If things go REALLY well, the earnout payment will
be very high

• Possible solution:
− Only pay an earnout if sales are higher than a specific minimum
amount (floor; minimum threshold)  Solution to problem 1
− Add a cap to the earnout  Solution to problem 2

44
Earnout with threshold

• Suppose PEQUI wants to create stronger incentives for the

target’s managers to perform and boost sales. Therefore, it
offers to pay twice the sales in year 3 in excess of the
expected sales (23.2 million).

• Example:
− Sales3 of 25 million: 1.8 million above the threshold  payment
of 3.6 million.
− Sales3 of 20 million: 3.2 million below the threshold  no
payment.
• More generally, the payout in year 3 is:
Earnout3 = 2 × Max[0; Sales3 – 23.2].
45
Regular earnouts: Payment in 3 years

The dashed line shows the payment of the regular earnout.

The solid red line is the earnout with a threshold of 23.2 million.
46
Earnout with threshold

• After taking a careful look at this earnout agreement, we realize that

the target’s managers receive two call options on the firm’s sales in 3
years… We can use the Black-Scholes model to price these options.

• To do so, we need:
− S = Present value of expected sales = 23.2/1.13 = 17.43
− X = Exercise price = minimum threshold = 23.2 million
− t = Time to maturity = 3 years
− r = Continuously compounded risk-free return = 3% (assumption)
− σ = Volatility of sales= 28.38% (assumption)

47
Earnout with threshold

• According to the Black-Scholes model, the current value of one

such option is 2.15 million.
• Because the managers receive 2 options, the value of the earnout
payment is 4.3 million.

• Total offer value = Cash + PVAnnuity + PVEarn Out

= 2.0 + 2.5 + 4.3 = 8.8 million.

• This turns out to be the same value as before (regular earnout).

However, the incentive effects are different:
− This earnout only kicks in if the target shareholders actually manage to
exceed industry growth  incentive to work hard.
− Potential danger: The upside is considerable…
• Possible solution: Add a cap to the payout!

48
Earnouts with thresholds and caps

• Now suppose PEQUI wants to limit its exposure and therefore

prefers capped earnout clauses.

• More specifically, we assume that PEQUI:

− Wants to maintain the minimum performance threshold of 23.2 million
in Sales3
− Believes that Sales3 in excess of 33 million would be a sign of luck
instead of managerial skills. Therefore, beyond 33 million in Sales3,
PEQUI wants a constant earnout

• What can PEQUI do to pitch this offer to the target management?

− Remember from before, that the value of the earnout alone was 4.3
million
− Therefore, the earnout with a cap should have a value of 4.3 (or more)

49
Idea

• For simplicity, let’s first assume that the earnout payment is

1×Sales3 if 23.2 ≤ Sales3 ≤ 33.
Max payment of 9.8
(= 33 – 23.2)
@ Sales3 = 33

Earnout triggered
@ Sales3 = 23.2

50
How to value this?

• A careful look at this payout profile shows us that it is a

combination of a call long (X = 23.2) and a call short (X = 33):

51
Valuation

• We know the value of 1 option on Sales3 in excess of 23.3

million (X): 2.15 million (see before).

• So, what we have to do is value a short position in an option

with X = 33 million. According to the Black-Scholes model,
the value of a long position is 0.74 million. Therefore, the
value of the short position is -0.74 million.

• Hence, an earnout agreement that pays 1 times Sales3 if

Sales3 are between 23.2 and 33 million has a value of:

Value earnout1×Sales = 2.15 – 0.74 = 1.41 million

52
Implementation

• From before, we know that the earnout part of the package

should have a value of 4.3 million.

• So the question is, how many times n PEQUI has to pay

Sales3 if Sales3 are between 23.2 and 33 million.

• We have to solve: 4.3 = n×1.41  n = 3.

• In words: PEQUI has to pay 3 times Sales3 to set the target

managers indifferent.

53
Summary

The green line shows the

payoff at maturity for the
earnout with floor (23.2) and
cap (33).

The dashed lines show the

payoffs of the two other
earnout agreements: regular (in
blue) and with floor only (red)

Note: The three earnouts have

the same value (4.3 million).
But they have very different
incentive effects…

54
Overview

• Background on mergers & acquisitions

• Acquisition motives

• Deal valuation

• Deal making

• Takeover defenses

55
Takeover defenses

• For a hostile takeover to succeed, the acquirer must go

around the target board and appeal directly to the target
shareholders (make an unsolicited offer to buy target stock
directly from the shareholder).

• The acquirer will usually couple this with a proxy fight: the
acquirer attempts to convince target shareholders to unseat
the target board by using their proxy votes to support the
acquirer‘s candidate for election to the target board.

• The target companies have a number of defensive

strategies available to them to stop this process.

56
Takeover defenses

• Poison pills issue new equity, stake acquirer will be diluted

+ more expensive, only done by managers who
are benefitting from perks, bad performance
afterwards

• Staggered boards don't renew board members every

year, but for exaple only every 3
years

• White knights company wants to be takenover, however

don't wants to be taken over by specific
firm

• Recapitalization increase leverage, pay out access

cash, firms tend to perform good
afterwards

• Regulatory approval

57
Advanced Valuation
Leveraged buyouts & Capital cash flows

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
Overview

• Leveraged Buyouts

• Capital cash flows

2
Leveraged buyouts

• Transactions that are financed with a lot of debt (leverage)

and little equity.
Global buyout trend 2010 - 2020

Source: McKinsey&Company
Global buyout trend 2007 - 2020

Source: McKinsey&Company
Leveraged buyouts (LBOs)

• LBO = Leveraged Buyout

− When investors buy a company (the target) with debt
• MBO = Management Buyout
− When the management of the target participates in the
transaction
• Principle:
– Fix a price
– Use as much debt as possible (constraint: cash flow > interest
payments + depreciation & amortization)
– Use the investor’s equity for the rest

6
Leveraged buyouts (LBOs)

• In practice, the investor does not directly invest; he/she

invests through a holding company.

investor
Banks
Holding

management

Target

7
LBO targets

• Targets can be:

− a closely held family firm
− non-core division of a conglomerate
− a listed firm (“going private” transaction)
• In the 1980s:
− mature companies with few investment needs (cash cows)
− little exposure to business cycle, high entry barriers
− margin of improvement in profits
• In the 1990-2000s:
– ”sleeping beauties” with growth opportunities

8
LBO investors

• Who are the buyers?

• Private equity funds
− financed by investors (“Limited Partners” or LPs), pension funds,
insurance companies, banks, family offices etc.
− with limited lifespan (7-10 years)
− assets under management (AUM) = 100m-10bn
• Private groups can be:
− independent (KKR, TPG Capital etc.)
− affiliated to large financial firms (AXA PE etc.)

9
LBO capital structure

• Sophisticated financing: LBOs use several debt

instruments
• Senior debt, several tranches e.g.:
− Tranche A: maturity 4 years (typically largest)
− Tranche B: maturity 8 years, etc.
• Junior debt / subordinated debt:
− Mezzanine debt: from investment fund (typically with private
equity part: warrants, convertible etc.)
− High yield debt: Risky debt (non-investment grade). “Junk bond”
issue with quarterly reporting for large amounts (>100M)

10
LBOs – the business model

• How do LBOs create value for their investors?

• Answer # 1: Tax benefits (tax shield)

• To benefit form a tax shield, holding and target must become

a single fiscal entity.

12
LBOs – the business model

• How do LBOs create value for their investors?

• Answer # 2: More efficient/effective management running the

firm (agency theory)?

• High levels of debt force management to be more

efficient/effective.
• Close monitoring by shareholders.
• Improvement in operating performance.
• Threat of bankruptcy.
13
Large LBOs in the 1980s
LBOs – the business model

• How do LBOs create value for their investors?

• Answer # 3: Make firms grow?

• Today, firms are generally well managed, even with a
dispersed shareholder base (improved corporate
governance).
• « New model » of private equity: « growth LBOs »
– Find a “sleeping beauty”
– Use all CFs from operations to finance growth/acquisitions
– sell a bigger firm

18
Overview

• Leveraged Buyouts

• Capital cash flows

debt tax shield

FCFt/(1 + Rwacc)^t
DCF : V =
t=0

CCF: V =
CCFt/(1 + Ru)^t
t=0
debt tax shield

19
Capital cash flow method

• As with Free Cash Flows (FCFs), Capital cash flows (CCF)

measure the cash available to all holders of capital.
• However, in this approach, cash flows are calculated to
include the benefits of interest tax shields.
• In a capital structure with just ordinary debt and equity:
− Capital cash flows equal the flows available to equity – net
income plus depreciation less capital expenditures and the
change in working capital – plus the cash interest paid to
bondholders.
• The interest tax shield decreases taxable income and thereby
increases cash flows.

20
Capital cash flow method

• Since interest tax shields are included in the cash flows, a

before-tax discount rate that corresponds to the risk of the
assets is appropriate to value capital cash flows.

• In the Free cash flow (FCF) method, the interest tax shield
enters through the cost of capital.

• Both methods give identical answers when identical

assumptions are used.

21
Capital cash flow method

• So why bother using capital cash flows?

• There are situations, when the FCF method is cumbersome

or difficult to apply.
− When the debt policy is defined as a dollar amount of
borrowing instead of as a target percentage of value
− When the amount of debt changes (a lot) over time.

• When leverage is changing, the WACC has to be

recalculated each period, so that the cash flows can be
correctly valued.
22
Capital cash flow method

• In the CCF method, the interest tax shield is included in

the cash flows and there is no reason to estimate the target
capital structure.
• The expected asset return depends on the risk of the assets
and therefore does not change when capital structure
changes.
• As a result, the discount rate for CCFs does not have to be
re-estimated every period.
• This can be especially useful when valuing highly levered
firms whose forecasted debt is usually expressed in
dollar/CHF terms and whose capital structure changes
substantially over time.
23
Calculating capital cash flows

Source: Ruback (2000)

24
Capital cash flows – example

• The following table contains many typical features of an LBO.

− The EBIT is close to the interest payments (in this case, EBIT is
greater than interest, and there are no pay-in-kind securities)
− Non-cash adjustments begin positive as depreciation exceeds
the capital expenditures and working capital management
improves but eventually becomes a use of cash.
− EBIT grows quickly.
− There are substantial asset sales predicted in the first year.

25
Capital cash flows – example

Forecasting Capital Cash Flows Assumptions

1 2 3 4 5 6
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Interest rate
Beginning bank debt @ 12% 50000 27640 22527 15955 6959 0 12%
Beginning subordinated debt @ 15% 40000 40000 40000 40000 40000 35056 15%

EBIT 14000 16100 18515 21292 24486 28159

Interest 12000 9317 8703 7915 6835 5258
Pre-tax income 2000 6783 9812 13377 17651 22901 Tax rate
Tax 640 2171 3140 4281 5648 7328 32%
Net income 1360 4613 6672 9097 12003 15572

Noncash adjustments 1000 500 -100 -100 -100 -100

After-tax proceeds from asset sales 20000 used to pay back debt

Available cash flow 22360 5113 6572 8997 11903 15472

Interest 12000 9317 8703 7915 6835 5258
Capital cash flow 34360 14429 15275 16911 18738 20731
Discount rate
Discount factor 0,8475 0,7182 0,6086 0,5158 0,4371 0,3704 18%
Present value 29119 10363 9297 8723 8190 7679

26
Capital cash flows – example

Equity valuation
terminal growth rate

0% 5% 10%
Present values:
Cash flows (years 1-6) 73371 73371 73371
Terminal Value 42663 62025 105591
Enterprise value 116034 135396 178962

Less: debt 90000 90000 90000

Equity value 26034 45396 88962

27
Advanced Valuation
Course review

Prof. Dr. Philip Valta

Institute for Financial Management
University of Bern
What is this course about?

• Most of you are familiar with project valuation and Discounted

Cash Flow (DCF) valuation.

• The value of an asset corresponds to the present value of the

future cash flows that it generates.

(2) Make them comparable across time (discounting)

Today Year 1 Year 2 Year 3 …

(1) Determine the relevant cash flows

(3) Value

2
 What is this course about?

(Market value) Balance sheet

Assets Debt

Advanced How can we value the

assets of a firm?
Valuation

Equity

3
Why is valuation important?

• In finance, value matters!

• In finance, we focus on firm value because it is the basis of
many decisions.
− Should the firm invest in a project?
− How should the project be financed, debt or equity, or both?
− Should the firm acquire its competitor?
− In which stocks should the investor invest?
− …
• The value implications of a corporate/investor decision are
in many instances the central decision criteria!
 Change in excess cash

20x2 20x2
Revenues 18000 EBIT 4000
- Costs of goods sold (excl. depreciation & amortization) 8000
- Taxes (EBIT × 20%) 800
- Selling, general, and administrative expenses 2000
- Other operating expenses 1000
NOPLAT 3200
Earnings before interest, taxes, and D&A (EBITDA) 7000 + Depreciation 3000
- Depreciation & amortization (D&A) 3000 - Increase Operating assets 300
Earnings before interest and taxes (EBIT) 4000 + Increase operating liabilities 600
- Interest expense 500 Operating cash flow 6500
Earnings before taxes (EBT) 3500
- Net long-term investments 3500
- Income taxes 700
Free Cash Flow 3000
Net income 2800
+ Increase long-term debt -1000
Assets 20x1 20x2 Change
- Interest expenses (after taxes) 400
Cash 1000 1200 200 Residual cash flow 1600
Operating assets 4000 4300 300 + Increase share capital 0
Long-term assets 15500 16000 500 - Dividend 1400
Total assets 20500 21500 1000 Change in excess cash 200

Liabilities and shareholders' equity 20x1 20x2 Change

Operating liabilities 2300 2900 600
Financial liabilities 10000 9000 -1000
Share capital 100 100 0 Dividend = Net income – Change
Retained earnings 8100 9500 1400 in retained earnings
Total liabilities and equity 20500 21500 1000

5
Summary: Cash flow derivation

20x2
EBIT 4000
- Taxes (EBIT × 20%) 800
NOPLAT 3200
+ Depreciation 3000
- Increase Operating assets 300
+ Increase operating liabilities 600
Operating cash flow 6500
- Net long-term investments 3500 Cash flow from investments
Free Cash Flow 3000 Available for debt/equity holders
+ Increase long-term debt -1000
Cash flow from debt financing
- Interest expenses (after taxes) 400
Residual cash flow 1600 Available for equity holders
+ Increase share capital 0
- Dividend 1400 Cash flow from equity financing
Change in excess cash 200

6
How to perform a financial analysis?

• A (typical) financial analysis consists of three parts:

• Part 1: Carry out a strategic and economic analysis

− Sector of the firm
− Competitors
− Distribution network
− Ownership structure
− Business strategy

• Part 2: Carefully analyze auditors’ reports and accounting rules

• Part 3: Examine the company’s financial accounts

− Four steps
7
Part 3: Financial analysis in four steps

• Part 3 consists of a detailed analysis of the firm’s financial

accounts. Such analysis can be done in four steps:

1. Margin analysis (value): Trend in sales, margins; break even point

2. Investment analysis: Trend in investment and working capital

3. Financing analysis: Trend in cash flow and balance sheet fragility

4. Profitability analysis: Trend in ROE and ROCE

• 1) Wealth creation… 2) requires investments… 3) that need to be

financed… 4) and provide sufficient returns.

8
Profitability analysis - leverage

• Leverage makes ROE much more volatile

− Debtholders are always senior to shareholders

− first dollars of EBIT are pledged to debtholders
– In exchange for their contribution to capital
– In exchange for low interest rate

• If success, shareholders get big profit for small investment

• If failure, shareholders absorb all the loss

9
The forecasted balance sheets and
income statements
Income statement 2012
2013
2014
20x0 E2013
E2014
E2015
E20x1 E2014
E2015
E2016
E20x2 E2015
E2016
E2017
E20x3 E2016
E2017
E2018
E20x4 E2017
E2018
E2019
E20x5
Sales 1'300.0 1'430.0 1'544.4 1'637.1 1'702.5 1'736.6
- Operating expenses 1'048.0 1'144.0 1'235.5 1'309.7 1'362.0 1'389.3
- Depreciation 65.0 112.1 110.2 108.7 107.4 106.3
EBIT 187.0 174.0 198.6 218.7 233.1 241.0
- Interest expenses 27.0 18.6 18.1 17.6 17.1 16.6
EBT 160.0 155.4 180.5 201.1 216.0 224.4
- Taxes (40%) 64.0 62.1 72.2 80.4 86.4 89.8
Net income 96.0 93.2 108.3 120.7 129.6 134.7

Balance sheet 2011

2012
2013
20x-1 2012
2013
2014
20x0 E2013
E2014
E2015
E20x1 E2014
E2015
E2016
E20x2 E2015
E2016
E2017
E20x3 E2016
E2017
E2018
E20x4 E2017
E2018
E2019
E20x5
Excess cash 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Operating cash 200.0 260.0 257.4 247.1 229.2 204.3 173.7
Accounts receivable 300.0 325.0 357.5 386.1 409.3 425.6 434.1
Other assets 50.0 50.0 50.0 50.0 50.0 50.0 50.0
Fixed assets 540.0 597.0 635.0 624.7 616.0 608.6 602.3
Total assets 1'090.0 1'232.0 1'299.9 1'307.9 1'304.5 1'288.5 1'260.1

Accounts payable 143.0 156.0 171.6 185.3 196.4 204.3 208.4

Short-term debt 70.0 90.0 80.0 70.0 60.0 50.0 40.0
Other liabilities 50.0 70.0 71.5 77.2 81.9 85.1 86.8
Long-term debt 270.0 282.0 282.0 282.0 282.0 282.0 282.0
Share capital 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Retained earnings 457.0 534.0 594.8 593.4 584.2 567.1 542.9
Total liabilities and equity 1'090.0 1'232.0 1'299.9 1'307.9 1'304.5 1'288.5 1'260.1

Retained earningst = Retained earningst-1 + Net incomet – Dividendst

10
Terminal value

• A publicly traded firm potentially has an infinite life-time.

The value is therefore the present value of cash flows
forever.

• Since we cannot estimate cash flows forever, we estimate

cash flows for a “growth period” and then estimate a terminal
value, to capture the value at the end of the period:

11
Cost of capital (terminology)

• Overall cost of (unlevered) assets/capital, rA (or rU)

− Required (expected, average) rate of return on assets
− This is the weighted average of the pre-tax cost of debt and equity
(whereas the WACC is the resulting weighted after-tax average)
− rA = rU = cost of equity if debt = 0 (this is why it is sometimes referred to
as unlevered cost of capital)

• Remember: The required rate of return on a given asset or

investment project equals the expected rate of return on alternative
investment opportunities with the same risk characteristics.

12
Cost of capital (terminology)

• Cost of debt, rD
− Required (expected, average) rate of return on debt
− If the firm has various types of debt outstanding, the cost of debt is the
weighted average required rate of return on the various types of debt

• Cost of equity, rE Re = Rf +Beta * (Rm - Rf)

− Required (expected, average) rate of return on equity

13
Bottom-up betas

• Breaking down betas into their business risk and financial

leverage components provides us with an alternative way of
estimating betas.

• We do not need past prices on an individual firm or asset to

estimate its beta.

• We can estimate the beta for a firm in five steps:

1. Find the business (industry) or businesses that your firm

operates in.

14
Bottom-up betas

2. Find publicly traded firms in each of these businesses

and obtain their regression betas. Compute the simple
average across these regression betas to arrive at an
average beta for these publicly traded firms. Unlever this
average beta using the average debt to equity ratio across
the publicly traded firms in the sample.
− Unlevered beta for business = Average beta across publicly
traded firms/ (1 + (1-𝜏𝜏) (Average D/E ratio across firms))

3. Estimate how much value your firm derives from each of the
different businesses it is in.
− If values are not available, use operating income or revenues as
weight.

15
Bottom-up betas

4. Compute a weighted average of the unlevered betas of

the different businesses (from step 2) using the weights from
step 3.

− Bottom-up unlevered beta for your firm = Weighted average of

the unlevered betas of the individual business

5. Compute a levered beta (equity beta) for your firm, using the
market debt to equity ratio for your firm:
Debt
Levered beta = Unlevered beta(1 + 1 − τ )
Equity

16
Firm valuation

• We can value the entire firm either with the DCF or the APV
approach.
• These two approaches make different assumptions about the
role of capital structure.

1. Discounting the free cash flows (cumulated cash flows to

all claimholders) with the weighted average cost of capital
− We assume a constant proportion of debt to capital
2. Adding the marginal impact of debt on value to the unlevered
firm value (Adjusted Present Value, or APV, approach)
− We assume a constant level of debt

17
General version of the FCF model

• If the firm reaches steady state after n years and starts

growing at a stable growth rate g after that, we can write firm
value as:

t=n
FCFEt FCFEn+1 /(WACCst − g)
Firm value = � t
+
(1 + WACChg ) (1 + WACChg )n
t=1

• FCF1 : Expected FCF next year

• WACC: Weighted average cost of capital, high growth (hg)
and stable growth (st)

18
Adjusted present value (APV)

• In the adjusted present value approach, the value of the

firm is written as the sum of the value of the firm without debt
(the unlevered firm) and the effect of debt on firm value.

Firm Value =
Unlevered Firm Value +
Tax Benefits of Debt –
Expected Bankruptcy Cost from the Debt

• The optimal Swiss Franc debt level is the one that maximizes
firm value.

19
Dealing with measurement error

• There are several ways we can deal with measurement error:

− Scenario analysis

− Sensitivity analysis

− Monte Carlo simulation

− Break-even analysis

20
Principles of relative valuation

• To do relative valuation,
− We need to identify comparable assets and obtain market
values for these assets.
− Convert these market values into standardized values, since
the absolute prices cannot be compared. This process of
standardizing creates price multiples.
− Compare the standardized value or multiple for the asset being
analyzed to the standardized values for comparable asset,
controlling for any differences between the firms that might
affect the multiple.

• Idea: «Let others (= the market) do the job»

21
The “theory” of multiples

• Multiples measure the amount the market is willing to pay

for one unit of sales, earnings, book value of equity, etc.
• In general, the market value of the asset you want to value
(MVT) can be estimated with the following equation:
 MVC 
MVT 
=  × VIT
 VIC 
Market value multiple

− MVC = Market value of the comparable assets (or peer-group)

− VIC = Valuation indicator for the comparable assets (or peer-
group)
− VIT = Valuation indicator of the asset you want to value
22
Multiples vs. DCF

• The multiples valuation approach is:

− Simple to understand
− Simple to communicate

• Yet it is:
− Difficult to compute correctly
− At least as inaccurate as DCF; and
− A black box

• Since the multiple approach yields independent estimates

from the DCF approach:
→ USE BOTH APPROACHES!
23
EVA valuation

• Next, we have to compute the firm’s expected NOPLAT. We

have all the relevant information in the previous slides:
1 2 3 4 5
EBIT 30.0 40.0 25.0 35.0 70.0
– Adjusted taxes (30%) 9.0 12.0 7.5 10.5 21.0
NOPLAT 21.0 28.0 17.5 24.5 49.0
– (Net) Invested capital t–1 × WACC 10.2 8.5 11.5 7.4 3.4
EVA 10.8 19.5 6.0 17.1 45.6
At the beginning of year 2, the firm’s (Net)
invested capital is 90 (= 63.1 + 26.9). Hence, the
capital charge is 90×0.094 = 8.5

• The present value of all future EVAs is:

10.8 19.5 6.0 17.1 45.6

MVA = + 2
+ 3
+ 4
+ 5
= 71.9
1.094 1.094 1.094 1.094 1.094
24
Financial options vs. real options

• Real options are the right to make a particular business

decision, such as capital investment.
• Real options, and the underlying assets on which they are
based, are often not traded in competitive markets.
• However, many of the principles of financial options also
apply to real options.
− Real options allow a decision maker to choose the most
attractive alternative after new information becomes available.
− The presence of real options adds value to the investment
opportunity.
− This value can be substantial if there is a great deal of
uncertainty.
25
Changing environment

Default line
V=
D

D(V,F,T,σ,r)
V
F
+
E

E(V,F,T,σ,r)
V
F

26
Replicating portfolio: More general setup

• Value of the portfolio today: 𝑃𝑃 = 𝑥𝑥𝑥𝑥 + 𝑦𝑦

• Therefore

1  (1 + r ) − d u − (1 + r )
Value = CFu + CFd 
1 + r  u − d u−d 

• With the correct risk neutral probabilities, the expected

cash flows of traded assets, discounted at the risk-free
rate, equals the observed market price of the traded asset.

27
Venture capital valuation

• Young firms often raise equity from venture capitalists.

• How do venture capitalists asses the value of these firms?
• They would typically use what is called the “VC method”.
− Earnings of the private firm are forecast in a future year when
the company can be expected to go public.
− These earnings, in conjunction with a multiple based on publicly
listed firms in the same business, are used to assess the value
at the time of IPO: this is the exit or terminal value.
− Discount the value back using a “target” or discount rate.

28
Pre- and post-money valuation

• The pre-money valuation is the post-money valuation net of

the required investment:

Pre-money valuation = Post-money valuation – Capital needs

= 33.5 – 6.7 = 26.8

• Interpretation: The pre-money valuation is positive. In

principle, the company seems to be a good investment.

• According to the VC-method, the pre-money valuation is the

current value of the company.

29
VC method

• Obviously, the VC-method per se is pretty straightforward

(computing the required stakes and protecting against dilution
is a bit more complicated).

• It is therefore not surprising that this method is very popular.

• Potential problems:
− The way we used the approach, we applied a current multiple to
an expected net income (5 years from now!). What if the market
conditions change?
− We still need to forecast the balance sheets and income
statements…
− How can discount rates of 40% or more be justified???
30
Acquisition motives

• Most acquirers pay a substantial acquisition premium (43%

for all US deals between 1980 and 2005).
• At the same time, for most investors an investment in the
stock market is a zero-NPV investment.
• How, then, can an acquirer pay a premium for a target and
still satisfy the requirement that the investment is a positive
NPV- investment opportunity?

⇒ Acquirer might be able to add economic value, as a result of

the acquisition, that an individual investor cannot add.
⇒ Synergies: cost reduction and revenue enhancement

31
Summary of the transaction

• Offer price to the target shareholders:

− 300 million cash ($30 per share)
− 150 million in equity ($15 per share)

• Equity Value of the merged companies

= Stand-alone acquirer + stand-alone target + Synergies – Cash payments
= 1’600 + 200 + 500 – 300 = 2’000

• Equity stake of the target shareholders in the merged

company = 150 / 2’000 = 7.5%

%T arg et 7.5%
• Shares issued = Shares outstanding ×
1 − %T arg et
100M ×
=
1 − 7.5%
8.1M
=

32
Example

• Suppose the owner of a computer device manufacturer wants

to sell her company. Based on her assumptions, the DCF-
value of the company is 200 million.

• She approaches a potential acquirer, who comes up with his

own valuation, which is only 150 million.
Buyer’s reservation Seller’s reservation
price (maximum he price (minimum
is willing to pay): 150 price she requires): 200

Valuation gap: 50 million

Valuation
33
Summary

The green line shows the

payoff at maturity for the
earnout with floor (23.2) and
cap (33).

The dashed lines show the

payoffs of the two other
earnout agreements: regular (in
blue) and with floor only (red)

Note: The three earnouts have

the same value (4.3 million).
But they have very different
incentive effects…

34
LBOs – the business model

• How do LBOs create value for their investors?

• Answer # 2: More efficient/effective management running the

firm (agency theory)?

• High levels of debt force management to be more

efficient/effective.
• Close monitoring by shareholders.
• Improvement in operating performance.
• Threat of bankruptcy.
35
LBOs – the business model

• How do LBOs create value for their investors?

• Answer # 3: Make firms grow?

• Today, firms are generally well managed, even with a
dispersed shareholder base (improved corporate
governance).
• « New model » of private equity: « growth LBOs »
– Find a “sleeping beauty”
– Use all CFs from operations to finance growth/acquisitions
– sell a bigger firm

36
 bespreking sample exam last podcast minute 45

Capital cash flows – example

Forecasting Capital Cash Flows Assumptions

1 2 3 4 5 6
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Interest rate
Beginning bank debt @ 12% 50000 27640 22527 15955 6959 0 12%
Beginning subordinated debt @ 15% 40000 40000 40000 40000 40000 35056 15%

EBIT 14000 16100 18515 21292 24486 28159

Interest 12000 9317 8703 7915 6835 5258
Pre-tax income 2000 6783 9812 13377 17651 22901 Tax rate
Tax 640 2171 3140 4281 5648 7328 32%
Net income 1360 4613 6672 9097 12003 15572

Noncash adjustments 1000 500 -100 -100 -100 -100

After-tax proceeds from asset sales 20000

Available cash flow 22360 5113 6572 8997 11903 15472

Interest 12000 9317 8703 7915 6835 5258
Capital cash flow 34360 14429 15275 16911 18738 20731
Discount rate
Discount factor 0,8475 0,7182 0,6086 0,5158 0,4371 0,3704 18%
Present value 29119 10363 9297 8723 8190 7679

37
SOUNDING GOOD OR DOING
GOOD: A SKEPTICAL LOOK AT ESG
Morality plays in markets!
Buzz Words and Magic Bullets!

¨ In my four decades in corporate finance and valuation, I have seen

many "new and revolutionary" ideas emerge, marketed as the
solution to all of the problems in business decision making.
¨ Most of the time, these ideas represent either a repackaging of
existing concepts, with a healthy dose of marketing and selling,
usually by consultants and bankers, and their magic fades quickly
once their limitations come to the surface, as they inevitably do.
¨ The latest entrant in this game is ESG (Environmental, Social and
Governance), and the sales pitch is wider and deeper. Companies
that improve their social goodness standing will not only become
more profitable and valuable over time, we are told, but they will
also advance society's best interests, thus resolving one of the
fundamental conflicts of private enterprise, while also enriching
investors.

2
Why now?

¨ 50 years since Friedman: The first is that it is the fiftieth

anniversary of one of the most influential opinion pieces in
media history, where Milton Friedman argued that the focus
of a company should be profitability, not social good.
¨ COVID and ESG: The second were multiple news stories about
how "good" companies have done better during the COVID
crisis and how much money was flowing into ESG funds.
¨ The Establishment has bought in: The third is a more long-
standing story line, where the establishment seems to have
bought into ESG consciousness, with business leaders in
the Conference Board signing on to a "stakeholder interest"
statement last year and institutional investors shifting more
money into ESG funds.

3
Measuring ESG: Challenges

¨ It is fuzzy: The first is that much of social impact is

qualitative and developing a numerical value for that
impact is difficult to do.
¨ And entirely subjective: The second is even trickier,
which is that there is little consensus on what social
impacts to measure, and the weights to assign to them.
¨ But it is still being measured: If your counter is that there
are multiple services now that measure ESG at
companies, you are right, but the lack of clarity and
consensus results in the companies being ranked very
differently by different services.

4
ESG Services disagree…

5
Even on high profile companies…

6
And the differences will persist…

¨ There are some who believe that this reflects a measurement

process that is still evolving, and that as companies provide more
disclosure on ESG data and ESG measurement services mature,
there will be consensus. I don’t believe it, because. if there were
consensus, it is unlikely that we would not need to convince
businesses to reflect that consensus.
¨ Even if you overlook disagreements on ESG as growing pains, there
is one more component that adds noise to the mix and that is the
direction of causality:
¤ Do companies perform better because they are socially conscious (good)
companies, or do companies that are doing well find it easier to do good?
¤ Put simply, if ESG metrics are based upon actions/measures that
companies that are doing better, either operationally and/or in markets,
can perform/deliver more easily than companies that are doing badly,
researchers will find that ESG and performance

7
The ESG Promises: Cake for all, with no calories!

¨ For companies, the promise is that being "good"

will generate higher profits for the company, at least in
the long term, with lower risk, and thus make them
more valuable.
¨ For investors in these companies, the promise is that
investing in "good" companies will generate higher
returns than investing in "bad" or middling companies.
¨ For society, the promise is that not only would good
companies help fight problems directly related to ESG,
like climate change and low wages, but also counter
more general problems like income inequality and
healthcare crises.

8
The ESG Questions

9
I. ESG and Value

The "It Proposition”: For "it" to affect value, "it" has to affect either the
cash flows or the risk in those cashflows.

10
The Good shall be rewarded

11
The Bad shall be punished

12
The Bad Guys win: Hell on Earth?

13
Value and ESG: The Evidence

¨ A Weak Link to Profitability: There are meta studies (summaries of all other studies) that
shine summarize hundreds of ESG research papers, and find a small positive link between
ESG and profitability, but one that is very sensitive to how profits are measured and over
what period. Breaking down ESG into its component parts, some studies find that
environment (E) offered the strongest positive link to performance and social (S) the
weakest, with governance (G) falling in the middle.
¨ A Stronger Link to Funding Costs: Studies of “sin” stocks, i.e., companies involved in
businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less
commonly held by institutions and that they face higher costs for funding, from equity and
debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and
fossil fuels (especially in the last decade), but these findings come with a troubling catch.
While these companies face higher costs, and have lower value, investors in these
companies generate higher returns.
¨ And to Failure/Disaster Risk: “Bad” companies are exposed to disaster risks, where a
combination of missteps by the company, luck, and a failure to build in enough protective
controls (because they cost too much) can cause a disaster, either in human or financial
terms. One study created a value-weighted portfolio of controversial firms that had a history
of violating ESG rules and reported negative excess returns of 3.5% on this portfolio, even
after controlling for risk, industry, and company characteristics.

14
II. ESG and Returns

¨ Constrained optimal? To begin with, the notion that adding an ESG

constraint to investing increases expected returns is counter intuitive.
After all, a constrained optimum can, at best, match an unconstrained
one, and most of the time, the constraint will create a cost.
¨ Truth in Advertising: In one of the few cases where honesty seems to have
prevailed over platitudes, the TIAA-CREF Social Choice Equity Fund
explicitly acknowledges this cost and uses it to explain its
underperformance, stating that “The CREF Social Choice Account returned
13.88 percent for the year [2017] compared with the 14.34 percent return
of its composite benchmark … Because of its ESG criteria, the Account did
not invest in a number of stocks and bonds ... the net effect was that the
Account underperformed its benchmark.”
¨ Internal contradiction: In fact, there is an inherent contradiction, at least
on the surface, between arguing that ESG leads to higher value and stock
prices, made to CEOs and CFOs of companies, and simultaneously arguing
that investors in ESG stocks will earn higher (positive excess) returns.

15
Why returns to ESG are tough to read…
Value Effect Market Pricing Investor Returns to ESG
ESG increases value Markets overreact, pushing up Negative excess returns for
prices too much investors in good ESG firms.

ESG decreases value Markets overreact, pushing down Positive excess returns for
prices too much investors in good ESG firms.

ESG increases value Markets underreact, with prices Positive excess returns for
going up too little. investors in good ESG firms.

ESG decreases value Markets underreact, with prices Negative excess returns for
going down too little. investors in good ESG firms.

ESG increases value Markets react correctly, with Zero excess returns for investors
prices increasing to reflect value. in good ESG firms.

ESG decreases value Markets underreact, with prices Zero excess returns for investors
going down too little. in good ESG firms.

16
And the research is all over the place…
¨ Invest in bad companies: A comparison of two Vanguard Index funds, the Vice fund
(invested in tobacco, gambling, and defense companies) and the FTSE Social Index fund
(invested in companies screened for good corporate behavior on multiple dimensions)
and note that a dollar invested in the former in August 2002 would have been worth
almost 20% more by 2015 than a dollar invested in the latter.
¨ Invest in good companies: At the other end of the spectrum, there are studies that
seem to indicate that there are positive excess returns to investing in good
companies. A study showed that stocks in the Anno Domini Index (of socially conscious
companies) outperformed the market, but that the outperformance was more due to
factor and industry tilts than to social responsiveness. Some of the strongest links
between returns and ESG come from the governance portion, which, as we noted
earlier, is ironic, because the essence of governance, at least as measured in most of
these studies, is fealty to shareholder rights, which is at odds with the current ESG
framework that pushes for a stakeholder perspective.
¨ ESG has no effect: Splitting the difference, there are other studies that find little or no
differences in returns between good and bad companies. In fact, studies that more
broadly look at factors that have driven stock returns for the last few decades find that
much of the positive payoff attributed to ESG comes from its correlation with
momentum and growth.

17
Glimmers of hope?

¨ While the overall evidence linking ESG to returns is weak, there are two
pathways that offer promise:
¤ Transition Period Payoff: The first scenario requires an adjustment period, where
being good increases value, but investors are slow to price in this reality. During the
adjustment period the highly rated ESG stocks will outperform the low ESG stocks,
as markets slowly incorporate ESG effects, but that is a one-time adjustment effect.
¤ Limit Downside: To the extent that socially responsible companies are less likely to
be caught up in controversy and court disaster, the argument is that they will also
have less downside risk as their counterparts who are less careful.
¨ Investing lesson: Investors who hope to benefit from ESG cannot do so by
investing mechanically in companies that already identified as good (or
bad), but have to adopt a more dynamic strategy built around either
aspects of corporate social responsibility that are not easily measured and
captured in scores, or from getting ahead of the market in recognizing
aspects of corporate behavior that will hurt or help the company in the
long term.

18
The COVID effect: ESG Fund Flows

19
The COVID effect: ESG Returns

20
With some pushback

¨ The consensus view that ESG investing outperformed

the market is now getting push back, with some arguing
that once you control for the sector tilt of ESG funds
(they tend to be more heavily invested in tech
companies), ESG, by itself, provided no added payoff
during the down period of the crisis (February
and March 2020) and pushed returns down during the
recovery phase.
¨ If success in active investing is defined as attracting
investor money, ESG has had a successful run during
COVID, but if it is defined as delivering returns, it is far
too early to be doing victory dances in the end zone.

21
To conclude..

¨ In many circles, ESG is being marketed as not only good for society, but
good for companies and for investors. In my view, the hype regarding ESG
has vastly outrun the reality of both what it is and what it can deliver, and
the buzzwords (sustainability, resilience) are not helpful.
¨ Much of the ESG literature starts with an almost perfunctory dismissal of
Milton Friedman’s thesis that companies should focus on delivering
profits and value to their shareholders, rather than play the role of social
policy makers. The more that I examine the arguments that advocates for
ESG make for why companies should expand mission statements, and the
evidence that they offer for the proposition, the more I am inclined to
side with Friedman.
¨ The ESG bandwagon may be gathering speed and getting companies and
investors on board, but when all is said and done, a lot of money will have
been spent, a few people (consultants, ESG experts, ESG measurers) will
have benefitted, but companies will not be any more socially responsible
than they were before ESG entered the business lexicon.

22