CHAPTER

13

Valuation

his chapter covers the topic of valuation, or the practice of placing a value on a business. Valuation is a vast and complex topicmany books have been written on this subject alone. My goal in this chapter is to introduce several of the most commonly used valuation approaches, including discounted cash ow, public company comparables, and mergers and acquisitions comparables. Beyond the coverage of specic valuation methodologies, a core concept of valuation is this: The best valuation approach is often a combination of approaches. In other words, it is often best to use several valuation techniques to assess the value of a business. In so doing, it is possible to triangulate on the value of a business by weighting various valuation approaches. I address the valuation of Napavale in this chapter by triangulating on the value of Napavaleby using and weighing several valuation methodologies. I cover the discounted cash ow, public company comparables, and mergers and acquisitions comparables valuation methodologies separately and then discuss the concept of triangulation and weighing these various approaches at the end of the chapter.

DISCOUNTED CASH FLOW

The discounted cash ow (DCF) valuation approach is widely used and is covered in many undergraduate and graduate-level nance classes in the United States. In essence, the general premise of the DCF approach is this: The value of a business is equal to the present value of the cash ows generated by that business in the future. There are two key concepts in this denitionpresent value and cash ows. While various interpretations of the meaning of cash ows exist, I will use Napavales free cash ows (as covered in Chapter 9) as the proxy for cash ows in this context. Using free cash ows in a DCF approach is

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a common practice and it builds on my work in Chapter 9 on the Free Cash Flows worksheet. The concept of present value, which I have not yet covered in this book, is central to the discipline of nance. Present value and the related concept of future value both deal with the value of something at a particular point in time. While present value may seem like a simple concept, it is actually deceptively complex. One way to think about the concept of present value is in terms of the value of a dollar now and the value of that same dollar in the future. Generally speaking, a dollar today is worth more than a dollar tomorrow. Please note, this is a broad and sweeping statement that incorporates a variety of assumptions and complex economic theories. My intent here is only to convey the essence of the concept of present valuenothing more. In an inationary economic environment (meaning, among other things, one in which prices increase), a dollars buying power will decrease over time. As such, if a dollars buying power decreases over time, it is worth more today than it is in the future. The equation that denes the relationship between present value and future value quanties this concept of the changing value of a dollar (or any other good or service) over time. This equation is: Present Value = Future Value (1 + Discount Rate)Time Period

Using this equation, it is possible to determine the present value of an asset given the following: its future value, a discount rate, and the time period (such as the number of years into the future) associated with the future value. The use of this equation should become clear as I walk through the DCF approach for Napavale. The rst step in building a DCF model for Napavale is to calculate the free cash ows for each of the accounting periods (quarters) covered in Napavales nancial model. I calculated the free cash ows in Chapter 9 and Figure 13.1 presents a view of the Free Cash Flows worksheet as I left it in Chapter 9. Figure 13.2 presents a view of the values and formulas underlying the worksheet cells in Napavales Free Cash Flows worksheet. The names of the input and output worksheet cells in Napavales Free Cash Flows worksheet are shown in Figure 13.3. Please refer to the coverage of free cash ows in Chapter 9 if you need to review the elements of the Free Cash Flows worksheet. Calculating something known as a terminal value for Napavale is the next step in building the DCF model. A terminal value represents the present value of all of a companys future free cash ows (until perpetuity,

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.1 Free Cash Flows Worksheet

FIGURE 13.2 Alternative View of the Free Cash Flows Worksheet

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FIGURE 13.3 Names of the Input and Output Cells Underlying the Free Cash
Flows Worksheet

or the end of time) at some point in the future. Since I cannot build a nancial model out indenitely into time, a terminal value encapsulates assumptions regarding future free cash ows (beyond the timeframe covered by the nancial model) in a single number. The terminal value is calculated for the nal accounting period covered by the nancial model. In essence, the terminal value represents the present value of Napavales free cash ows into perpetuity at some point in the future. I have calculated Napavales terminal value using the following formula: Terminal Value = (Free Cash Flow for X4) (1 + Growth Rate to Perpetuity) Discount Rate Growth Rate to Perpetuity

This is a well-known formula, but many different approaches may be used to calculate a terminal value. Please note that I am using free cash ow for X4 in this calculation. Technically speaking, this terminal value calculation is meant to project out free cash ow for the time period subsequent to the nal period (typically a particular year) covered in the nancial model. As such, I have based my terminal value calculation on the free cash ow that is generated in all of X4.

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ANALYSIS OF A FINANCIAL MODEL

When you build your own nancial models, it is important to be clear on how you are calculating free cash ow projections in your terminal value calculation, Generally speaking, the free cash ow value used in this terminal value calculation relates to a year time period. Figure 13.4 presents a view of the Assumptions and Dashboard worksheet with the addition of the assumptions related to Napavales discount rate and growth rate to perpetuity. Napavales updated Free Cash Flows worksheet is presented in Figure 13.5. Note that I have calculated Napavales total free cash ows by adding the terminal value to the free cash ows calculated in Chapter 9. An alternative view of the Free Cash Flows worksheet in which the values and formulas underlying the worksheet cells are exposed is presented in Figure 13.6. The names of the input and output worksheet cells in Napavales Free Cash Flows worksheet are shown in Figure 13.7. Figure 13.8 offers a view of the names of the input cells in the Assumptions and Dashboard worksheet. The nal step in building Napavales DCF model is to calculate and add the present values for each accounting period (quarter) based on the total free cash ows that incorporate the terminal value. The present value of each of Napavales free cash ows is calculated using the present value formula described earlier in this chapter: Present Value = Future Value (1 + Discount Rate)Time Period

FIGURE 13.4 Assumptions and Dashboard Worksheet

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FIGURE 13.5 Updated Free Cash Flows Worksheet Using the assumption that today is the rst day of 1Q X4 and each accounting period (quarter) represents one quarter (0.25) of a year, Figure 13.9 presents Napavales updated Free Cash Flows worksheet in which the present value of each accounting periods (quarters) free cash ow is calculated. Note that Napavales NPVin other words, Napavales

FIGURE 13.6 Alternative View of the Free Cash Flows Worksheet

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.7 Names of the Input and Output Cells Underlying the Free Cash
Flows Worksheet

FIGURE 13.8 Names of the Input and Output Cells Underlying the
Assumptions and Dashboard Worksheet

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FIGURE 13.9 Updated Free Cash Flows Worksheet

value as determined by the DCF modelis equal to the sum of all of the present values of each of the accounting periods (quarters) free cash ows. Please note that I am not incorporating the equity investment of $1 million into the discounted cash ow valuation of Napavale. I am calculating the post-money valuation herein other words, this discounted cash ow approach values Napavale assuming the $1 million has already been invested into the company. As with many valuation techniques, you can include the equity investment into the valuation, but you must take such an investment into consideration when you create and calculate the capitalization chart and ownership percentages of the company. (These topics are discussed in Chapter 14.) My approach with regard to the equity investment is one way to value Napavale. While there are other ways to run such a valuation, remember to be clear about how investments into a company are accounted for when valuing the company. Figure 13.10 presents a view of Napavales updated Free Cash Flows worksheet in which the values and formulas underlying the worksheet cells are visible. The names of the input and output worksheet cells in Napavales updated Free Cash Flows worksheet are shown in Figure 13.11.

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.10 Alternative View of the Updated Free Cash Flows Worksheet

FIGURE 13.11 Names of the Input and Output Cells Underlying the Updated Free Cash Flows Worksheet

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PUBLIC COMPANY COMPARABLES

The public company comparables valuation approach is a comparative methodology in which the values of publicly traded companies are used as proxies for Napavales valuation. More specically, the manner in which publicly traded companies valuations are related to certain measures and metrics, such as sales, net income, or free cash ows, is used to estimate a value for Napavale as a company. I am going to use ctitious companies and numbers in this analysis, but the methodology outlined in this section of the book may be easily applied to the use of actual market-based numbers as well. I will use two types of ctitious public companies for the public company comparables approach: direct competitors to Napavale and companies included in a ctitious index similar to the S&P 500. Using direct competitors should give a sense of how investors value companies in Napavales industry and using an index of stocks should provide some perspective on how investors value the market as a whole. The rst step in building a public companies comparables analysis is to collect relevant data for the public companies against which Napavale will be compared. I am going to collect data on companies valuations, sales, net income, and free cash ows. Note that this data will represent projections for each of these companies next 12 months (four quarters) of operations. Using this data will allow a more direct comparison of Napavale with the competitors and the stock index. Figure 13.12 provides a view of this data

FIGURE 13.12 Data for Fictitious Companies and Fictitious Index of Stocks

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.13 Calculations of Multiples of Various Operational Measures for the ctitious companies and the ctitious index of stocks that I use in my valuation of Napavale. The next step involved in building a public company comparables valuation model is to calculate the multiples for each of these operational measures (sales, net income, and free cash ows) as represented by each of the competitor companys and stock indexs valuation. Figure 13.13 provides a view of these calculations. Note that I have also included a calculation of the median for each of the respective multiple calculationsI will use these median gures to value Napavale using the public company comparables methodology later in this chapter. I ordered companies in descending order by valuation (price). A view of the values and formulas underlying the worksheet cells associated with the multiple calculations is shown in Figure 13.14. Figure 13.15 provides a view of the names of the input and output cells associated with the calculation of the multiplevalues.

FIGURE 13.14 Alternative View of the Calculations of Multiples of Various Operational Measures

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FIGURE 13.15 Names of the Input and Output Cells Underlying the Calculations of Multiples of Various Operational Measures The nal step in the public company comparables valuation approach is to apply the appropriate multiples of chosen measures and metrics (sales, net income, and free cash ows in this case) to Napavale. I use the median multiples that I calculated for Napavales competitors and the value that I calculated for the stock index to value Napavale using the public comparables valuation approach. Figure 13.16 shows the completed public company comparables valuation worksheet. The values and formulas underlying the worksheet cells in the public company comparables valuation worksheet are shown in Figure 13.17. Figure 13.18 offers a view of the names underlying the public company comparables valuation worksheet.

FIGURE 13.16 Completed Public Company Comparables Valuation

Worksheet

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.17 Alternative View of the Completed Public Company Comparables Valuation Worksheet

FIGURE 13.18 Names of the Input and Output Cells Underlying the Completed Public Company Comparables Valuation Worksheet

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Note that when I triangulate on a value for Napavale later in this chapter, I use the value derived for Napavales direct competitors using the public company comparables valuation approach and not the value derived for the stock index. I believe Napavales direct competitors provide a better sense of how the market would value Napavale than does the stock index valueI calculated the stock index value for the sake of reference only.

MERGERS AND ACQUISITIONS COMPARABLES

The mergers and acquisitions comparables valuation approach, like the public company comparables valuation approach, is a comparative methodology. In the case of the mergers and acquisitions valuation approach, data from recent mergers and acquisitions in Napavales market is used to estimate a value for Napavale as a company. The term mergers and acquisitions refers to the combination or acquisition of businesses. As with the public company comparables approach, I am going to use ctitious companies and numbers in this analysis, but the methodology outlined in this section of the book may be easily applied to the use of actual market-based numbers as well. I will use data related to ctitious mergers and acquisitions within Napavales market (also called industry). The rst step in building a mergers and acquisitions comparables analysis is to collect relevant data for mergers and acquisitions transactions in Napavales market. I am going to collect data on companies valuations (as determined by mergers and acquisitions prices), sales, net income, and asset values. Note that this data will represent projections for each of these companies next 12 months (four quarters) of operations. Using this data will allow a more direct comparison of Napavale with its competitors. Figure 13.19 provides a view of this data for the ctitious mergers and acquisitions transactions that I use in my valuation of Napavale. The second step involved in building a mergers and acquisitions comparables valuation model is to calculate the multiple for each of these operational measures (sales, net income, and asset values) as represented by each of the transactions prices (which is the same idea as their valuations). Figure 13.20 provides a view of these calculations. Note that I have also included a calculation of the median for each of the respective multiple calculationsI will use these median gures to value Napavale using the mergers and acquisitions comparables methodology

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.19 Data for Fictitious Mergers and Acquisitions Transactions later in this chapter. I ordered companies in descending order by valuation (price). A view of the values and formulas underlying the worksheet cells associated with the multiple calculations is shown in Figure 13.21. Figure 13.22 provides a view of the names of the input and output cells associated with the calculation of the multiple values.

FIGURE 13.20 Calculations of Multiples of Various Operational Measures

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FIGURE 13.21 Alternative View of the Calculations of Multiples of Various Operational Measures

The nal step in the mergers and acquisitions comparables valuation approach is to apply the appropriate multiples of chosen measures/metrics (sales, net income, and asset values in this case) to Napavale. I use the median multiples that I calculated for the mergers and acquisitions transactions to value Napavale in this case. Figure 13.23 shows the completed mergers and acquisitions comparables valuation worksheet. The values and formulas underlying the worksheet cells in the mergers and acquisitions comparables valuation worksheet are shown in Figure 13.24. Figure 13.25 offers a view of the names underlying the mergers and acquisitions comparables valuation worksheet.

FIGURE 13.22 Names of the Input and Output Cells Underlying the Calculations of Multiples of Various Operational Measures

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.23 Completed Mergers and Acquisitions Comparables Valuation Worksheet

FIGURE 13.24 Alternative View of the Completed Mergers and Acquisitions Comparables Valuation Worksheet

FIGURE 13.25 Names of the Input and Output Cells Underlying the Completed Mergers and Acquisitions Comparables Valuation Worksheet

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WEIGHTED VALUATION
Now that I have calculated Napavales estimated valuation using the discounted cash ow technique, public company comparables approach, and mergers and acquisitions comparables approach, I apply a relative weight to each of these valuation methodologies to triangulate on an overall valuation for Napavale. Determining the appropriate weighting for each of these valuation methodologies is a matter of judgmentthe weightings that I apply to the methodologies reect my bias as to the relative importance of each valuation approach. You should use whatever relative weightings seem most appropriate for your own company. Figure 13.26 presents a view of Napavales Valuation worksheet in which the valuation results of each of the three valuation approaches covered in this chapter are shown. I have chosen to use the Price to Sales median multiple value for Napavales direct competitors for the public company comparables valuation and the Price to Sales median multiple value for the mergers and acquisitions comparables valuation. This is only a matter of preference and you are free to choose which multiples to use in the valuations of your own companies. I have also included relative weights and weighted valuations for each of these valuation approaches. The weighted valuations are calculated as: (Weighted Valuation) = (Valuation) * (Relative Weight). Note that I have also totaled the weighted valuation gures to determine a total or nal valuation for Napavale as a business. The values and formulas underlying Napavales Valuation worksheet are exposed in Figure 13.27. Figure 13.28 offers a view of the names of the worksheet cells underlying Napavales Valuation worksheet.

FIGURE 13.26 Valuation Worksheet

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ANALYSIS OF A FINANCIAL MODEL

FIGURE 13.27 Alternative View of the Valuation Worksheet

FIGURE 13.28 Names of the Input and Output Cells Underlying the Valuation
Worksheet

Please note that the total valuation shown in Figure 13.26 represents my estimate of Napavales valuation. This value represents a weighted total of the three valuation approaches (discounted cash ow, public company comparables, and mergers and acquisitions comparables) covered in this chapter.

QUESTIONS
Each of the questions for this chapter relates to the hypothetical company named Company 456this company was used in the Questions section of Chapter 12. To review, Company 456 sells display monitors to physicians. As such, Company 456 is a product-oriented (as opposed to a serviceoriented) business.

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The questions for this chapter will address scal year X4 on a quarterly basis (four specic quarters, 1Q4Q for year X4). The following questions will test your knowledge of the material covered in this chapter in an applied mannerspecically, you will be asked to triangulate on a valuation for Company 456 using discounted cash ow, public company comparables, and mergers and acquisitions valuation methodologies. To prepare you for this chapters questions, Figure Q13.1 offers a view of Company 456s Free Cash Flows worksheet to provide some background information related to Company 456s operations. A portion of Company 456s Assumptions and Dashboard worksheet is shown in Figure Q13.2. Figure Q13.3 presents a view of the data associated with ctitious companies and a ctitious stock index that will be used in the public company comparables valuation for Company 456. Data associated with ctitious mergers and acquisitions transactions that will be used in the mergers and acquisitions comparables valuation for Company 456 is presented in Figure Q13.4. The relative weightings to be used in Chapter 13s questions for each of the valuation approaches are shown in Figure Q13.5.

FIGURE Q13.1 Company 456s Free Cash Flows Worksheet

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ANALYSIS OF A FINANCIAL MODEL

FIGURE Q13.2 Company 456s Assumptions and Dashboard Worksheet

FIGURE Q13.3 Data for Fictitious Companies and Fictitious Index of Stocks

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FIGURE Q13.4 Data for Fictitious Mergers and Acquisitions Transactions

FIGURE Q13.5 Relative Weightings for Each Valuation Approach

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ANALYSIS OF A FINANCIAL MODEL

1. Given the information presented, calculate Company 456s total free cash ows. 2. Given the information presented, calculate Company 456s net present value. 3. Calculate, using the information presented, the multiple of (i) sales, (ii) Net Income, and (iii) free cash ows for each of the comparable public companies and the stock index. Also calculate the median value for the multiples of the public company comparables as a group. 4. Apply the median multiple and the stock index multiple as calculated in Question 3 to Company 456 to derive a public company comparable valuation for Company 456. 5. Calculate, using the information presented, the multiple of (i) sales, (ii) Net Income, and (iii) Asset values for each of the mergers and acquisitions transactions. Also calculate the median value for the multiples of the mergers and acquisitions transactions as a group. 6. Apply the median multiples as calculated in Question 5 to Company 456 to derive a mergers and acquisitions comparable valuation for Company 456. 7. Calculate the weighted valuations and total valuation for Company 456 using the DCF valuation, the public company comparables valuation (multiple of sales for competitors method), and the mergers and acquisitions valuation (multiple of sales for competitors method).