Valuation in different scenarios

Valuation in Acquisition Analysis:

Valuation should play a central part of acquisition analysis. The bidding firm or individual has to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. There are special factors to consider in takeover valuation. First, there is synergy, the increase in value that many managers foresee as occurring after mergers because the combined firm is able to accomplish things that the individual firms could not. The effects of synergy on the combined value of the two firms (target plus bidding firm) have to be considered before a decision is made on the bid. Second, the value of control, which measures the effects on value of changing management and restructuring the target firm, will have to be taken into account in deciding on a fair price. This is of particular concern in hostile takeovers. As we noted earlier, there is a significant problem with bias in takeover valuations. Target firms may be over-optimistic in estimating value, especially when the takeover is hostile, and they are trying to convince their stockholders that the offer price is too low. Similarly, if the bidding firm has decided, for strategic reasons, to do an acquisition, there may be strong pressure on the analyst to come up with an estimate of value that backs up the acquisition.

Valuation in Corporate Finance:

There is a role for valuation at every stage of a firm’s life cycle. For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital. The share of a firm that a venture capitalist will demand in exchange for a capital infusion will depend upon the value she estimates for the firm. As the companies get larger and decide to go public,

valuations determine the prices at which they are offered to the market in the public offering. Once established, decisions on where to invest, how much to borrow and how much to return to the owners will be all decisions that are affected by valuation. If the objective in corporate finance is to maximize firm value, the relationship between financial decisions, corporate strategy and firm value has to be delineated. As a final note, value enhancement has become the mantra of management consultants and CEOs who want to keep stockholders happy, and doing it right requires an understanding of the levers of value. In fact, many consulting firms have come up with their own measures of value (EVA and CFROI, for instance) that they contend facilitate value enhancement.

Applicability of multiples and limitations

The allure of multiples is that they are simple and easy to relate to. They can be used to obtain estimates of value quickly for firms and assets, and are particularly useful when there are a large number of comparable firms being traded on financial markets, and the market is, on average, pricing these firms correctly. In fact, relative valuation is tailor made for analysts and portfolio managers who not only have to find under valued equities in any market, no matter how overvalued, but also get judged on a relative basis. An analyst who picks stocks based upon their PE ratios, relative to the sectors they  operate in, will always find under valued stocks in any market; if entire sectors are over valued and his stocks decline, he will still look good on a relative basis since his stocks will decline less than comparable stocks(assuming the relative valuation is right). By the same token, they are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly similar in terms of risk and growth, the definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a group of comparable firms to confirm his or her biases about a firm's value. While this potential for bias exists with discounted cash flow valuation as well, the analyst in DCF valuation is forced to be much more explicit about the assumptions which determine the final value. With multiples, these assumptions are often left unstated. The other problem with using multiples based upon comparable firms is that it builds in errors (over valuation or under valuation) that the market might be making in valuing these firms. If, for instance, we find a company to be under valued because it trades at 15 times earnings and comparable companies trade at 25 times earnings, we may still lose on the investment if the entire sector is over valued. In relative valuation, all that we can claim isthat a stock looks cheap or expensive relative to the group we compared it to, rather than make an absolute judgement about value. Ultimately, relative valuation judgements depend upon how well we have picked the comparable companies and how how good a job the market has done in pricing them.

Relative Valuation

While the focus in classrooms and academic discussions remains on discounted cash flow valuation, the reality is that most assets are valued on a relative basis. In  relative valuation, we value an asset by looking at how the market prices similar assets. Thus, when determining what to pay for a house, we look at what similar houses in the neighbor hood sold for rather than doing an intrinsic valuation. Extending this analogy to 

stocks, investors often decide whether a stock is cheap or expensive by comparing its pricing to that of similar stocks (usually in its peer group). In this section, we will consider the basis for relative valuation, waysin which it can be used and its advantages and disadvantages. Basis for approach In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable. Included in this description  are two key components of relative valuation. The first is the notion of comparable or similar assets. From a valuation standpoint, this would imply assets with similar cash flows, risk and growth potential. In practice, it is usually taken to mean other companies that are in the same business as the company being valued. The other is a standardized price. After all, the price per share of a company is in some sense arbitrary since it is a function of the number of shares outstanding; a two for one stock split would halve the price. Dividing the price or market value by some measure that is related to that value will yield a standardized price. When valuing stocks, this essentially translates into using multiples where we divide the market value by earnings, book value or revenues to arrive at an estimate of standardized value. We can then compare these numbers across companies.

The simplest and most direct applications of relative valuations are with real assets where it is easy to find similar assets or even identical ones. The asking price for a Mickey Mantle rookie baseball card or a 1965 Ford Mustang is relatively easy to estimate given that there are other Mickey Mantle cards and 1965 Ford Mustangs out there and that the prices at which they have been bought and sold can be obtained. With equity valuation, relative valuation becomes more complicated by two realities. The first is the absence of similar assets, requiring us to stretch the definition of comparable to include companiesthat are different from the one that we are valuing. After all, what company in the world is remotely similar to Microsoft or GE? The other is that different ways of standardizing prices (different multiples) can yield different values for the same
company. Harking back to our earlier discussion of discounted cash flow valuation, we argued that discounted cash flow valuation was a search (albeit unfulfilled) for intrinsic value. In relative valuation, we have given up on estimating intrinsic value and essentially put our trust in markets getting it right, at least on average.


Variations on Relative Valuation In relative valuation, the value of an asset is based upon how similar assets are priced. In practice, there are three variations on relative valuation, with the differences primarily in how we define comparable firms and control for differences across firms:

 a. Direct comparison: In this approach, analysts try to find one or two companies that look almost exactly like the company they are trying to value and estimate the value based upon how these “similar” companies are priced. The key part in this analysis is identifying these similar companies and getting their market values.

b. Peer Group Average: In the second, analysts compare how their company is priced(using a multiple) with how the peer group is priced (using the average for that multiple). Thus, a stock is considered cheap if it trade at 12 times earnings and the average price earnings ratio for the sector is 15. Implicit in this approach is the assumption that while companies may vary widely across a sector, the average for the sector is representative for a typical company.

c. Peer group average adjusted for differences  Recognizing that there can be wide differences between the company being valued and other companies in the comparable firm group, analysts sometimes try to control for differences between companies. In many cases, the control is subjective: a company with higher expected growth than the industry will trade at a higher multiple of earnings than the industry average but how much higher is left unspecified. In a few cases, analysts explicitly try to control for differences between companies by either adjusting the multiple being used or by using statistical techniques. As an example of the former, consider PEG ratios. These ratios are computed by dividing PE ratios by expected growth rates, thus controlling (at least in theory) for differences in growth and allowing analysts to compare companies with
different growth rates. For statistical controls, we can use a multiple regression where we can regress the multiple that we are using against the fundamentals that we believe cause that multiple to vary across companies. The resulting regression can be used to estimate the value of an individual company. In fact, we will argue later in this book that statistical techniques are powerful enough to allow us to expand the comparable firm sample to include the entire market.

DCF Valuation- Pluses and Minuses

To true believers, discounted cash flow valuation is the only way to approach valuation, but the benefits may be more nuanced that they are willing to admit. On the plus side, discounted cash flow valuation, done right, requires analysts to understand the businesses that they are valuing and ask searching questions about the sustainability of cash flows and risk. Discounted cash flow valuation is tailor made for those who buy into

the Warren Buffett adage that what we are buying are not stocks but the underlying businesses. In addition, discounted cash flow valuations is inherently contrarian in the sense that it forces analysts to look for the fundamentals that drive value rather than what market perceptions are.Consequently, if stock prices rise (fall) disproportionately relative to the underlying earnings and cash flows, discounted cash flows models are likely to find stocks to be over valued (under valued). There are, however, limitations with discounted cash flow valuation. In the hands of sloppy analysts, discounted cash flow valuations can be manipulated to generate

estimates of value that have no relationship to intrinsic value. We also need substantially more information to value a company with discounted cash flow models, since we have to estimate cash flows, growth rates and discount rates. Finally, discounted cash flow models may very well find every stock in a sector or even a market to be over valued, if market perceptions have run ahead of fundamentals. For portfolio managers and equity research analysts, who are required to find equities to buy even in the most over valued markets, this creates a conundrum. They can go with their discounted cash flow valuations and conclude that everything is overvalued, which may put them out of business, or they can find an alternate approach that is more sensitive to market moods. It should come as no surprise that many choose the latter.

Inputs to Discounted Cash Flow Models

There are three inputs that are required to value any asset in this model - the expected cash flow, the timing of the cash flow and the discount rate that is appropriate given the riskiness of these cash flows. While we will be looking at discount rate and cash flow estimation in far more detail in the coming chapters, we will lay out the fundamentals in this section.

a. Discount Rates
In valuation, we begin with the fundamental notion that the discount rate used on a cash flow should reflect its riskiness, with higher risk cash flows having higher discount rates. There are two ways of viewing risk. The first is purely in terms of the likelihood that an entity will default on a commitment to make a payment, such as interest or principal due, and this is called default risk. When looking at debt, the cost of debt is the
rate that reflects this default risk. The second way of viewing risk is in terms of the variation of actual returns
around expected returns. The actual returns on a risky investment can be very different from expected returns; the greater the variation, the greater the risk. When looking at equity, we tend to use measures of risk based upon return variance. While the next chapter will look at the different models that attempt to do this in far more detail, there are some basic points on which these models agree. The first is that risk in an investment has to perceived through the eyes of the marginal investor in that investment, and this marginal investor is assumed to be well diversified across multiple investments. Therefore, the risk in an investment that should determine discount rates is the non diversifiable or market risk of that investment. The second is that the expected return on any investment can be obtained starting with the expected return on a risk-less investment, and adding to it a premium to reflect the amount of market risk in that investment. This expected return yields the cost of equity.


The cost of capital can be obtained by taking an average of the cost of equity, estimated as above, and the after-tax cost of borrowing, based upon default risk, and weighting by the proportions used by each. We will argue that the weights used, when valuing an on-going business, should be based upon the market values of debt and equity. While there are some analysts who use book value weights, doing so violates a basic principle of valuation, which is that at a fair value, one should be indifferent between buying and selling an asset.

b. Expected Cash Flows
In the strictest sense, the only cash flow an equity investor gets out of a publicly traded firm is the dividend; models that use the dividends as cash flows are called dividend discount models. A broader definition of cash flows to equity would be the cash flows left over after the cash flow claims of non-equity investors in the firm have been met (interest and principal payments to debt holders and preferred dividends) and after enough of these cash flows has been reinvested into the firm to sustain the projected growth in cash flows. This is the free cash flow to equity (FCFE), and models that use these cash flows are called FCFE discount models. The cash flow to the firm is the cumulated cash flow to all claim holders in the firm. One way to obtain this cash flow is to add the free cash flows to equity to the cash flows to lenders (debt) and preferred stockholders. A far simpler way of obtaining the same number is to estimate the cash flows prior to debt and preferred dividend payments, by subtracting from the after-tax operating income the net investment needs to sustain growth. This cash flow is called the free cash flow to the firm (FCFF) and the models that use these cash flows are called FCFF models.

c. Expected Growth
It is while estimating the expected growth in cash flows in the future that analysts confront uncertainty most directly. There are three generic ways of estimating growth. One is to look at a company’s past and use the historical growth rate posted by that company. The peril is that past growth may provide little indication of future growth. The second is to obtain estimates of growth from more informed sources. For some analysts,
this translates into using the estimates provided by a company’s management whereas for others it takes the form of using consensus estimates of growth made by others who follow the firm. The bias associated with both these sources should raise questions about the resulting valuations. We will promote a third way, where the expected growth rate is tied to two variables that are determined by the firm being valued - how much of the earnings are reinvested back into the firm and how well those earnings are reinvested. In the equity
valuation model, this expected growth rate is a product of the retention ratio, i.e. the proportion of net income not paid out to stockholders, and the return on equity on the projects taken with that money. In the firm valuation model, the expected growth rate is a product of the reinvestment rate, which is the proportion of after-tax operating income that goes into net new investments and the return on capital earned on these investments. The advantages of using these fundamental growth rates are two fold. The first is that the
resulting valuations will be internally consistent and companies that are assumed to have high growth are required to pay for the growth with more reinvestment. The second is that it lays the foundation for considering how firms can make themselves more valuable to their investors.

Variations on DCF Models

The model that we have presented in this section, where expected cash flows are discounted back at a risk-adjusted discount rate, is the most commonly used discounted cash flow approach but there are two widely used variants. In the first, we separate the cash flows into excess return cash flows and normal return cash flows. Earning the risk adjusted required return (cost of capital or equity)is considered a normal return cash flow but any cash flows above or below this number are categorized as excess returns; excess returns can therefore be either positive or negative. With the excess return valuation framework, the value of a business can be written as the sum of two components:
Value of business = Capital Invested in firm today + Present value of excess return cash flows from both existing and future projects

If we make the assumption that the accounting measure of capital invested (book value of capital) is a good measure of capital invested in assets today, this approach implies that firms that earn positive excess return cash flows will trade at market values higher than their book values and that the reverse will be true for firms that earn negative excess return cash flows.

In the second variation, called the adjusted present value (APV) approach, we separate the effects on value of debt financing from the value of the assets of a business. In general, using debt to fund a firm’s operations creates tax benefits (because interest expenses are tax deductible) on the plus side and increases bankruptcy risk (and expected  bankruptcy costs) on the minus side. In the APV approach, the value of a firm can be
written as follows:
Value of business = Value of business with 100% equity financing + Present value of Expected Tax Benefits of Debt – Expected Bankruptcy Costs

In contrast to the conventional approach, where the effects of debt financing are captured in the discount rate, the APV approach attempts to estimate the expected dollar value of debt benefits and costs separately from the value of the operating assets.While proponents of each approach like to claim that their approach is the best and most precise, P.S that the three approaches yield the same estimates of value, if we make consistent assumptions.

Equity Valuation versus Firm Valuation

There are two ways in which we can approach discounted cash flow valuation. The first is to value the entire business, with both assets-in-place and growth assets; this is often termed firm or enterprise valuation.

The cash flows before debt payments and after reinvestment needs are called free cash flows to the firm, and the discount rate that reflects the composite cost of financing from all sources of capital is called the cost of capital. The second way is to just value the equity stake in the business, and this is called equity valuation.

The cash flows after debt payments and reinvestment needs are called free cash flows to equity, and the discount rate that reflects just the cost of equity financing is the cost of equity. Note also that we can always get from the former (firm value) to the latter (equity value) by netting out the value of all non-equity claims from firm value. Done right, the value of equity should be the same whether it is valued directly (by discounting cash flows to equity a the cost of equity) or indirectly (by valuing the firm and subtracting out the value of all non-equity claims). 

Classifying Discounted Cash Flow Models

There are three distinct ways in which we can categorize discounted cash flow models. In the first, we differentiate between valuing a business as a going concern as opposed to a collection of assets. In the second, we draw a distinction between valuing the equity in a business and valuing the business itself. In the third, we lay out three different and equivalent ways of doing discounted cash flow valuation – the expected

cash flow approach, a value based upon excess returns and adjusted present value. 

Going Concern versus Asset Valuation

The value of an asset in the discounted cash flow framework is the present value of the expected cash flows on that asset. Extending this proposition to valuing a business, it can be argued that the value of a business is the sum of the values of the individual assets owned by the business. While this may be technically right, there is a key  difference between valuing a collection of assets and a business. A business or a company is an on-going entity with assets that it already owns and assets it expects to invest in the future.

Investments that have already been made are categorized as assets in place, but investments that we expect the business to make in the future are growth assets. A financial balance sheet provides a good framework to draw out the differences between valuing a business as a going concern and valuing it as a collection of assets. In  a going concern valuation, we have to make our best judgments not only on existing investments but also on expected future investments and their profitability. While this may seem to be foolhardy, a large proportion of the market value of growth companies comes from their growth assets. In an asset-based valuation, we focus primarily on the assets in place and estimate the value of each asset separately. Adding the asset values together yields the value of the business. For companies with lucrative growth

opportunities, asset-based valuations will yield lower values than going concern valuations.

One special case of asset-based valuation is liquidation valuation, where we value assets based upon the presumption that they have to be sold now. In theory, this should be equal to the value obtained from discounted cash flow valuations of individual assets but the urgency associated with liquidating assets quickly may result in a discount on the value. How large the discount will be will depend upon the number of potential buyers for the assets, the asset characteristics and the state of the economy.