Special Cases of Business Valuation di: Marco Vulpiani Cap.1 - The possible valuation methods

CHAPTER 1 THE POSSIBLE VALUATION METHODS CHAPTER 1 - The Possible Valuation Methods

“Nowadays people know the price of everything and the value of nothing.”

(Oscar Wilde, “The Picture of Dorian Gray”)

“What I have here in my heart Is like faith, but not faith….

What I have here in this room Is knowledge without proof…..

What I have here in my hand Is like knowing but deeper It's why I have faith..”

(Marillion,“Faith”)

CHAPTER 1 THE POSSIBLE VALUATION METHODS Introduction 1.1 Financial Methods 1.1.1 1.1.1.1 1.1.1.2 1.1.1.3 1.1.1.4 1.1.2 1.1.2.1 1.1.2.2 1.1.2.3 1.1.2.4 1.1.2.5 1.1.2.6 1.1.2.7 1.1.2.8 1.1.2.9 1.1.2.10 1.1.3 1.1.3.1 1.1.3.2 1.1.3.3 1.1.3.4 1.1.3.5 1.1.3.6 1.1.4 1.1.4.1 1.1.4.2 1.1.4.3

1.2

Discounted Cash Flow Method The key inputs in DCF valuation Cash flows The discount rate From firm value to equity value Adjusted Present Value Method Introduction Description of the APV Method Cash flows The discount rate The terminal value The “unlevered” value The value of tax benefits The firm value APV and DCF Concluding remarks on the APV Economic Value Added Method Introduction Definition of Economic Value Added - EVA© EVA© as a business valuation method Summary of the main advantages of EVA© Business valuation with the EVA© method EVA© vs DCF Net Income Method The expected income flows The discount rate (i) Explicit period (n)

Market Methods 1.2.1 1.2.2

Stock Exchange Multiple Method Comparable Transactions Method

1.3

Asset-based Methods and Mixed Method 1.3.1 1.3.2 1.3.2.1 1.3.2.2 1.3.3

References

Goodwill Equity Methods Simple equity method Complex equity method Mixed Method

CHAPTER 1 - The Possible Valuation Methods

Introduction Valuation is one of the most critical phases in the implementation of M&A projects and in business decision processes in general.

In particular, the theoretical value of a firm is the parameter by which different counterparties base their expectations. The final price may of course differ significantly from the theoretical reference value, depending on other aspects that are independent of the true “stand alone” value (such as synergies, market conditions, etc.). The price estimate, requiring many assumptions, characteristically shows a significant level of subjectivity. This is evident from the many cases of failed negotiations, resulting from misalignments in terms of price expectations.

For Businesses in special situations, the valuation process is more complex still, due to the “special” status of the business which makes it more difficult to forecast its economic and financial outlook.

A general description of the main valuation methods used is provided below, with specific reference to the valuation of businesses in special situations.

In particular, the following main valuation methods are described in both theoretical and practical terms:  Financial methods;  Market methods;  Asset-based methods.

7

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Part I - The Theoretical Background

CHAPTER 1 - The Possible Valuation Methods

1.1

Financial Methods

A considerable number of models have been developed within the more general category of financial methods. Nevertheless, the theoretical rationale behind the method is that the value on a given date can be represented by the cash flows that will be produced by the firm during its future life, appropriately discounted to reflect time and risk factors.

These methods are justified by the empirical evidence of a correlation between the values measured by the stock market and the cash flows generated by the business. The below chart (Copeland T. E. et al., 1991), shows the correlation between firm market value and cash flow (both values having been reported at the corresponding book value so as to render them “dimensionless” and therefore comparable) for S&P 500 Index companies. The chart shows that the correlation (r-squared) between Market Value and Cash Flow is equal to 0.94. This has led to the conclusion that the real driver of business value is the cash flow generated:

Fig. 1.1 – Value vs Cash flow

In other words, as summarised by the authors, for investors, “Cash is King”.

9

Part I - The Theoretical Background

10

From a practical point of view, the financial method is expressed in the formulation of value as the sum of a firm's future cash flows, suitably discounted, as summarised in the following formula:

∑

[1.1]

where: CFt

= Cash flow in time period t;

r

= Discount rate reflecting the risk and the time factor of the estimated cash flows.

There is an objective difficulty in predicting the temporal duration of the enterprise. The idea of a company having a hypothetically unlimited duration is generally considered acceptable. This is because companies usually have a long-term life expectancy (decades) and because the effect of long-term cash flows has become negligible in recent years.

For obvious practical reasons (forecasting capability), this “unlimited” time period is divided, into two sub-periods: the explicit forecast period, in which cash flows are punctually estimated, and the residual period, in which the residual value is estimated using simplified assumptions (terminal value):

∑ Value of cash flows, explicit time period (calculated)

[1.2]

Terminal Value (estimated)

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CHAPTER 1 - The Possible Valuation Methods

where: N

= Explicit forecast period;

CFt

= Cash flow in time period t;

r

= Discount rate.

The terminal value is estimated by using some simplifying assumptions. One of the most commonly adopted is the one expressed by the “Gordon formula”, which assumes the stable growth of cash flows: CF(n+1) = CFn * (1+g)

[1.3]

where: n > N = number of years after the explicit forecast period; CF

= normalised cash flow;

r

= discount rate;

g

= growth rate.

This formula assumes that the cash flow will grow at a constant rate. In this case the second term of [1.2] becomes a so-called convergent series of infinite terms, which converges into a single, simple result:

∑

[1.4]

This greatly simplifies the valuation process as it allows the valuation to be carried out with the following limited information:  CFn

= N cash flows in the explicit period;

 CF

= cash flow to be assumed normalized for terminal

Part I - The Theoretical Background

12

value;  r

= discount rate;

 g

= growth rate.

Under these conditions, within the scope of the general group of financial methods, each specific valuation technique differs substantially in terms of the object of valuation:  equity (direct methods) or enterprise (indirect methods);  cash flow, punctual or normalised;  individual assumptions carried out when applying the method (discount rate, taxes, etc.).

Aside from the advantages or disadvantages, the main financial methods can be identified with the DCF method (Myers S. C., 1974) and the APV method.

Both methods are based on the conclusions of the theory developed

by Modigliani & Miller (1958-1963) regarding the link between financial structure and firm value, although there is a difference, as explained in greater detail below, in the methodological approach.

Modigliani & Miller Proposition I (1958) states that, in the context of those important simplified assumptions (efficient market, no taxes, etc.) the value of a financially indebted company (“levered”) is the same as that of a debt-free company (“unlevered”) and postulates that the financial structure does not influence firm value. This concept is developed in proposition II (1963), according to which the cost of equity increases in direct correlation to the debt/equity ratio.

More generally, it is normally accepted that, if one does not take into consideration the hypothetical absence of taxes, debt has the following main effects on firm value:

CHAPTER 1 - The Possible Valuation Methods

1. tax benefits associated with indebtedness (hereinafter, for the sake of brevity, referred to as “tax shield”); 2. the cost of bankruptcy (or insolvency); 3. the effect of “psychological tension” that the debt may have on management due to the increased focus on cash outflow and consequently on operating cash flows (“Equity is a 1

pillow, debt a sword” ).

While the latter of the two effects are usually neglected in the valuation phase (unless specific circumstances arise), the first effect, the tax benefit as regards the debt, does not appear to be negligible.

Both the Discounted Cash Flow and APV methods consider the tax effects of debt and it can be argued that they differ substantially particularly in the way in which the value associated to the tax shield is calculated, as described in depth in the next paragraph.

1

See Stewart and Glassman (1988) cited in the references.

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Part I - The Theoretical Background

14

1.1.1 Discounted Cash Flow Method The discounted cash flow method, better known by the acronym DCF, is the method based on the discounting of the available cash flows. As is common knowledge, the DCF, is the financial method most used in practice.

The method is based on cash flows calculated assuming the absence of debt (“unlevered”), i.e. without the effect of leverage generated by debt.

This method is typically applied in order to determine the firm value as a whole.

In other words, the theoretical value of the economic capital is calculated by algebraically adding to the present value of cash flows from operations, the value of the net financial position, namely:  in the case of debts, subtracting the net debt;  in the case of liquidity, adding the liquidity.

1.1.1.1

The key inputs in DCF valuation

On the basis of the topics mentioned so far, the method requires the determination, of just a few important inputs:

∑

Value of cash flows, explicit time period (calculated)

[

]

Terminal Value (estimated)

[1.5]

CHAPTER 1 - The Possible Valuation Methods

Thus the elements necessary for valuation using the DCF method are:  expected cash flows;  discount rate;  growth rate.

The discount rate is taken into account during the discounting process, which makes the cash flows occurring in different periods homogeneous and comparable on a given date.

1.1.1.2

Cash flows

Cash flows are monetary flows and are recorded on the basis of the actual time of receipt/payment (cash basis of accounting) rather than economic accountability (accruals basis of accounting). Indeed, the accounting results, defined on an accruals basis, give rise to accounting income that does not represent the actual resources available to the company and its shareholders in a given time period.

Cash flows considered are those generated from (or absorbed by) the enterprise’s operating activities, i.e. cash flows from the company’s ordinary operations.

Cash flows are calculated gross of financial charges. Financial charges, the taking out and repayment of debt, in fact fall under the financial management rather than operational management of the company, and are not therefore included in the calculation of the cash flows.

As described below, the financial tax benefit is taken into account when calculating the discount rate, by reducing the cost of debt by the tax shield (1 - tax rate).

Unlevered Cash Flows are calculated as follows:

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Part I - The Theoretical Background

16

Earnings Before Interest and Taxes (-)

Figurative taxes on operating income

(+)

Depreciation and amortisation, net of the use of provisions

(-)

Increase (decrease) in working capital

(-)

Investment (divestment) in fixed assets

(=)

Unlevered cash flow

1.1.1.3

The discount rate2

The discount rate represents the return required by those who are to finance the enterprise in terms of equity capital and debt capital.

The “yield” is calculated by applying the WACC formula (Weighted Average Cost of Capital), which indicates the weighted average cost of capital for the company.

The WACC or weighted average cost of capital is calculated as follows: WACC = Ke * We + Kd * Wd * (1 - t) where:

2

 Ke

= cost of equity;

 We

= weight of equity;

 Kd

= cost of debt;

 Wd

= weight of debt;

 t

= tax rate.

For further details on the discount rate, see the next chapter.

[1.6]

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CHAPTER 1 - The Possible Valuation Methods

The cost of equity is generally estimated by applying the CAPM formula (Capital Asset Pricing Model).

The CAPM formula is as follows: Ke = Rf + Betal * MRP

[1.7]

where:  Rf

= risk-free rate;

 Betal = beta levered;  MRP = market Risk Premium.

The beta coefficient indicates the extent of the risk for the specific company, expressed by the volatility of its performance compared to that of the market as a whole.

1.1.1.4

From firm value to equity value

The sum of the above-defined cash flows, discounted by the WACC, allows determination of the value the company (“Firm Value”) in the explicit forecast period.

In order to calculate the value in the residual life, reference will be made to a simplified formula, for example formula [1.4].

To this end, a “normalised” cash flow, representative of the cash flows expected during the normal residual life, must be identified.

In practice, reference is generally made to the operating results from the last year of the explicit period (for the expected results closest to the estimated period), and the cash flow is based on the following main assumptions:  working capital variation: null or growing in line with revenue growth;

Part I - The Theoretical Background

18

 investments: equal to depreciation/amortisation.

The latter assumption is particularly coherent with the assumption of the asset with an infinite life.

Below the scheme of normalised cash flows is summarised, estimated on the basis of such assumptions: Earnings Before Interest and Taxes (-)

Figurative taxes on operating income

(=)

Nopat

(+)

Depreciation, amortisation net of funds utilisation (D&A)

(-)

Increase (decrease) in working capital = 0

(-)

Investments (divestment) in fixed assets = D&A

(=)

Unlevered cash flow = NOPAT

The total value of the company (“enterprise value”) is determined by adding the terminal value to the cash flows from the business plan.

Lastly, the value of the net financial position is added (i.e. the debt is deducted from or the cash is added) to the enterprise value, in order to determine the equity value of the company, as illustrated in the below graph: Terminal Value FCFF Plan Value

Enterprise Value

Net Financial Position

Equity Value

Fig. 1.2 – From firm value to capital value

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CHAPTER 1 - The Possible Valuation Methods

3

1.1.2 Adjusted Present Value Method

1.1.2.1

Introduction

In the Adjusted Present Value method (hereinafter “APV”) the value of the firm is calculated as the sum of the “unlevered” value (as if financed solely with equity), plus the value of the tax savings: Enterprise Value = “Unlevered” Enterprise Value + PV of tax savings

[1.8]

According to the DCF method, the cash flows are always assumed to be “unlevered”, and the tax benefit from discounting of the cash flows (tax shield) is taken into account, thus reducing (in the calculation of the Weighted average Cost of Capital, hereinafter, “WACC”) the cost of debt: WACC = Ke * E/(E+D) + Kd * D/(E+D) * (l – t)

[1.9]

where:

3

 t

= marginal tax rate;

 Ke

= cost of equity;

 Kd

= cost of debt;

 E

= equity value (hereinafter, “Equity”);

 D

= net financial debt value (hereinafter, “Debt”).

This paragraph is mainly based on the “Considerazioni sul Metodo di Valutazione APV” article (Vulpiani M., 2002).

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Part I - The Theoretical Background

Indeed, an implicitly simplified assumption is made in the DCF method: the relationship between the value of debt and the value of equity, hereinafter referred to as “market leverage” or simply “leverage”, is constant over the company’s life. This clearly does not occur in real companies, and this assumption is thus an approximation rendered necessary by the method. In addition to being a significant approximation, there are also considerable difficulties in the concrete application of this assumption.

First of all, the values of the equity and the net financial debt used to calculate the D/E ratio must be represented, at least theoretically, by market values. When a valuation process is underway, the value of the firm (and of its Net Financial Debt and Equity components) is probably unknown. This difficulty can however be overcome in various ways (by applying an iterative procedure for example, or by evaluating equity using other methods, etc.).

The main difficulty, even theoretically, is in the choice of which value use as leverage. It is reasonable for the levels of a company’s debt to vary year after year. There is therefore an evident complexity in representing the financial structure throughout the life of the company, which is assumed to be constant. In this sense, professional practice tends to suggest the use of a leverage known as “target leverage” for the company. This professional practice is supported by practical considerations relating to the sensitivity of the values of the two components (the explicit forecast period and terminal value) and the discount rate used, together with the assumption that a company should have a target financial structure . This leverage is set as the medium-long term leverage objective by the management. The difficulty arises from the fact that, management has frequently not clearly defined this objective. In fact, at least theoretically, target leverage, especially if understood as a management objective, should be the objective that minimises the cost of capital and thus maximises the value. Yet the dynamic day-to-day business typically sees the

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CHAPTER 1 - The Possible Valuation Methods

financial structure as subservient to operational needs and strategic development rather than to optimising the financial nature.

The valuation process must thus refer to sector leverages (i.e. the average leverage of a sample of guideline companies), or to the leverage of the last few years of the business plan.

This simplified assumption is very often “adopted” without much thought while overlooking its impact on the valuation conclusions.

In order to provide an indication of the quantitative significance of this assumption, a “case study” is reported in the following paragraph (see below: valuation of the “Engineering” company) while highlighting the changes in value arising as a result of changes in this assumption (ceteris paribus), as part of a valuation using the DCF method: Leverage

WACC

Value

Var. %

units

%

EUR/mln

%

0.0 0.5 1.0 1.5 2.0

12.3 11.2 10.6 10.3 10.1

3.5 4.5 5.1 5.5 5.8

(31) (12) 0 8 14

Tab. 1.1 – Value sensitivity to the leverage target

A variation of +/-1 unit of leverage, compared to the basic assumption of leverage target equal to 1, results in a value fluctuation 4

of +14% to -31% .

4

In this sensitivity, for the sake of simplicity, changes in the cost of debt on variation of the range under consideration, have been assumed to be negligible (in the case, for example, of companies with a high EBIT to Net Financial Charges – interest Coverage ratio).

Part I - The Theoretical Background

22

Considering the difficulties set out above with regards to the choice of the leverage target, the sensitivity is therefore noteworthy.

1.1.2.2

Description of the APV Method

A brief description of the APV method, applied to the valuation of 5

the hypothetical “Engineering” company , is provided below.

As previously mentioned, according to the APV method, the theoretical value of the company (the “Firm Value”) can be expressed as the sum of the theoretical value of the company in the absence of debt (as if the firm has been 100% funded with equity), and the theoretical value of the tax benefits determined by the financial debt.

Vl = Vu + VTS

[1.10]

where:  Vl

= theoretical value of the levered firm;

 Vu

= theoretical value of the unlevered firm;

 VTS

= tax benefits of the debt (Tax Shield).

The APV method, similar to the DCF method, calculates the “unlevered” value based on the Cash Flow, while assuming the absence of debt (“unlevered”), net of related taxes and discounted at an appropriate rate.

More precisely, as described below, both Vu and VTS values have been calculated in the explicit period and estimated for the residual life.

5

A purely theoretical case developed for the purpose of this document. Any reference to cases of real companies or investments is purely coincidental.

CHAPTER 1 - The Possible Valuation Methods

1.1.2.3

Cash flows

More specifically, in the APV method, unlevered cash flows are obtained as follows: EBIT (Earnings Before Interest and Taxes) -

Taxes paid on EBIT

+

Depreciation/Amortisation

-

Investments

-/(+) Increase/(Decrease) in Working Capital =

Unlevered Cash Flow

On the basis of the same assumption, the cash flows used to calculate the unlevered value in the APV method are the same as in the DFC method. The main difference relates to the discount rate used in the valuation.

1.1.2.4

The discount rate

The traditional DCF method is based on the aforedescribed WACC. In the APV method however, the discount rate used for the unlevered cash flows is the unlevered cost of equity. This assumption is consistent with the objective of determining the value of the enterprise, when the enterprise is financed exclusively with equity capital.

In order to estimate the cost of the “unlevered” equity the same “practices” are followed as for the WACC and, in particular, reference is generally made to the Capital Asset Pricing Model method

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Part I - The Theoretical Background

24

(hereinafter referred to as CAPM) developed by W. Sharpe, which 6 expresses the cost of the equity with the following formula : Ke = Rf + β * Market Risk

[1.11]

where:  Ke

= cost of the firm’s equity capital;

 Rf

= risk free rate;

 Market Risk = premium for the benchmark Stock Premium Exchange Market;  β

= multiplicative factor representative of the risk.

The beta, representative of the cost associated with the nondiversifiable risk (i.e. the minimum risk that is assumed must be paid to the shareholders of the company) must be unlevered, in the case of the APV, i.e. it must exclude the financial risk component and assume that the company is solely financed by equity. The “historical” betas, whether sector betas or betas of sample companies taken as reference for comparative analysis, are clearly affected by the specific financial risk.

Such betas must therefore be “purified” of the firm-specific “leverage” effect.

Reference is made to this end to the contribution of Hamada, who analysed the correlation between beta and financial leverage, 7 demonstrating the relationship between levered and unlevered beta. β = βu + βu * (1 - t) * D/E = βu * [ 1 + (1 - t) D/E ] 6 7

A more detailed description of the method can be found in chapter 2.

See Hamada (1969) cited in the references.

[1.12]

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CHAPTER 1 - The Possible Valuation Methods

where:  βu

= beta unlevered;

 t

= marginal tax rate;

 D/E

= Debt/Equity = leverage.

Formula [1.12] allows calculation of the unlevered beta starting from the levered beta. The unlevered cost of equity is determined using Formula [1.11]: Keu = rf + βu * Market Risk

[1.13]

where: 

Keu = cost of the equity capital of the unlevered firm;



βu = unlevered beta of the firm.

More specifically, the following assumptions were made when evaluating the “Engineering” case study company:  risk free rate (5.1%): long-term BTP maturity yield;  market Risk Premium (6.1%): the premium adopted for the Italian Stock Exchange Market;  beta (1.2): average unlevered beta of a panel of comparable companies (see below table).

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26

Unlevered beta of comparables listed companies Comparables companies Vega Group Plc Mechanical Technology Inc. BCI Navigation ICT Automatisering NV Yeoman Group Plc

Levered beta

Debt/Equity ratio

Tax rate

Unlevered beta (*)

0.76 1.77 1.39 1.05 1.19

0.19 0.13 -0.03 -0.18 -0.10

35.12% 40.00% 40.00% 32.94% 31.00%

0.68 1.64 1.39 1.05 1.19

Average unlevered beta

1.19

(*) In case of negative D/E ratio (cash position) Unlevered beta is assumed equal to Levered beta.

Tab. 1.2 – Estimate of beta from “comparables”

The discount rate, calculated on the basis of these assumptions, in the two unlevered cost of equity and WACC forms, is summarised in the following table: Unlevered Cost of Equity and WACC Risk-free interest rate (BTP average) % Risk premium % Beta unlevered Beta levered Cost of unlevered equity % Cost of equity % Cost of debt before taxes % Marginal income tax rate Cost of debt after taxes % Leverage WACC %

5.1 6.1 1.2 1.96 12.3 17.0 7.6 35% 4.9 1.0 11.0

Tab. 1.3 – Estimate of the cost of unlevered equity

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CHAPTER 1 - The Possible Valuation Methods

1.1.2.5

The terminal value

With both the DCF method and the APV method, the value of the firm is obtained by adding the cumulative value of “unlevered” discounted cash flows to the terminal value.

The formula most frequently used is the growing perpetuity formula, which calculates the terminal value by assuming that the value of the normalised cash flow will grow at a constant rate each year of its residual life (“g” factor). This formula can of course also be used in the APV method, using the cost of unlevered equity as the discount rate.

[1.14] where: 

FCFn+1 = normalised cash flow, representing the residual life after the year n, the last year of the explicit forecast;



Keu

= cost of “unlevered” equity, i.e. in the event of the absence of debt;



g

= expected growth rate.

In case of the “Engineering” company, the following normalised cash flow was estimated:

Part I - The Theoretical Background

28

Normalized Free Cash Flow (EUR/'000)

Unlevered Net Income Amortization Gross Cash Flow Disinvestments Technical Investments Working Capital changes Other sources/uses Total investment Normalized Free Cash flow

878 284 1,163 (284) (284) 878

Tab. 1.4 – Free Cash Flow estimate

A growth rate (g) of 1% was assumed.

1.1.2.6

The “Unlevered” Value

The enterprise value, gross of the tax benefits due to debt, is obtained from the sum of the value in the specific period and the terminal value, both calculated as “unlevered”, In the event of the “Engineering” company, the estimated enterprise value is: Unlevered value = -3.1 + 4.9 = + 1.8 EUR/mln

1.1.2.7

The Value of tax benefits

The value of the tax benefits associated to the debt is added to the unlevered value. The tax benefit is valued as the sum of the suitably discounted projected annual tax benefits.

The discount rate to be used for discounting the tax benefits is a subject of debate among scholars. To our knowledge, there are currently three main positions:

CHAPTER 1 - The Possible Valuation Methods

1. cost of debt; 2. cost of unlevered equity; 3. other (intermediate rate between the two).

Regardless of the various theoretical demonstrations (of lesser or greater complexity), conceptually the different positions are based on the following considerations: 1. Academics in favour of position 1), cost of debt, believe that since the tax benefits have arisen from the financial charges associated with the debt position, the rate to be applied must, accordingly, be the cost of debt. In particular, M&M and Myers make this assumption in the respective cases of enterprises with zero growth rate and growth rates other than zero; 2. Academics in favour of position 2), unlevered cost, believe that since there are no tax benefits (if there is no taxable income), and such income being subject to enterprise risk, the rate at which the income before taxes should be discounted, must therefore be the cost of equity (unlevered). In particular: 

Miles & Ezzell (Miles J. A. & Ezzell J. R., 1980) and Ezzell & Miles (Ezzel J. R. & Miles J. A., 1983) argue that the tax shield should be discounted at the cost of debt in the first year and at the unlevered cost in the subsequent remaining years;



Harris & Pringle (Harris R. S. & Pringle J. J., 1985) argue that the discounting must be carried out at the unlevered cost every year, including the first year;



Kaplan & Ruback (Kaplan S. N. & Ruback R. S., 1995) have developed a model known as the “Compressed Adjusted Present Value” (CAPV) for cases of non-zero growth rate. In this, the tax benefits are discounted to

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Part I - The Theoretical Background

30

unlevered costs and show interesting correlations between the results obtained from the valuation using the CAPV applied to realised transactions.

3. Concerning academics in favour of the intermediated rates thesis, reference should be made to Luehrman (Luehrman T. A., 1997), according to whom the appropriate rate should be between the previous two. To the author’s knowledge, except for the subjective choice of the appraiser, literature does not precisely indicate, and according to which criteria, an arbitrary rate between the two.

Moreover, in one paper, the authors (Ehrhardt M. C. & Daves P. R., 1999), examined the combined impact of firm growth (growth rate) and tax shield on the values of the company. They compared the different approaches (Ehrhardt M. C. & Daves P. R., 1999), showing that if the tax shield of a growing company is discounted at a rate that is less than the cost of the unlevered equity, then the valuation results are inconsistent with intuitive sense and everyday observations. In particular, the authors refer to the specific case in which the unlevered cost is less than the levered cost of equity, and the cost of capital decreases when the capital increases, as if the amount of debt were increasing.

On the basis of these latter theoretical considerations, we are in favour of the position whereby the tax shield should be discounted at the unlevered cost of equity.

In the “Engineering” case study, the value of the tax shield, using the unlevered cost of equity as discount rate, is equal to 1.2 EUR/mln (see table 1.6): VTS explicit period

= + 0.4 EUR/mln

VTS Terminal:

= + 0.8 EUR/mln

CHAPTER 1 - The Possible Valuation Methods

VTS Total:

1.1.2.8

= + 1.2 EUR/mln

The Firm Value

In this case study, the firm value is equal to: Vl = Vu + VTS = 1.8 + 1.2 = + 3.0 EUR/mln

1.1.2.9

APV and DCF

The valuation, carried out using the DCF method, assuming a target and stable leverage ratio equal to 1, ceteris paribus leads to the following conclusions regarding the firm value (see Table 1.6): Vl

= + 2.6 EUR/mln

delta Vs APV

= - 13%

In this case, using the DCF method, the value is underestimated by 13% with respect to the value determined by the APV method. This underestimation is certainly in part attributable to the approximation made in the explicit period, in which using the DCF, in assuming a constant discount rate, the benefits associated with the debt in the first few years are underestimated.

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Part I - The Theoretical Background

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DCF BUSINESS EVALUATION Year 1 Year 2

(EUR/'000)

EBIT Figurative taxes Unlevered Net Income Amortization Gross Cash Flow Disinvestments Technical investments Working Capital changes Other sources/uses Investment Free cash flow Free cash flow present value Cumulated free cash flow present value FCF Continuining Value Present value of FCF Continuing value

Year 3

Year 4

1,261 (640) 621 209

1,373 (700) 673 232

1,542 (776) 766 253

1,743 (873) 870 284

829 (209) (635) (843) (14) (13) (13)

906 (232) (3,406) (3,638) (2,733) (2,219) (2,232)

1,019 (253) (1,519) (1,772) (754) (552) (2,784)

1,154 (284) (1,539) (1,823) (669) (441) (3,225) 8,903 5,871

Corporate value @ 31/12

Tab. 1.5 – Valuation using the DCF method

2,646

33

CHAPTER 1 - The Possible Valuation Methods

APV BUSINESS EVALUATION Year 1 Year 2

(EUR/'000)

EBIT Figurative taxes Unlevered Net Income Amortization Gross Cash Flow Disinvestments Technical investments Working Capital changes Other sources/uses Investment Free cash flow Free cash flow present value Cumulated free cash flow present value FCF Continuining Value Present value of FCF Continuing value Debt Tax Shield Cash Flow Debt Tax Shield Cash Flow present value Cumulated Tax Shield Cash Flow Tax Shield Cash Flow continuing value Present value of Tax Shield Continuing value

Year 3

Year 4

1,261 (640) 621 209 829

1,373 (700) 673 232 906

1,542 (776) 766 253 1,019

1,743 (873) 870 284 1,154

(209) (635) (843) (14) (12) (12) 70 62 62

(232) (3,406) (3,638) (2,733) (2,167) (2,179) 112 88 150

(253) (1,519) (1,772) (754) (532) (2,711) 166 117 268

(284) (1,539) (1,823) (669) (420) (3,132) 7,847 4,932 204 128 396 1,205 757

Corporate value @ 31/12

2,954

Tab. 1.6 – Valuation using the APV method

1.1.2.10 Concluding Remarks on the APV It can generally be said that in certain business conditions, such as limited variability of the financial position, appropriate selection of the target leverage, reduced taxation, etc., the conclusions reached on the company being valued using the DCF method do not substantially differ from those reached using the APV method. Some authors even argue and demonstrate that, under certain, purely hypothetical assumptions that rarely arise in practice, the conclusions are indeed the same (see Fernandez P., 1999; 2001).

Part I - The Theoretical Background

34

In the business world, the assumption of a constant debt to equity ratio for the entire life of the company (assumed to be infinite if the perpetuity formula is used to calculate the terminal value), is difficult 8

to sustain .

The APV method, with the due limitations, overcomes this assumption (at least in the explicit period) and focuses on the actual development of the financial structure over time, reducing the level of approximation in the valuation process. This approximation can be significant in companies recording significant changes in the level of debt (with respect to the firm value), such as in companies subject to financial restructuring, or in the case of the selection of an inappropriate target leverage.

8

Let us consider for example the case of a value-oriented company, which generates value through cash flows in every reporting period. In order to maintain a constant ratio, the firm would need to increase the level of debt by an amount corresponding to the increase in value, multiplied by the leverage. Without targeted financial measures, which should be undertaken by the company for such purposes, this appears difficult to achieve.

35

CHAPTER 1 - The Possible Valuation Methods

1.1.3 Economic Value Added Method

1.1.3.1

Introduction

It is now widely accepted that one of the key objectives of company management should be maximising the value of a company, as a higher firm value:  remunerates shareholders;  generates benefits for the company as a whole.

Indeed, the search for value creation leads to the allocation of scarce resources for more productive use and the more effectively such resources are managed and used then the more solid is the firm’s economic development.

Traditional indicators, typically based on accounting measures, do not allow correct measurement in terms of shareholder value creation.

The value is clearly linked to the company’s profitability (the higher the profitability the greater the value).

An indicator often used to measure a company’s profitability is represented by the return on equity, ROE, defined as the ratio of net profit to shareholders’ equity: [1.15] However, ROE is influenced by a number of accounting distortions due to:  the choice of valuation method for inventories (e.g. LIFO, FIFO);  the recognition or non-recognition of research and

Part I - The Theoretical Background

36

development costs;  the allocation to provisions of part of the liquidity generated by the company through its operating activities.

In addition, as a measure of the company’s profitability, ROE is sensitive to changes in the mix of equity and debt used by the firm and in the interest rate paid on the debt, as indicated in the following formula: ROE = [ROI + (ROI - FC/D) * D/E] * (1-t)

[1.16]

where: 

ROI = return on investment (EBIT/Net Invested Capital);



FC

= financial charges;



D

= financial debt;



D/E = leverage;



t

= tax rate.

It is thus difficult to determine whether an increase or a decrease in ROE can be attributed to operational rather than financial reasons. In adopting ROE as a corporate objective, management may be forced to accept projects that are not profitable for the company, as they are financed through debt, and forgo profitable investments as they are financed through equity.

In other words, if attention is focused on ROE:  operational decisions are not separate from financial decisions and investments are not therefore valued on the exclusive basis of their characteristics;  projects that are effectively advantageous for the company

37

CHAPTER 1 - The Possible Valuation Methods

may not be accepted, as a sufficient profitability is required to cover the equity capital.

As part of the valuation of the company’s performance, a more representative indicator is the rate of return on capital employed (ROCE – Return on Capital Employed).

This is calculated as the ratio of: 

Net Operating Profit After Tax (NOPAT); to



total capital employed in operations, similar to the return (net of taxes) on the capital employed by the company.

[1.17]

where: 

NOPAT = Income available to shareholders + financial expenses after taxes; Capital Employed = Equity + Net Financial Debt



as previously mentioned, NOPAT is the operating net operating profit after tax calculated on the operating profit.

First of all, operating costs (including depreciation) are deducted from revenues. What emerges from this calculation is the Net Operating Income.

Taxes payable on the operating income are then deducted (in terms of liquidity). The NOPAT is given by the residual amount, thus:

Part I - The Theoretical Background

38

[1.18] 4,00

where:

3,50

Val/ R-s t-st

3,00

NOPAT

Capital

= sales

= net working capital

- operating costs

+ net fixed assets

Value Capital Valore Capitale 1988

- taxes

2,50 2,00 1,50 1,00

Stock market analysis shows a high degree of correlation between market value and ROCE (in relation to the cost of capital):

0,50 0,00

Tas

4.0 R-sqr = 0.63

3.5 Value Capital

2.0 2.5 2.0 1.5 1.0

Data relating to the food industry

0.5 0.0

0.5

1.0

1.5

2.0

2.5

3.0

Rate of Return / Cost of Capital (5 years average) Sources: Stewart G. B. (1991), The quest for value, HarperBusiness

Fig. 1.3 – Correlation between market value and ROCE/Cost of Capital

39

CHAPTER 1 - The Possible Valuation Methods

1.1.3.2

Definition of Economic Value Added - EVA©

The rate of return on capital employed (ROCE) is an excellent tool for assessing the economic profitability of a single investment project, but it appears inadequate for assessing the results achieved by a business area or by a whole company.

The only indicator that takes into account all the possible ways of creating or destroying value is represented by EVA© – Economic Value Added – namely the residual income after subtracting the cost of capital from the operating income (Steward B. G., 1991).

EVA© is calculated starting from the spread between:



ROCE ( r ) and;



cost of capital (WACC).

and the value obtained is multiplied by the value of the capital invested in the company’s ordinary operations: EVA© = (r - WACC) * Invested capital

[1.19]

where: WACC = weighted average cost of capital EVA© can also be seen as the multiplication of the two rates by capital: EVA© = (r - WACC) * capital

[1.20]

EVA© = r * capital - WACC * capital

[1.21]

This formula, duly rearranged, gives: EVA© = NOPAT - WACC * capital

[1.22]

Part I - The Theoretical Background

40

In other words: EVA© = Nopat – Cost of capital employed

[1.23]

EVA© is thus operating income net of return on the capital employed.

Using EVA© as a performance indicator assumes that the company must pay its investors (equity) and lenders (debt) an interest rate (indicative) equal to the WACC. The EVA© will increase if:  EBIT is increased without investing new resources;  capital is only invested in projects with returns greater than the cost of capital;  the company divests from those activities that absorb, rather than create, value.

The EVA© conversely decreases if:  management uses funds in projects with returns lower that the cost of capital;  management is not interested in investments that would provide returns greater than the cost of capital.

Although there are many actions that can be taken in order to create value, all of these must fall into at least one of the categories measured by an increase in EVA©.

EVA©, in fact, increases if operating efficiency improves, by investing in projects that are profitable and if the resources are divested from non-profitable activities.

CHAPTER 1 - The Possible Valuation Methods

In summary, there are three value creation routes, and the EVA© takes them all into consideration:  increase in operating income without investing in additional resources;  invest in additional resources until such as time as the return is greater than the cost that the company must pay for the use of such resources;  divest and repay contracted debt until such a time as the income that is being renounced is more than offset by the savings on the cost of capital.

The main advantages of EVA© are:  it is the only measure of performance to be directly linked to the company’s market value;  it is the factor that determines the premium (or discount) in the market valuation of the company’s shares.

Two different companies may have the similar profitability levels but strongly different value added for shareholders, positive in one case (“value creation” situation) and negative in the other (“value destruction” situation).

In this case, EVA© allows this different situation to be highlighted.

The following is an example of ROCE by industry in the U.S. as analysed by Damodaran (Damodaran A., 2014). Taking for example the Tobacco sector, it can be observed that while it is in 1st place in terms of profitability, it is at 10th place in terms of value created.

41

Part I - The Theoretical Background

109.7% 57.8% 57.1% 51.5% 47.2% 46.3% 42.0% 38.7% 37.2% 35.1% 33.2% 29.6% 29.3% 29.2% 28.4% 28.0% 27.3% 26.2% 26.1% 25.6% 0.0% 1.4% 1.3% 0.3% 0.2% 0.0% 0.0% 0.0% 0.0% -0.6% -7.3%

Fig. 1.4 - Profitability by sector – ROCE

First 20 sectors

Last 10 sectors

Tobacco Aerospace/Defense Computer Services Advertising Information Services Computer Software Computers/Peripherals Healthcare Services Household Products Electrical Equipment Retail (Internet) Entertainment Chemical (Specialty) Healthcare Equipment Pharma & Drugs Machinery Beverage Broadcasting Publshing & Newspapers Food Wholesalers …

Real Estate (Development) Real Estate (General/Diversified) Brokerage & Investment Banking Financial Svcs. (Non-bank & Insurance) R.E.I.T. Bank Banks (Regional) Thrift Telecom (Wireless) Oil/Gas (Production and Exploration)

Last 10 sectors

First 20 sectors

42

Computers/Peripherals Pharma & Drugs Computer Software Oil/Gas (Integrated) Aerospace/Defense Healthcare Services Computer Services Household Products Oilfield Svcs/Equip.

Tobacco Healthcare Equipment Information Services Entertainment Telecom. Services Food Processing Cable TV Retail (General) Chemical (Specialty) Beverage Telecom. Equipment …

Investment Co. Telecom (Wireless) Financial Svcs.

Bank R.E.I.T. Banks (Regional) Brokerage & Investment Banking Financial Svcs. (Non-bank & Insurance) Oil/Gas (Production and Exploration) $(186,741) Thrift $(214,439)

$49,628 $46,147 $41,929 $41,649 $34,304 $31,293 $24,662 $24,015 $22,934 $21,903 $21,039 $19,012 $18,843 $17,919 $17,129 $16,390 $15,155 $15,013 $14,752 $14,400 $(5,010) $(7,503) $(17,294) $(17,896) $(21,192) $(23,648) $(41,845)

$(108,466)

Fig.1.5 - EVA© by sector

43

CHAPTER 1 - The Possible Valuation Methods

The EVA© method thus provides key information regarding business portfolio policies. With the aim of maximising the overall value of the company, the method identifies the businesses to be disposed of, those to be further developed and those to be maintained, according to the portfolio matrix as a function of the EVA© (see figure 1.6 below).

Business Portfolio EVA Analysis Strategic Importance Positive

Value Creation Potential

ENHANCE

DISPOSE

The core business of the company in order to consolidate the competitive position.

Non-core businesses with adequate margins are to be disposed of in a manner that should ensure a reasonable value (e.g. intra-group market).

RATIONALISING

RATIONALISING TO DISPOSE

Core Business in which to retrieve industrial competitiveness through market coverage and rationalisation of industrial structure/strategy.

Negative

Non-core businesses in which to verify postrationalization to define procedures and deadlines for disposal

High

Low

Strategic Importance

Portfolio options dependent on the strategic importance of the business and on their value creation potential Fig. 1.6 – Business Portfolio Matrix in terms of EVA©

Part I - The Theoretical Background

44

1.1.3.3

EVA© as a business valuation method

The EVA© is directly linked to the company’s market value. In fact, discounting the forecasted values, EVA© indicates the company’s market value.

The present value of the EVA© indicates the market value that management has added to or subtracted from invested capital. The theoretical market value of the company is therefore equal to: Market Value = Capital + Present Value of all future EVA© [1.24] The valuation model based on the EVA© concept shows how much value has and will be added (or subtracted) due to the specific allocation of resources and their management. If the value is compared with the capital employed, the value that management has added or subtracted (“MVA”) is obtained by adding or subtracting it from the value of the invested capital: MVA = market value – employed capital

[1.25]

MVA = present value of all future EVA©

[1.26]

The Market Value Added (MVA) is the difference between the market value of a company and the capital invested.

Like the EVA©, the MVA is a measure of the company’s overall results; it indicates how successfully a company has invested its resources in the past and the likelihood of it efficiently reinvesting in the future.

EVA© is an internal indicator of business performance that feeds the MVA, which on the other hand represents the external measurement of the business’ results.

In calculating the present value of the EVA©, the cost of capital employed and the cost of capital necessary to finance new investment

CHAPTER 1 - The Possible Valuation Methods

projects is implicitly subtracted, the indicator being as operating profit net of the invested capital return.

The EVAŠ is thus an internal indicator of performance capable of influencing the creation of a premium (or a discount) in the market value of the company.

45

+

...

Market Value

Capital Market Value

MV Lost

Discount Value

Fig. 1.7 – Firm value in terms of EVA ©; MVA

Sources: Stewart G. B. (1991), The quest for value, HarperBusiness

Capital

MV Added

Premium Value

+

...

46 Part I - The Theoretical Background

CHAPTER 1 - The Possible Valuation Methods

Considering that all companies carry out allocation and capital management activities, this method has proven to be the most effective on the basis of a simple conceptual distinction.

1.1.3.4

Summary of the main advantages of the EVA©

The main advantages of the EVA© are:  It is the only measure of performance to be directly linked to the company’s market value;  It is the factor that determines the premium (or discount) in the market valuation of company shares.

Two companies may have the same profitability levels, but different value added for shareholders, positive in one case (“value creation” situation) and negative in the other (“value destruction” situation). In this case the EVA© allows determination of which of the two is worth more in the eye of investors.

The method is therefore a valuation tool for the valuation of companies, but which can also be used as a management tool since it allows measurement of the marginal value added each year.

The EVA© is not a simple system for measuring corporate performance, but if implemented as a “Value Based Management” it becomes a system that encourages employees to create value for the company. This particular aspect has been better analysed and developed by Stern, Steward and Chew (Stem J. M. et al., 1995).

47

Part I - The Theoretical Background

48

1.1.3.5

Business valuation using the EVA© method

An example of the application of EVA© as a business valuation method is reported.

Taking into consideration company Y with the following operational characteristics:  NOPAT equal to $1,000 for year 0 (the most recent financial year for which there are results);  Y’s NOPAT is increasing by 10% per year, with a rate of return of 12.5% and 80% reinvestment of its NOPAT into its core business; the table highlights:  the prediction of the values of the EVA©;  the company’s value determined by the method in question.

(USD/'000)

Year 1

Year 2

Year 3

Year 4

Year 5 Normalised

NOPAT Initial Invested Capital r WACC (r - WACC ) Initial Invested Capital EVA

1,100 8,800 12.5% 10.0% 2.5% 8,800 220

1,210 9,680 12.5% 10.0% 2.5% 9,680 242

1,331 10,648 12.5% 10.0% 2.5% 10,648 266

1,464 11,713 12.5% 10.0% 2.5% 11,713 293

1,611 12,884 12.5% 10.0% 2.5% 12,884 323

1,772 14,173 12.5% 10.0% 2.5% 14,173 355

Discount factor (10%)

0.9535

0.8668

0.7880

0.7164

0.6512

6.5123 (a)

210 210

210 420

210 630

210 840

EVA present value Cumulated EVA present value

210 1,050

Capital (*) MarketValue ( *)

2,310 3,360 9,230 12,590

At the beginning of the year of Year 1 to the capital have been added the interest earned for half a year to take into account the financial value over time: 9,230$ = 8,800$ x (1+10%) 0.5 4.5

(a) = (1/0.1)/[(1 + 0.1) ]

Sources: Stewart G. B. (1991), The quest for value, HarperBusiness

Tab. 1.7 – Firm value - EVA©

CHAPTER 1 - The Possible Valuation Methods

The rate of return on capital is stable to an amount of 12.5% and is therefore 2.5 percentage points greater than the cost of capital for the company, assumed as a fixed 10%.

This scheme is valid until year 5. From this date the incremental investment will have a rate of return equal to the cost of capital. The consequence will be a freezing of the size of the EVAŠ, which will be fixed at 355 USD (normalized situation).

This present value of 355 USD, achieved by the company in perpetuity, is estimated using the discounting rate (WACC). The present value of all future EVAs, amounting to 3,360 USD corresponds to the new value created with respect to the resources invested. In order to obtain the firm value, this value must be added to the invested capital.

Cumulative present value of EVA + Employed capital = Market Value 3,360 USD + 9,230 USD = 12,590 USD

1.1.3.6

EVAŠ vs DCF

Starting from the company Y considered in the previous example, the methodology for determining the value using the DCF method is illustrated below:

49

Part I - The Theoretical Background

50

Year 1 Year 2 Year 3 Year 4 Year 5 Normalised

(USD/'000)

NOPAT Investments = DCF x Discount Factor at 10% (*) = DCF present value

( *) ( **)

1,100 1,210 1,331 1,464 1,611 880 968 1,065 1,171 1,288 220 242 266 293 323 0.953 0.867 0.788 0.716 0.651 210 210 210 210 210

1,772 1,772 6.512 (**) 11,540 ∑ = 12,590 = Market Value 8,800 = Capital 1.43 = Value/Capital

DCF discounted mid-way through the year Present value of 1 USD From the beginning of Year 1 to infinity = (1/0.1)/[(1 + 0.1) 4.5 ]

Sources: Stewart G. B. (1991), The quest for value, HarperBusiness

Tab. 1.8 – Firm value – DCF

The value of the firm Y determined using the DCF method leads to the same results as calculated using the EVA© (with the same basic assumption: growth rate, discount rate, etc.). This is due to the theoretical assumptions, which are the same for the two methods analysed, in particular:  the value is independent of the financial structure (except for the tax shield);  the considered result is therefore the “unlevered” result (NOPAT);  the tax shield is taken into account in calculating the discount rate;  the firm value exclusively relates to the company’s future financial performance.

In other words, both methods are based on the Modigliani – Miller archetype.

The EVA© valuation process is therefore based on the same theory as the DCF valuation process, but has the advantage of identifying the value for each year.

Moreover, EVA© is a very straight-forward valuation method.

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CHAPTER 1 - The Possible Valuation Methods

1.1.4 Net Income Method The income valuation method is used to determine the value of the economic capital based on an estimation of the projected income flows that the company is able to produce in future years.

In particular, in its simplest form, it is based on identification of expected average normalised earnings, which represent the company’s ability to produce a stable flow of wealth within a given period of time.

The income method generally determines the firm value on the basis of the following information:  future flow of expected earnings during the explicit valuation period;  value of the discount rates expressing the cost of capital.

In summary, the method used is based on the following formula: 1

2

W = R1 / (1+i) + R2 / (1+i) + … + TV

[1.27]

where: 

W = theoretical equity value;



Ri = normalised income arising from operations in year 1, 2,… n;



TV = terminal value of the company;



i

= discount rate.

In its simplified form, it is expressed by the following formula: W = R / (i - g)

[1.28]

Part I - The Theoretical Background

52

where the symbols have the following meanings: W = theoretical equity value; R

= average normal income expected over the long-term;

i

= normal rate of return of the risk capital invested for the sector of origin;

g

= average long-term income growth rate.

The flow that provides reliable income results is the economic flow that can be obtained by supplementing and adjusting the accounting flow.

Such amendments can be summarised in three processes:  normalisation;  integration that takes into account the dynamics of the intangible assets and other assets that are currently not recognised in the accounts;  alignment/adjustment is used to eliminate the distorting effects of inflation and consequently gives uniformity to the flows of various years.

The income methods present various possible time horizons, with minimum limit of a few years (usually 3-5) and infinite upper limit (formula [1.2.8]).

The tendency to limit the duration of the expected cash flows to just a few years, derives from the following:  the increasing uncertainty as regards the estimation of the income cash flows as they move away in time;  the increasing reduction of the annual flows as a result of the

CHAPTER 1 - The Possible Valuation Methods

discounting process, as they move further away in time.

The elements necessary for performing a valuation using the income method are:  normalised income;  the final value of the company;  the capitalisation period;  the discount rate.

Income normalisation aims to remove the randomness of a series of income components in order to ensure recognition in the relevant reporting period, thus ensuring homogeneity of the flows for the various years over time Income normalisation therefore requires:  the redistribution of “extraordinary” income and costs over time;  the elimination of income and expenses “not directly relating to operations”;  neutralisation of accounting policies that are deemed distortive as regards the objective.

More generally, in its more common form of application and in reference to the above parameters, practice suggests the following approaches.

1.1.4.1

The expected income flows

The expected income flows can be expressed with a series of results in the explicit forecast years; with an average value valid for an indeterminate period or for a defined period of time; with a “range” of

53

Part I - The Theoretical Background

54

values that express the variability of possible results depending on the scenarios that arise. These flows are selected for a restricted time period of about 3-5 years as beyond this time period, reasonable and documented assumptions are replaced by conventions and automatism that largely deprive the results of credibility.

1.1.4.2

The discount rate (i)

The discount rate corresponds to the expected rate of return on the capital invested in the company for comparability against financial capital investment alternatives; in this sense, the cost of equity capital “i”, should be identified as the sum of the return of capital in the absence of risk, and the return expected by an investor in the specific sector.

1.1.4.3

Explicit period (n)

The choice of period “n” is intended to limit the growth of the value component relating to the income results over time. In professional practice, the planning period more frequently varies between 3 and 5 years, but in some cases, it can encompass intervals of 5-10 years. The latter is typically the case of companies operating in sectors characterised by a long economic cycle, or in those companies with a strong market penetration.

The second step that is necessary in order to obtain a reliable set of income results, is integration of those values relating to both tangible and intangible assets that are not recognised in the accounts.

The main problem primarily relates to intangible assets, which generate costs that are entirely attributed to the income statement as they occur, but for which there are no accounting procedures in place that are suitable for recognising the increase and decrease dynamics.

CHAPTER 1 - The Possible Valuation Methods

These are generally value categories that generate capital gains not recognised in the accounts, which accumulate over time, acquiring decisive weight in terms of measuring income.

These accumulated capital gains can be considered a reason to integrate the annual income data, in case they:  can be reliably measured, both in their global value and in their distribution over time;  are recognizable;  do not result in a duplication of values.

With the income method, as for the other methods, goodwill (along with all the other possible components of intangible assets not recognised in the accounts) is indirectly computable in the surplus value, identified by comparison with the book value.

55

Part I - The Theoretical Background

56

1.2 Market Methods

1.2.1 Stock Exchange Multiples Method According to this method, the enterprise value of a company is determined on the basis of multiples of certain key economic business measures that are expressed by the market and refer to listed companies operating in the same sectors as the company to be valued.

In short: Firm Value = MF * determined economic business measure

[1.29]

where: MF = Multiplicative Factor In the relative valuation (Damodaran A., 2002), the enterprise value is estimated by looking at the way comparable companies are valued. To this end, the starting point consist of converting prices into multiples, followed by comparison of such multiples in the companies defined as comparable.

In applying this valuation method, the value assigned to the company is equal to the value determined by the stock market, regardless of the actual value of the company’s assets or income.

The main limitations consist of the reliability of market opinion and of stock exchange sensitivity to contingent circumstances.

The purpose of this method is to develop relations (through the use of multiples) based on the actual stock prices of comparable companies with a view to identifying the relationship between the market price of a firm’s assets and economical business variables.

CHAPTER 1 - The Possible Valuation Methods

The multiple thus identified is then applied to the same economical variable of the company being valued so as to finally determine its value through a simple multiplication. The multiples method then takes the expected growth of the result and the assessment of the risk directly from the market, through the multiples.

The choice of multipliers presents some problems in relation to the observations and data collection reference period; the use of both short and medium reference periods is advisable in order to verify any fluctuations attributable to the volatility of the equity markets and/or individual stocks.

For the application of this method, it is necessary to identify a set of listed companies comparable with the company in question. The degree of comparability is assessed on the basis of:  the sector;  competitive conditions;  the size of the company;  the profit margins of companies that must be in line with those of the company being valued.

For the purposes of application of the multiples method, the following requirements must be met:  there must be a similarity in the growth rates of the expected cash flows of the business and in the degree of risk, between comparable companies;  the value of the firm must vary in direct proportion to the changes in the economical measure selected as a performance parameter.

57

58

Part I - The Theoretical Background

Indeed, comparable companies rarely meet these assumptions; cash flows usually have different expected growth and different levels of risk and there is also no certainty as to what should be the most effective measure of performance for the purpose of drawing comparisons between companies.

The consequence of this aspect is that selection of the sample comparable companies is likely to become extremely subjective, what is more, the person performing the valuation of the company is very likely to have already formed his own opinion as to the company’s future expectation, tending to amend the multiple according to such expectations.

This contrasts with the assumption that the method should avoid estimates and take the growth expectations as regards the company's results directly from the market; it is thus clear that the results of the valuation obtained using the multiples method can be in some circumstances less reliable than those obtained using financial methods.

The two types of multiples most frequently used for company valuation using the market approach are:  multiples calculated taking into account the market value of equity alone (P), allowing a direct estimate of the equity value;  multiples calculated taking into account the total value of the company (enterprise value), which estimates the value of the capital indirectly, this being the difference between the operating capital value (asset value) and the market value of financial debt (or net debt, in the event of the presence of cash and cash equivalents).

59

CHAPTER 1 - The Possible Valuation Methods

Mark et price per share Net earnings per share

P/E (Price/Earnings Ratio)

EV/EBIT (Enterprise Value/Earnings before Interest and Taxes)

Equity value + Debt value EBIT

Equity value + Debt value Sales

EV/Sales

Mark et price per share Book value per share

P/BV

Fig. 1.8 – Fundamental multiples

In addition to fundamental multiples, there are also derived multiples, which follow the same logic as the former, and are used by analysts to limit the consequences of the lack of uniformity between the selected companies in terms of depreciation and provision policies: Mark et price per share Net income + D&A per share

P/CE (Price/Cash Earning)

EV/EBITDA (Enterprise Value / Earnings before Interest, Taxes, Depreciation and Am ortization)

Equity value + Debt value EBITDA

Fig. 1.9 – Derived Multiples

These multiples are widely used in financial markets as they are able to provide a quick valuation.

Placing areas of the balance sheet expressed at market value side by side with the same values expressed through multiples gives the following results:

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Fig. 1.10 – Asset side and equity side multiples

As stated by Damodaran (Damodaran A., 1997), equity side multiples, which are widely used in the valuation process, lend themselves to a hasty valuation, thus leading to incorrect conclusions.

If there are fundamental differences in terms of countries, planned time frames and company analysis, then the multiples will also differ.

Asset sides multiples have the advantage of being more easily comparable to companies with different financial leverage than equity side ones.

1.2.2 Comparable transactions method The valuation method of comparable transactions differs from the multiples-based method in relation to the nature of the prices that express the negotiated values used to construct the multiples.

Indeed, in the comparable transactions method, the prices referred to are those detectable in the context of private negotiations for controlling stakes in comparable companies.

The valuation process of the method in question is identical to the process followed in the multiples method, even if the problems arising during the collection and adjustment of the prices differ, due to the

CHAPTER 1 - The Possible Valuation Methods

different context in which they are formed. It thus emerges that in the method of similar transactions, the main problems include the following:  the collection of transaction prices for stakes in the economic capital of comparable companies, due to the relatively modest degree of publicity that is characteristic of the corporate control market. The gathering of information relating to the share prices and financial statements of comparable companies involved in mergers and acquisitions is generally more expensive and less reliable than the collection of similar information relating to listed companies;  the need to ensure that market conditions have not changed in the period of time elapsing from the time the prices were collected and the valuation was performed;  the low frequency of transactions of the same nature often makes it necessary to extend the recognition period of transactions and prices to include the risk of inconsistent value, where the conditions for carrying out the activities and negotiations have changed over time.

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1.3 Asset-based Methods and Mixed Methods

1.3.1 Goodwill As part of main valuation methods defined in theory and used in practice, the following methods have also been developed:  Equity methods;  Mixed methods.

Before proceeding to a more detailed description of the characteristics and applicability of each of the above methods, let us first examine the definition of “goodwill”.

Goodwill can be defined as the ability to produce income by making all of the company’s tangible and intangible asset components work synergistically; goodwill is the value that is generally recognised by those that have invested resources and capitalised energies over time, in order to bring the company to a certain level of operation.

Guatri (Guatri L., 1990) shows that the exchange value of an operating complex can be of a different amount that the values of the individual elements, specifically due to the efficiency or inefficiency of their coordination.

Goodwill is an intangible component that is not adequately represented in corporate balance sheets (trademarks, patents, knowhow, image, market share, organisation, etc.).

Sometimes, goodwill is simplistically understood as a substitute concept of the company’s intangible components (e.g. trademarks and image), while at other times it is, more correctly considered separately.

Goodwill can be either positive (in which case the term goodwill is used), or negative (in which case the term badwill is used), when the

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expected profitability is insufficient to ensure an adequate return on invested capital.

From a “quantitative” perspective, it is defined as the difference between the theoretical value of shareholders’ equity and the corresponding book value: Goodwill = Theoretical value of equity – Book value of shareholders’ equity

G

Equity Value

Goodwill

EqV BV

Book Value

Fig. 1.11 – Goodwill as part of the Equity Value

1.3.2 Equity Methods The equity valuation method is based on identification of the “market value” or “current value” of all assets less liabilities on a going concern basis, through the discounting of all significant monetary values.

This value corresponds to the replacement or reconstruction value of both tangible and intangible assets to a condition of use.

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This method guarantees a good indication of capital strength, but has the drawback of not considering the financial and income aspects of future operations.

The equity estimation is based on the analytical valuation of the individual assets and liabilities that make up the capital: while liability items are always taken into account, the treatment of asset items varies.

Tangible assets, receivables and cash and cash equivalents always enter into the calculation, while intangible assets are valued on the basis of different methodologies, depending on whether or not they are taken into account (and on the manner in which they are taken into account).

In particular, we can distinguish:  simple equity methods that only comprise tangible assets;  complex equity methods involving specific valuation of intangible assets (intangibles). It should be noted that within this category of methods there is a distinction between (Guatri L., 1990);  analytical methods, involving the valuation of intangible assets, conducted through analytical estimation criteria;  empirical methods, involving the valuation of intangible assets, on the basis of the parameters obtained from operator negotiation behaviour.

In professional practice, simple equity methods have a greater application in all categories of companies, while always forming a base of relevant information. Their relevance expresses “adjusted shareholders’ equity”, indicated by the letter K.

CHAPTER 1 - The Possible Valuation Methods

Complex equity methods have a real significance when the estimation criteria of intangible assets reach a sufficient degree of acceptance and standardisation (e.g. brands).

The starting element for the simple equity valuation method is the book value of the equity, which includes the profit for the year with the exclusion of any amounts to be distributed.

1.3.2.1

Simple equity method

Starting from the book value of the equity, the following takes place:  analysis of assets and liability items so as to ensure their compliance with correct, generally accepted accounting principles;  expression, in terms of current values (market or estimation) of non-cash assets (fixed assets, inventories, securities, equity investments..) thus generating a series of capital gains or losses;  possibly restating the value of deferred receivables and payables with or without interest.

A suitable starting point is essential to any business valuation, thus there should be a thorough checking of all accounting data and, in particular, checks to ensure that:  all assets and liabilities are recognised;  all assets items are based on valid records;  receivables take into account the actual possibility of recovery;  liability provisions correspond to the actual or probable

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amounts accruing;  risks expressed in the memorandum accounts are suitably valued.

The adjusted shareholders’ equity, with the exclusion of the valuation of intangible assets, is defined by the sum of the book value of shareholders’ equity (c), gains (p) and losses (m) that have taken place; deducting, where appropriate, any theoretical tax charges.

In summary, if “t” is the tax rate, the economic value of a company is represented by: K= C + [(P1+P2+…) - (M1+M2+…)] (1-t)

1.3.2.2

[1.30]

Complex equity method

There are situations in which the adjusted shareholders’ equity K assumes a more complex structure in order to account for intangible assets.

The valuation of intangibles can be carried out on the basis of different approaches: The cost approach, in the following versions:  historical residual cost;  cost of reproduction;  cost of loss.

The economical approach, in the versions:  differential income;  cash flow differential;

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 market approach, in two versions: - comparable royalty rate; - market multiples for comparable intangible assets.

The adjusted net capital in the presence of intangible assets (K) is given by the following formula: K’= K + I * (1-t)

[1.31]

where:  I

= intangible asset value;

 t

= theoretical tax rate.

1.3.3 Mixed Method The mixed method combines aspects of the equity and income methods, while attempting to mediate between the advantages and disadvantages thereof.

This method simultaneously considers the size, structure, and profitability of the company’s assets, while taking historical or future trends into account. The mixed method creates a balance between objectivity and verifiability needs of the asset base and the rationality expressed by assessment of expected income flows and the relevant risks.

The proposed method highlights the value of goodwill understood as the difference between the result of the income valuation approach and the net asset value.

The mixed goodwill valuation method determines the economic value of the company based on two elements:

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 shareholders’ equity expressed in current values;  the goodwill or badwill attributable to equity in relation to a firm’s ability to produce a positive or negative excess return compared to a normal rate of return achievable by the same business.

The mixed equity-income method, in the formulation proposed by doctrine and used in professional practice, has the following formula: W = K’ + an i’ (R - i K’) + SA

[1.32]

Where the symbols have the following meanings: W = theoretical current economic value of the company; K’ = value of shareholders’ equity at fair value. This is equal to the adjusted shareholders’ equity K, without considering the value of the assets that are not instrumental to company operations SA; R

= average income expected over the long-term;

an i’ = discounting of a deferred income that is equal to the excess or lower earnings (R - iK’), with a duration of n years at a rate of i; i

= normal rate of return on risk capital invested, by sector of origin;

i’

= financial discount rate (equal to the return on risk-free assets);

SA = surplus assets.

The method logic consists of checking both the estimate of company asset value (based on verifying the company’s ability to

CHAPTER 1 - The Possible Valuation Methods

remunerate the capital employed) and estimating the income (based on the breakdown of business income into two components: normalised and excess income).

According to this criterion, firm value is ideally divided into two basic components:  the value of assets;  the value of goodwill.

Adjusted shareholders’ equity K stems from the valuation, at current market value, on a going concern basis, of all assets less all liabilities.

This valuation is generally divided into the following steps:  identification of the book value of shareholders’ equity;  assessment of any difference between the current value and the book value of assets and liabilities in the balance sheets;  calculation of theoretical tax from accounting delta;  calculation of adjusted shareholders’ equity.

Measurement of the book value of shareholders’ equity does not generally raise practical problems, as it is performed by adding the equity reserves resulting from the financial statements to the paid-up capital. This amount is then supplemented by the net profit for the reporting period, taking into account any distribution of dividends that have already been approved or are in the process of being approved.

The main practical problem encountered in applying the method in question is linked to determination of the i, i’ rates and of the reference time horizon (n).

In the original formulation of the equity-income method, based on the independent estimate of goodwill, the definition of n is the very

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basis of the procedure, which is based on a limited term of profit, as it assumes that the conditions generating a greater than normal income cannot last over the long term and are therefore destined to cancel themselves out or to fade over the course of a few years. The prudential nature thereof is clear and should lead to a default valuation of goodwill. Thus according to the most widespread practice and doctrine (Guatri L. and Bini M., 2005; Zanda G. et al., 2001) that was once the most commonly adopted, n could vary between 3 and 10 years. There is however no standard time and the duration must be assessed on a case by case basis.

The normal interest rate i, applied to the adjusted net capital (K or K’) is a measure of performance that is deemed satisfactory, within the limits of the norm, while taking into consideration the degree of risk to which the company is exposed. A question that must be asked is whether the normal rate of return applicable to the mixed procedure is in line with the capitalisation rate applicable to the income method.

In professional appraisals these rates are sometimes assumed to be the same; other times they are different.

The discount rate i’ is to be understood as the pure financial consideration for the passage of time. It is thus a means of transferring the values of time ti to the initial time to: as such, it is independent from firm-specific risk and is linked to “risk free” financial parameters (to the rate of return of Government Bonds of similar durations for example).

Nevertheless, in some cases also cost of equity is utilised. According to some authors (Guatri L. and Bini M., 2005), in case of positive spread (R – i K’), cost of equity is preferable.

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