Anno accademico

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1 Anno accademico Corso di Laurea Magistrale in Economia Aziendale Curriculum amministrazione e governance delle aziende (ex DM 270) PRINCIPLES OF BUSINESS VALUATION

2 Normalizing Operating Earnings A few examples of specific normalization techniques directly applied in practice Founding Managing Partner Cross Court Capital October 2018

3 EARNINGS BASED METHODS Normalizing Operating Earnings Page 2 October 2018

4 Earnings Based Methods The value of a company (Net Worth) depends on its ability to generate sustainable recurring cash flow throughout its life-span Cash flow-based methods are preferable to any other (Earnings, Book-Value, Hybrid) W = CF ( i g) Earnings based methods are derived from the Dividend Discount Model, which is a cash based method based on the assumption that, in the longterm, distributions match net earnings W = Div ( i g) The basic Earnings method is the discounted perpetual earnings (this can be assimilated to the inverse of the P/E multiple) Discounted operating earnings methods can be used, but need to subtract Net Debt W W = = E ( i g) EBIT ND ( WACC g) Other earnings methods are Discounted future earning stream Excess Earnings Excess operating earnings (EVA Method evolution) W = n i= 1 E i W = ( E NAV i ) a + ni NAV W = ( EBIT (1 t) AV wacc ) ani+ AV ND Normalizing Operating Earnings Page 3 October 2018

5 Multiple Methods Based on Earnings Earnings methods are the most widely used in the comparative approach to valuation Comparable company analysis Comparable acquisitions analysis Instead of discounting an earnings stream, these methods use multiples applied to punctual earnings (i.e. they are simple and not composite ) The methods derive their foundation from markets (whether regulated or not) Traditional earnings methods derive their foundations from analytical analysis of risk The 2 approaches, of course, are inter-linked (P/E = 1 / (i-g)) The most important earnings-based multiples used are EV/EBITDA EV/EBIT P/E PEG = P/E / ((g*100)) Normalizing Operating Earnings Page 4 October 2018

6 Earnings Adjustments In order to be used, earnings need to be adjusted to: Reflect recurring or sustainable profitability (normalization) Proxy for cash (elimination of accounting policies) Must normalize for the future. Thus need to consider: Market potential Comparable companies (growth and margins) Country regulation (i.e. tax rate) Current financial market conditions (i.e. debt value) Historical trend Off balance sheet income stream (i.e. tax loss carry-forward, excess cash, real estate) Normalizing Operating Earnings Page 5 October 2018

7 Normalization Neutralize for accounting and non-recurring items average last three years? Exceptionals Cost over-capitalization Leasing Exchange rate gains / losses Derivatives (potential losses / gains) Raw materials Taxes (in case using net earnings) Under-represented revenue stream (excess cash flow, surplus assets) Normalizing Operating Earnings Page 6 October 2018

8 Proxy for Cash Earnings will have to be assimilated, where possible, to cash flow items As such, it is preferable to adjust for non-cash items such as Depreciation Goodwill amortization Cash interest Cash taxes Subsidies Normalizing Operating Earnings Page 7 October 2018

9 SOME EXAMPLES OF EARNINGS NORMALIZATION APPLICATIONS Normalizing Operating Earnings Page 8 October 2018

10 Raw Material Prices Volatility Companies which base the greater part of their products value on raw-material transformation, have their accounts subject to rawmaterial price volatility Could make significant gains when raw material prices fall and the selling prices of products don t follow suit or have a time lag or, viceversa, in case they rise Could be subject to margin squeeze (in case they can t raise prices to customers) Need to understand trade-off between selling prices and raw-material costs The important thing to understand is whether a company s products become, indefinitely, commodities (from specialties) or vice versa Transformation into commodities will create definitive margin squeeze Transformation into specialties will create definitive margin expansion Normalizing Operating Earnings Page 9 October 2018

11 Case 1 Introduction Company X, active in the transformation of yellow phosphorous used in lube oil and plastic (sourced out of China), has its accounts significantly impacted by the sudden increase/decrease of the cost of raw material The average price of yellow phosphorous had been around US$ 2.000/ton. In recent times (2016 and 2017) the market underwent an extraordinary increase in its cost The price of yellow phosphorous, in its rising trend, created an immediate margin squeeze as the Company was not able to immediately increase the selling price of its products The Company reacted initially increasing inventory and subsequently its selling prices of key products in 2017 to its clients The price of yellow phosphorous, in the latter part of 2016, underwent a sudden and quick decrease to reach prior crisis levels in 2018 While in its decreasing raw material cost trend, the Company did not reduce its selling prices immediately. In 2018 the selling prices of its products were forecasted to decrease having been negotiated downwards with clients Consequently there was an immediate negative effect on 2016 EBITDA (and working capital) and extremely positive on such items in 2017 and 2018 Normalizing Operating Earnings Page 10 October 2018

12 Case 1 Normalization Analyzing the Company s financial plan, in order to correctly represent the effective economics of its business and subsequently estimate the sustainability and recurrence of its earnings in time, it is necessary to normalize such economics to neutralize for raw material cost volatility in the years In substance, the margin component exclusively created (or destroyed) by raw material price increase/decrease had to be eliminated The methodology used was the definition of an average-normal contribution margin (taken, for example, historically) and then estimating EBITDA by deducting fixed costs In the following slide is the end result of the margin normalization process As can be seen, the sustainable EBITDA margin for this business is around 16-18%, and EBITA around 11-13%. Of course the analysis considers margins, but not the price effect on revenues: Should selling prices decrease sharply, without raw material prices decreasing, sales reduction would have a full impact on EBITDA (full margin squeeze) Normalizing Operating Earnings Page 11 October 2018

13 Case 1 Normalization ( uro million) Income Statement 2013A 2014A 2015A 2016A 2017A 2018E 2019E 2020E 2021E Sales 27,3 34,2 60,1 83,9 76,4 73,8 81,2 89,8 97,4 Reported EBITDA 5,6 6,1 8,7 12,2 16,9 15,6 15,8 17,2 18,3 (% on sales) 20,6% 17,8% 14,5% 14,6% 22,2% 21,2% 19,5% 19,2% 18,8% EBITDA normalisation 1,1 1,3 0,3 5,4 (1,9) (2,8) (2,3) (1,4) (0,5) Normalized EBITDA 6,7 7,4 9,0 17,6 15,1 12,9 13,5 15,8 17,8 (% on sales) 24,5% 21,6% 14,9% 21,0% 19,8% 17,4% 16,6% 17,6% 18,3% Reported EBITA 3,6 3,9 5,8 8,8 13,2 11,5 11,2 12,7 13,5 (% on sales) 13,3% 11,3% 9,7% 10,5% 17,3% 15,6% 13,9% 14,2% 13,9% Normalized EBITA 4,7 5,2 6,1 14,2 11,4 8,8 8,9 11,3 13,0 (% on sales) 17,2% 15,1% 10,1% 16,9% 14,9% 11,9% 11,0% 12,6% 13,4% Normalizing Operating Earnings Page 12 October 2018

14 Case 1 Methodology: Simple Example 2015A 2016A 2017A 2018E Unit Price Volume Sales Cost per Unit Cost of Sales Income Statement 2015A 2016A 2017A 2018E Avg Sales Cost of Sales Contribution Margin % 0% 50% 43% Fixed costs EBITDA % -30% 31% 21% Normalized CM (40%) Normalization effect Normalized EBITDA % 10% 21% 19% Normalizing Operating Earnings Page 13 October 2018

15 Case 2 Introduction Company Y is active in the transformation of tomatoes and, as such, has the greater part of its value proposition linked to its cost of raw materials Traditionally Company Y s accounts have been impacted by sudden significant, and not unusual, swings in the price of tomatoes (raw material) Selling prices, mostly to retail outlets and supermarkets, are also influenced by mismatching time lags between selling prices and cost increases In recent years, but particularly in 2017, the entire industry has witnessed a significant rise in selling prices, without significant increases in production costs. As such, selling prices varied significantly (from /kg 1,34 in 2016 to /kg 1,56 in 2017), differently from sustained production costs which remained stable Such increases in selling prices anticipated the end of at least half of European Union contributions to tomato farming in Between 2019 and 2020 such grants (subsidies) will be eliminated completely It is assumed that costs increases will catch up to selling price increases and eliminate abnormal margins Hence it had been necessary to normalize for effects in accounts Normalizing Operating Earnings Page 14 October 2018

16 Case 2 Normalization In this case, as seen before, normalization is required to estimate recurring and sustainable earnings for the future The method we used is the inversion of the LIFO reserve, into weighted average cost accounting LIFO reserve accounting method tends to under-estimate earnings (in the case of inflationary price trends) and undervalue inventory levels Inventory will have to be accounted as WAC (CMP) and effects on costs (i.e. reported earnings) will then be recalculated to estimate normalized earnings As can be seen from the following slide, normalization then leads to a new margin Normalization included in the table also considers other extraordinary effects Sustainable EBITDA margins for this company are between 10-10,5%, whereas EBIT in the range 8-8,5% Such margins were then compared to similar companies through a side-by-side analysis to check for consistency Normalizing Operating Earnings Page 15 October 2018

17 Case 2 Normalization ( uro million) Income Statement 2015A 2016A 2017A 2018E 2019E 2020E Sales 94,3 119,5 140,9 148,4 170,4 190,3 Reported EBITDA 5,4 8,4 18,6 16,0 18,0 20,3 (% on sales) 5,7% 7,0% 13,2% 10,8% 10,6% 10,7% EBITDA normalisation 1,2 3,9 (4,1) Normalized EBITDA 6,6 12,3 14,5 16,0 18,0 20,3 (% on sales) 7,0% 10,3% 10,3% 10,8% 10,6% 10,7% Reported EBITA 2,9 5,4 15,1 12,5 14,2 16,4 (% on sales) 3,1% 4,5% 10,7% 8,4% 8,3% 8,6% Normalized EBITA 4,1 9,3 11,0 12,5 14,2 16,4 (% on sales) 4,3% 7,8% 7,8% 8,4% 8,3% 8,6% Normalizing Operating Earnings Page 16 October 2018

18 Case 2 Simple Example LIFO Cost Volume acquired Avg Unit cost Cost of Raw Materials Sold LIFO Unit cost Units at inventory E-o-Y Inventory Change in inventory Weighted Avg Cost Volume acquired Avg Unit cost Cost of Raw Materials Sold Units at inventory E-o-Y Inventory Change in inventory Normalization of Earnings Normalizing Operating Earnings Page 17 October 2018

19 Case 3: Cost Over-capitalization In the case a company capitalizes costs, it is necessary to analyze the nature of the capitalized costs, in other words the true long-term return/payback of asset Need to understand nature of cost Need to understand returns over the years Need to re-calculate and reduce depreciation (impact on EBIT), and taxes (impact on Net Income) In normalization of cost over-capitalization, tax impact needs to be adjusted (theoretical) Impact on EBITDA is pre-tax, but net debt for tax could be reduced Tax rate will decrease due to tax shield Here is a simple example: YR avg Mult EV Reported EBITDA Over-capitalisation Normalized EBITDA ,0x YR avg Mult EqV Reported Earnngs 60 72, Over-capitalisation Tax Shield 3,3 4,0 5,0 5,6 6,6 Normalized Net Earnings 53,3 64,5 90,0 113,6 136, ,0x Normalizing Operating Earnings Page 18 October 2018

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