CHALLENGING THE DISCOUNT RATE SIMON DALGARNO

Transcription

1 CHALLENGING THE DISCOUNT RATE BRENDAN DAW & SIMON DALGARNO

2 CHALLENGING THE DISCOUNT RATE 2 CHALLENGING THE DISCOUNT RATE

3 REWARD AND RISK Is the reward worth the risk? How do we measure the trade-off? 3 CHALLENGING THE DISCOUNT RATE 3

4 MEASURING THE RETURN It s the present value of the future benefits We discount future cash flows for : The time value of money The opportunity cost of an alternative investment The specific risk of this investment achieving the expected cash flows. 4 CHALLENGING THE DISCOUNT RATE 4

5 RETURNS RISK & RETURN TRADEOFF High Discount rate 20% B PE Firms Biotech co. Returns of 30%- 50% A Discount rate 12% Share Market Returns of 12%-14% Low Risk free Asset Returns of 2%-3% Property Returns of 6%-8% Low RISK High AVH: 5~ CHALLENGING THE DISCOUNT RATE 5

6 COMMON USES Project evaluation Business case modelling Decision making Impairment testing Business and asset valuation Regulated pricing models ROI calculations 6 CHALLENGING THE DISCOUNT RATE 6

7 COMMON ERRORS Using the same rate we always use Using word of mouth / rule of thumb / stab in the dark Asking a colleague what they use Not updating the rate to reflect current conditions Lack of understanding Incorrect application: o nominal rate applied to real cash flows o post tax rate applied to pre tax cash flows o using cost of capital to pre interest cash flows (should use WACC) Calculation error: o Mis-calculating the components o Not optimising the level of gearing when measuring WACC 7 CHALLENGING THE DISCOUNT RATE 7

8 Yr 1 Yr 3 Yr 5 Yr 7 Yr 9 Yr 11 Yr 13 Yr 15 Yr 17 Yr 19 Yr 21 Yr 23 Yr 25 Yr 27 Yr 29 $'000 EXAMPLE Three cash flow profiles, each with an equivalent NPV of $5m at 12.5% 6,000 Hypothetical cash flows 5,000 56,112 4,000 3,000 2,000 27,860 1,000 22,007 0 High early growth then to CPI Constant Growth High hockey stick late growth 8 CHALLENGING THE DISCOUNT RATE 8

9 VALUE IMPACT OF DISCOUNTING 9 CHALLENGING THE DISCOUNT RATE 9

10 TYPES OF DISCOUNT RATES Cost of equity (Ke) o 100% equity funded projects o Applies to after interest cash flows Weighted Average Cost of Capital (WACC) o Based on mix of debt (Kd) & equity (Ke) at optimum level o Applies to pre-interest cash flows 10 CHALLENGING THE DISCOUNT RATE 10

11 COST OF EQUITY Ke = Rf + β (MRP) + OC Rf- Risk free rate β Beta- sensitivity to the market MRP Market risk Premium OC Specific risks o o o Size Forecasting risk Other- Eg key person/client/competitor AVH: 5~ CHALLENGING THE DISCOUNT RATE 11

12 WEIGHTED AVERAGE COST OF CAPITAL WACC = weighted average cost of capital Ke = shareholders required rate of return (cost of equity) Kd = lenders required rate of return (cost of debt) t = the company s tax rate E = market value of the equity of the company D = market value of the debt V = D + E. 12 CHALLENGING THE DISCOUNT RATE 12

13 OPTIMISING WACC 13 CHALLENGING THE DISCOUNT RATE 13

14 ADDITIONAL CONSIDERATIONS Factors that impact discount rates Factor Impact on Discount Rates Lower Higher Industry Growth Expanding proven market Declining or new market Business Growth Above industry norms Below Industry norms Location and Facilities Above Average Below Average Diversification of products and geographic markets Diverse products and multiple markets Limited product lines and markets Competition Few competitors and/or high barriers to entry Highly competitive and/or unstable market. Concentration of Revenue A large number of customers High Customer Concentration A few large customers account for 50% 60% of revenue Forward Orders Reorder patters High level of future revenue links to committed forward orders Long term relationships, agreed contract renewals Customer has a high switching cost. Price is not primary factor in decision Future revenue not underpinned by forward orders Once off, lumpy or regular rebids in a competitive process Customer has a low switching cost. Customer is Price Sensitive Contractual Relationship Long term stable customers Contracted (Price and volume) or Cost plus contract Short history and or high churn Uncontracted or Fixed Price Contracts 14 CHALLENGING THE DISCOUNT RATE Leadenhall Corporate Advisory Pty Ltd

15 ADDITIONAL CONSIDERATIONS Factor Impact on Hurdle Rates Lower Higher Seasonality of revenue and/or of the clients revenue No seasonality Highly seasonal revenue Future Growth opportunities Expansion will come from existing services in existing markets Expansion is based on new server or new market. Nature of Costs Higher proportion of variable overheads Higher proportion of fixed overheads Stability and Skills of Employees Long term, well trained and motivated employees High turnover and/or unskilled employees Business Systems Business process and service is highly systematised and requires littlie modification between clients Business process or service is highly customised by client and / or assignment Management involvement required Limited ongoing management time required Significant ongoing management time required Stability of Historical Earnings Stable and above industry norms Marginal, erratic or less than 3 years good history or below industry norms Working capital requirements and payment terms Little if any working capital requirement and /or agreed upfront payments and contractual progress payments. High working capital requirement or progress payments not agreed in timing or amount. Expected Demand for Capital Capex expected to be less than depreciation Significant Capex or guarantees required. Counterparty Risk Government, large corporates and companies providing part payment up front or bank guarantees Smaller companies or subsidiaries of large corporates and special purpose entities with no guarantee from parent 15 CHALLENGING THE DISCOUNT RATE 15

16 DISCOUNT RATE Different levels of earnings will result in different valuation conclusions: Pre - Tax Cash Flows Post - Tax Cash Flows Before Interest Cash Flows Pre - Tax WACC Post Tax WACC After Interest Cash Flows Pre - Tax Ke Post Tax Ke Result Enterprise Value Value of Equity Equivalent multiple EBIT EBITA EBITDA P/E Dividend Yield 16 CHALLENGING THE DISCOUNT RATE 16

17 RECENT CHANGES IN WACC 11.0% Movements in WACC 10.0% 9.0% 8.8% 1.3% 8.0% 0.4% 0.0% 0.2% 8.2% 7.0% 6.0% 5.0% 4.0% December 2013 Rf EMRP Gearing Credit spread December CHALLENGING THE DISCOUNT RATE 17

18 ALTERNATIVES Guideline Public Company Method From multiples derived from listed comparable companies. Merger and Acquisition Method From multiples derived from comparable transactions. First Principals Method From multiples calculate based on the Required Rate of Return of an investment. 18 CHALLENGING THE DISCOUNT RATE 18

19 GUIDELINE PUBLIC COMPANY METHOD RSM Bird Cameron Business Acquisition and Impairment Review 2010 RSM Bird Cameron Business Acquisition and Impairment Review CHALLENGING THE DISCOUNT RATE 19

20 GUIDELINE PUBLIC COMPANY METHOD Guideline Public Company Method For ASX 300 companies the discount rates noted were often within the range of 10% to 12% For non ASX 300 companies the discount rates noted were most often within the range of 12% to 14% RSM Bird Cameron Business Acquisition and Impairment Review CHALLENGING THE DISCOUNT RATE 20

21 RISK PREMIUM FOR BUSINESS Description Category Business Status 1 Established business Industry Competition Strong trade position Financing Requirements Well financed Management Depth Depth in management Past Earnings Stable Future Earnings Highly predictable Risk Premium* (Pre-tax) Implied EBIT Multiple ** 6 10% 9.1 x 2 Established business More competitive Well financed Depth in management Stable Fairly predictable 11 15% 6.3 x 3 N/A Highly competitive Little capital required No depth in management N/A As risk is high not very predictable 16 20% 4.8 x 4A Small, depends on special skills N/A Little capital required N/A N/A Very unpredictable 21 25% 3.8 x 4B Large, established, highly cyclical N/A N/A May be depth in management Past earnings may not be stable Very unpredictable 23 25% 3.7 x 5 Small one person business N/A N/A Managed by main operator N/A Extremely unpredictable 26 30% 3.3 x * To be added to the risk-free rate Developed from an article by James H. Schilt and Hanan & Kiebier, Inc, Business Valuation News. ** Midpoint Assuming 6% Risk Free rate and 3% ongoing growth AVH: 5~ CHALLENGING THE DISCOUNT RATE 21

22 DISCOUNT RATE Rates of Return Required by Venture Capital Investors Stage of Development Plummer 1 Scherlis & Sahlman 2 Sahlman, Stevenson and Bhide 3 Startup 4 50%-70% 50%-70% 50%-100% Frist stage or early development 5 40%-60% 40%-60% 40%-60% Second stage or expansion 6 35%-50% 30%-50% 30%-40% Bridge/Initial Public Offering (IPO) 7 25%-35% 20%-35% 20%-30% 1. James L. Plummer, QED Report on Venture Capital Financial Analysis (Pale Alto: QED Research, Inc., 1987). 2. Daniel R Scherlis and William A Sahlman, A Method for Valuing High Risk, Long Term, Investments: The Venture Capital Method, Harvard Business School Teaching Note (Boston: Harvard Business School Publishing, 1989). 3. William A. Sahlman, Howard H. Stevenson, Amar V. Bhide, et al., Financing Entrepreneurial Ventures, Business Fundamental Series (Boston: Harvard business School Publishing 1998). 4. As described in the publications referenced in this table, startup-stage investments typically are made in enterprises that are less than a year old. The venture funding is to be used substantially for product development, prototype testing, and test marketing. 5. As described in the publications referenced in this table, early development-stage investments are made in enterprises that appear viable and for which further technical risk is deemed minimal, although commercial risk may be significant. 6. As described in the publications referenced in this table, enterprises in the expansion stage usually have shipped some product to consumers (including beta versions). 7. As described in the publications referenced in this table, bridge/ipo-stage financing covers such activities as pilot plant construction, production design, and production testing, as well as bridge financing in anticipation of a later IPO. (AICPA Equity Security Taskforce: - Practice aid on the Valuation of Privately Held Company Equity Securities Issued as Compensation, Para B.02) 22 CHALLENGING THE DISCOUNT RATE 22

23 BRENDAN DAW Qualifications Bachelor of Commerce (Accountancy), University of South Australia Chartered Accountants Australia & New Zealand Graduate Diploma in Corporate Finance Professional Certificates in Leadership and Marketing Chartered Accountant Business Valuation Specialist Professional Memberships Member of Chartered Accountants Australia & New Zealand Registered Tax Agent Experience Brendan joined Leadenhall in 2010 with over 20 years experience in private industry, the accounting profession, and the public sector. Brendan s wide ranging expertise includes being Principal of his own consulting firm, a Director and CEO in several small businesses as well as over 10 years as a CFO/Financial Controller. Brendan s acumen spans developing and implementing business plans, managing finances, resources and IT systems, analysing information, creating adaptive financial models and undertaking complex business valuations. Plus he is highly skilled in preparing conclusive financial reports, providing expert opinions and advice to the SME market. 23 CHALLENGING THE DISCOUNT RATE

24 SIMON DALGARNO Qualifications Bachelor of Economics, University of Adelaide Institute of Chartered Accountants in Australia Graduate Diploma in Applied Finance & Investment, FINSIA Professional Memberships Fellow of the Institute of Chartered Accountants in Australia Fellow of the Financial Services Institute of Australasia Member of the International Association of Consultants, Valuers and Analysts Experience Simon has worked in the valuation industry for in excess of sixteen years and has completed numerous valuations for private and public companies including: businesses - from power stations and heavy engineering to rubbish dumps and consulting practices intellectual property - brands, plant breeding rights, databases and computer systems. Simon regularly advises on Option Valuation (AASB 2), Purchase Price Allocations (AASB 3) and Impairment testing (AASB 136) in accordance with the accounting standards. He regularly conducts seminars on valuation theory and practice for legal and accounting professionals and is a major contributor to the leading valuation text, Australian Valuation Handbook. 24 CHALLENGING THE DISCOUNT RATE

25 ABOUT LEADENHALL CORPORATE ADVISORY Leadenhall has been established for 28 years and we specialises in business valuations and in mergers and acquisitions advice. Valuation Business and company valuations Independent Expert s Reports Compliance Valuation (PPA, Impairment, Options) Technology and IP valuations Transactions Acquisitions, divestments and MBO s Mergers and acquisitions advice Succession planning Growth strategies and development plans 25 CHALLENGING THE DISCOUNT RATE

26 CONTACT ADELAIDE Level 1, 31 Franklin St Adelaide SA 5000 Contact: Simon Dalgarno T M Contact: Brendan Daw brendan.daw@leadenhall.com.au T M SYDNEY Level 11, 65 York St Sydney NSW 2000 Contact: Richard Norris richard.norris@leadenhall.com.au T M Contact: Dave Pearson dave.pearson@leadenhall.com.au T M MELBOURNE Level 9, 440 Collins St Melbourne VIC 3000 Contact: Elena Saarbrucken elena.saarbrucken@leadenhall.com.au T M leadenhall.com.au 26 CHALLENGING THE DISCOUNT RATE