Advanced Topics in Valuation

Transcription

1 product: 4493 course code: c362

2 Module Introduction and Overview Contents 1 Introduction to the Module 2 2 The Module Author 3 3 Study Materials 3 4 Module Overview 4 5 Learning Outcomes 5 6 Teaching and Learning Strategy 6 7 Assessment 7

3 1 Introduction to the Module Welcome to the module Advanced Topics in Valuation. This is the second valuation module available to study at CeFiMS. It is assumed you already have an understanding of the fundamental methods for valuing a company using the discounted cash flow approach, studied in Introduction to Valuation. The aim of this module is to broaden and strengthen your understanding of the DCF method, by studying valuation in a number of more advanced and specialised situations. Unit 1 examines the structure and operation of a relatively complex spreadsheet valuation model. It shows how to use a spreadsheet to collect the financial information from a conventional income statement and balance sheet for a company, reorganise the statements to compute NOPLAT and invested capital, calculate free cash flow, build forecasts, and compute estimated valuation. As such, this unit also provides an opportunity to reinforce and apply understanding of the enterprise DCF method in a more challenging context. Unit 2 analyses how value can be created (or destroyed) by acquisitions, and how much of any value created goes to the shareholders of the acquiring firm. The decision to pay for an acquisition in cash or in stock is considered, and the unit contrasts the effect of acquisitions on value creation and on accounting measures like earnings per share. The unit also examines how value can be created from divestitures. Unit 3 considers how corporate taxation influences the valuation process. It examines the statutory tax rate, the effective tax rate, and how to compute the operating tax rate required for forecast NOPLAT and free cash flow. Unit 3 also analyses temporary differences between reported taxes and actual taxes paid, the interpretation of deferred tax assets and deferred tax liabilities, and how to compute the operating tax cash rate. The unit assesses the implications for valuation of base erosion and profit shifting. Unit 4 examines the income statement in more detail, identifying items which are one-off or non-operational, as well as provisions and reserves which are used to transfer income and expenses between reporting periods. The unit also considers off-balance-sheet items, and in particular, operating leases, and examines how off-balance-sheet operating leases distort measures of invested capital and return on invested capital. The unit analyses the adjustments required to capitalise such leases to bring them into the valuation process. Unit 5 considers the effect of inflation on valuation, and explains how to make financial projections in real and nominal terms. The unit also considers the steps required to take account of cash flows denominated in foreign currencies, and explains two methods for discounting foreign currency cash flows using the spot exchange rate and forward exchange rate. Unit 6 looks at the specific issues associated with financial analysis and valuation of businesses in emerging markets. It considers the sources of risk for businesses, and discusses how to incorporate these risks in valuation using probability-weighted scenarios, or country risk premiums. 2 University of London

4 Introduction and Overview Unit 7 examines the methods available to analyse and value flexibility, using decision tree analysis and real options valuation. The unit provides a brief introduction to the pricing of financial options, and applies these results to analyse flexibility in real investment projects. Unit 8 provides an introduction to the valuation of banks. It explains the equity discounted cash flow approach, performance analysis using economic spreads on loans and deposits, and valuation using economic spreads. 2 The Module Author Dr Jonathan Simms is a tutor for CeFiMS, and has taught at University of Manchester, University of Durham and University of London. He has contributed to development of various CeFiMS courses including Risk Management: Principles & Applications, Econometric Principles and Data Analysis, Econometric Analysis and Applications, Financial Econometrics, Introduction to Valuation, Public Financial Management: Reporting and Audit, Banking Strategy, and Introduction to Law and to Finance. 3 Study Materials As with all courses, you will have received a study guide (these are specially authored units ), a Course Reader, and online you will find a specimen examination paper to demonstrate the kinds of questions appropriate to a final examination and two assignments that will be marked by your course tutor and form part of your overall assessment mark. Study Guide In order to structure your learning, we have put together this study guide, consisting of eight units of work. Each unit should be studied within a week. It is designed in such a way that studying the unit and the associated core readings will require between 15 and 20 hours. The units will introduce the key topics, the core readings and assignments for the course. Frequent referral to learning outcomes and references back to issues studied earlier in the course, and the setting of study activities within the units, will help you follow the course and check your learning progress. The textbook for this course is: Tim Koller, Marc Goedhart and David Wessels (2015) Valuation. Measuring and Managing the Value of Companies, Fifth edition, Hoboken New Jersey: John Wiley & Sons. The introductory sections from this textbook are studied in Introduction to Valuation. In this module you will focus on the sections dealing with more advanced topics and specialised situations. You will be advised in the course text when to read these and what to focus on when reading from them. Centre for Financial and Management Studies 3

5 4 Module Overview Unit 1 Developing and Using a Spreadsheet Valuation Model 1.1 Introduction 1.2 Reorganise the Financial Statements 1.3 Free Cash Flow 1.4 Forecast Ratios 1.5 Forecast NOPLAT, Invested Capital and FCF 1.6 Valuation 1.7 Exercise: Updating the Spreadsheet Valuation Model 1.8 Conclusion References Unit 2 Corporate Portfolio Strategy 2.1 Introduction 2.2 The Best Owner 2.3 Mergers and Acquisitions 2.4 Divestitures 2.5 Conclusion References Review Questions Unit 3 Taxation 3.1 Introduction 3.2 Operating Taxes on the Reorganised Income Statement 3.3 Converting Operating Taxes to Operating Cash Taxes 3.4 Taxes in the Spreadsheet Valuation Model 3.5 Base Erosion and Profit Shifting 3.6 Conclusion References Review Question Unit 4 Non-operating Expenses and Off-Balance-Sheet Items 4.1 Introduction 4.2 Non-operating Expenses and One-Time Charges 4.3 Provisions and Reserves 4.4 Off-Balance-Sheet Leases 4.5 Conclusion References Review Questions Unit 5 Inflation and Foreign Currency 5.1 Introduction 5.2 Inflation Leads to Lower Value Creation 5.3 Financial Projections in Real and Nominal Terms 5.4 Forecasting Cash Flows in Foreign and Domestic Currency 5.5 Conclusion References Review Questions 4 University of London

6 Introduction and Overview Unit 6 Valuation in Emerging Markets 6.1 Introduction 6.2 Historical Analysis 6.3 Creating a Consistent Set of Economic Assumptions 6.4 Incorporating Emerging-Market Risk in Valuation 6.5 Estimating Cost of Capital in Emerging Markets 6.6 Conclusion References Review Questions Unit 7 Valuing Flexibility 7.1 Introduction 7.2 Pricing Financial Options 7.3 Valuing Flexibility 7.4 Four-Step Process for Valuing Flexibility 7.5 Conclusion References Review Questions Unit 8 Valuing Banks 8.1 Introduction 8.2 Principles of Bank Valuation 8.3 Economic Spread Analysis and Value Creation 8.4 Deposit and Loan Franchise 8.5 Practical Challenges 8.6 Conclusion References Review Questions 5 Learning Outcomes When you have completed your study of this course you will be able to analyse in detail the relations between the various steps in discounted cash flow valuation in a spreadsheet model build a complex spreadsheet valuation model examine the value created by an acquisition for the shareholders of the acquiring firm analyse the effect on value created (or destroyed) of all-cash considerations, all-share considerations, and mixed considerations explain why it is necessary to focus on value creation and not accounting measures when considering acquisitions identify circumstances when divestitures can create value compute the operating tax rate when all information is available, and assess the approximations to estimate the operating tax rate with incomplete information explain how temporary differences arise between reported taxes and actual taxes, and interpret deferred tax liabilities and deferred tax assets Centre for Financial and Management Studies 5

7 identify non-operational items which are classified on the income statement as operational, and examine operational items for one-off or non-operational amounts explain and make adjustments for provisions and reserves in the calculation of NOPLAT discuss the effects of not reporting operating leases on the balance sheet assess the impact of capitalising operating leases on NOPLAT, ROIC and equity valuation examine the effect on valuation of complete and incomplete inflation pass on produce financial projections in real and nominal terms explain and use the spot rate method and forward rate method to discount cash flows denominated in foreign currency estimate synthetic forward exchange rates using the covered interest parity condition assess differences in reporting standards between mature and emerging markets, and the impact on valuation incorporate emerging market risk into valuation using the probability weighted scenario approach, and the country risk premium approach use decision tree analysis and real options to value flexibility value the interest-generating activities of banks using the equity cash flow method analyse performance and value creation using economic spreads on loans and deposits. 6 Teaching and Learning Strategy When you work through the course materials, there are various exercises based upon the textbook, the readings, Excel workbooks which are provided, and the unit content. These are designed to consolidate your knowledge and skills. We recommend that you do the exercises, before you look at the answers that are provided in the unit text. At certain points we will ask you to reflect on these advanced topics in valuation in relation to companies and countries with which you are familiar. It will be valuable for you and your fellow students to share these reflections on the OSC. Short notes setting out the issue and the approach will enrich your experience of the course. Please feel free to raise queries with your tutor and with your fellow students, if there are things that are not clear to you. Do this as soon as you find a problem, because waiting will hold you up as you work through the course. We hope that you will find the course instructive, useful and challenging. 6 University of London

8 Introduction and Overview 7 Assessment Your performance on each module is assessed through two written assignments and one examination. The assignments are written after week four and eight of the module session and the examination is taken at a local examination centre in September/October. Preparing for Assignments and Exams There is good advice on preparing for assignments and exams and writing them in Sections 8.2 and 8.3 of Studying at a Distance by Talbot. We recommend that you follow this advice. The examinations you will sit are designed to evaluate your knowledge and skills in the subjects you have studied: they are not designed to trick you. If you have studied the module thoroughly, you will pass the exam. Understanding assessment questions Examination and assignment questions are set to test different knowledge and skills. Sometimes a question will contain more than one part, each part testing a different aspect of your skills and knowledge. You need to spot the key words to know what is being asked of you. Here we categorise the types of things that are asked for in assignments and exams, and the words used. All the examples are from the Centre for Financial and management Studies examination papers and assignment questions. Definitions Some questions mainly require you to show that you have learned some concepts, by setting out their precise meanings. Such questions are likely to be preliminary and be supplemented by more analytical questions. Generally Pass marks are awarded if the answer only contains definitions. They will contain words such as: Describe Contrast Define Write notes on Examine Outline Distinguish between What is meant by Compare List Reasoning Other questions are designed to test your reasoning, by explaining cause and effect. Convincing explanations generally carry additional marks to basic definitions. They will include words such as: Interpret Explain What conditions influence What are the consequences of What are the implications of Centre for Financial and Management Studies 7

9 Judgement Others ask you to make a judgement, perhaps of a policy or of a course of action. They will include words like: Evaluate Critically examine Assess Do you agree that To what extent does Calculation Sometimes, you are asked to make a calculation, using a specified technique, where the question begins: Use indifference curve analysis to Using any economic model you know Calculate the standard deviation Test whether It is most likely that questions that ask you to make a calculation will also ask for an application of the result, or an interpretation. Advice Other questions ask you to provide advice in a particular situation. This applies to law questions and to policy papers where advice is asked in relation to a policy problem. Your advice should be based on relevant law, principles and evidence of what actions are likely to be effective. The questions may begin: Advise Provide advice on Explain how you would advise Critique In many cases the question will include the word critically. This means that you are expected to look at the question from at least two points of view, offering a critique of each view and your judgment. You are expected to be critical of what you have read. The questions may begin: Critically analyse Critically consider Critically assess Critically discuss the argument that Examine by argument Questions that begin with discuss are similar they ask you to examine by argument, to debate and give reasons for and against a variety of options, for example Discuss the advantages and disadvantages of Discuss this statement Discuss the view that Discuss the arguments and debates concerning 8 University of London

10 Introduction and Overview The grading scheme: Assignments The assignment questions contain fairly detailed guidance about what is required. All assignment answers are limited to 2,500 words and are marked using marking guidelines. When you receive your grade it is accompanied by comments on your paper, including advice about how you might improve, and any clarifications about matters you may not have understood. These comments are designed to help you master the subject and to improve your skills as you progress through your programme. Postgraduate Assignment Marking Criteria The marking criteria for your programme draws upon these minimum core criteria, which are applicable to the assessment of all assignments: understanding of the subject utilisation of proper academic [or other] style (e.g. citation of references, or use of proper legal style for court reports, etc.) relevance of material selected and of the arguments proposed planning and organisation logical coherence critical evaluation comprehensiveness of research evidence of synthesis innovation / creativity / originality The language used must be of a sufficient standard to permit assessment of these. The guidelines below reflect the standards of work expected at postgraduate level. All assessed work is marked by your Tutor or a member of academic staff, and a sample is then moderated by another member of academic staff. Any assignment may be made available to the external examiner(s). 80+ (Distinction). A mark of 80+ will fulfil the following criteria: very significant ability to plan, organise and execute independently a research project or coursework assignment; very significant ability to evaluate literature and theory critically and make informed judgements; very high levels of creativity, originality and independence of thought; very significant ability to evaluate critically existing methodologies and suggest new approaches to current research or professional practice; very significant ability to analyse data critically; outstanding levels of accuracy, technical competence, organisation, expression (Distinction). A mark in the range will fulfil the following criteria: significant ability to plan, organise and execute independently a research project or coursework assignment; clear evidence of wide and relevant reading, referencing and an engagement with the conceptual issues; Centre for Financial and Management Studies 9

11 capacity to develop a sophisticated and intelligent argument; rigorous use and a sophisticated understanding of relevant source materials, balancing appropriately between factual detail and key theoretical issues. Materials are evaluated directly and their assumptions and arguments challenged and/or appraised; correct referencing; significant ability to analyse data critically; original thinking and a willingness to take risks (Merit). A mark in the range will fulfil the following criteria: ability to plan, organise and execute independently a research project or coursework assignment; strong evidence of critical insight and thinking; a detailed understanding of the major factual and/or theoretical issues and directly engages with the relevant literature on the topic; clear evidence of planning and appropriate choice of sources and methodology with correct referencing; ability to analyse data critically; capacity to develop a focussed and clear argument and articulate clearly and convincingly a sustained train of logical thought (Pass). A mark in the range will fulfil the following criteria: ability to plan, organise and execute a research project or coursework assignment; a reasonable understanding of the major factual and/or theoretical issues involved; evidence of some knowledge of the literature with correct referencing; ability to analyse data; shows examples of a clear train of thought or argument; the text is introduced and concludes appropriately (Fail). A Fail will be awarded in cases in which there is: limited ability to plan, organise and execute a research project or coursework assignment; some awareness and understanding of the literature and of factual or theoretical issues, but with little development; limited ability to analyse data; incomplete referencing; limited ability to present a clear and coherent argument (Fail). A Fail will be awarded in cases in which there is: very limited ability to plan, organise and execute a research project or coursework assignment; failure to develop a coherent argument that relates to the research project or assignment; no engagement with the relevant literature or demonstrable knowledge of the key issues; incomplete referencing; clear conceptual or factual errors or misunderstandings; 10 University of London

12 Introduction and Overview only fragmentary evidence of critical thought or data analysis (Fail). A Fail will be awarded in cases in which there is: no demonstrable ability to plan, organise and execute a research project or coursework assignment; little or no knowledge or understanding related to the research project or assignment; little or no knowledge of the relevant literature; major errors in referencing; no evidence of critical thought or data analysis; incoherent argument. The grading scheme: Examinations The written examinations are unseen (you will only see the paper in the exam centre) and written by hand, over a three hour period. We advise that you practise writing exams in these conditions as part of your examination preparation, as it is not something you would normally do. You are not allowed to take in books or notes to the exam room. This means that you need to revise thoroughly in preparation for each exam. This is especially important if you have completed the module in the early part of the year, or in a previous year. Details of the general definitions of what is expected in order to obtain a particular grade are shown below. These guidelines take account of the fact that examination conditions are less conducive to polished work than the conditions in which you write your assignments. Note that as the criteria of each grade rises, it accumulates the elements of the grade below. Assignments awarded better marks will therefore have become comprehensive in both their depth of core skills and advanced skills. Postgraduate Unseen Written Examinations Marking Criteria 80+ (Distinction). A mark of 80+ will fulfil the following criteria: very significant ability to evaluate literature and theory critically and make informed judgements; very high levels of creativity, originality and independence of thought; outstanding levels of accuracy, technical competence, organisation, expression; shows outstanding ability of synthesis under exam pressure (Distinction). A mark in the range will fulfil the following criteria: shows clear evidence of wide and relevant reading and an engagement with the conceptual issues; develops a sophisticated and intelligent argument; shows a rigorous use and a sophisticated understanding of relevant source materials, balancing appropriately between factual detail and key theoretical issues. materials are evaluated directly and their assumptions and arguments challenged and/or appraised; shows original thinking and a willingness to take risks; Centre for Financial and Management Studies 11

13 shows significant ability of synthesis under exam pressure (Merit). A mark in the range will fulfil the following criteria: shows strong evidence of critical insight and critical thinking; shows a detailed understanding of the major factual and/or theoretical issues and directly engages with the relevant literature on the topic; develops a focussed and clear argument and articulates clearly and convincingly a sustained train of logical thought; shows clear evidence of planning and appropriate choice of sources and methodology, and ability of synthesis under exam pressure (Pass). A mark in the range will fulfil the following criteria: shows a reasonable understanding of the major factual and/or theoretical issues involved: shows evidence of planning and selection from appropriate sources; demonstrates some knowledge of the literature; the text shows, in places, examples of a clear train of thought or argument; the text is introduced and concludes appropriately (Fail). A Fail will be awarded in cases in which: there is some awareness and understanding of the factual or theoretical issues, but with little development; misunderstandings are evident; there is some evidence of planning, although irrelevant/unrelated material or arguments are included (Fail). A Fail will be awarded in cases which: fail to answer the question or to develop an argument that relates to the question set; do not engage with the relevant literature or demonstrate a knowledge of the key issues; contain clear conceptual or factual errors or misunderstandings (Fail). A Fail will be awarded in cases which: show no knowledge or understanding related to the question set; show no evidence of critical thought or analysis; contain short answers and incoherent argument. Specimen exam papers [ : Learning & Teaching Quality Committee] CeFiMS does not provide past papers or model answers to papers. Modules are continuously updated, and past papers will not be a reliable guide to current and future examinations. The specimen exam paper is designed to be relevant and to reflect the exam that will be set on this module. Your final examination will have the same structure and style and the range of question will be comparable to those in the Specimen Exam. The number of questions will be the same, but the wording and the requirements of each question will be different. 12 University of London

14 Introduction and Overview Good luck on your final examination. Further information Online you will find documentation and information on each year s examination registration and administration process. If you still have questions, both academics and administrators are available to answer queries. The Regulations are also available at setting out the rules by which exams are governed. Centre for Financial and Management Studies 13

15 DO NOT REMOVE THE QUESTION PAPER FROM THE EXAMINATION HALL UNIVERSITY OF LONDON CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES MSc Examination MBA Examination Postgraduate Diploma Advanced Topics in Valuation Specimen Exam 91DFMC362 This is a specimen examination paper designed to show you the type of examination you will have at the end of the year for Advanced Topics in Valuation. The number of questions and the structure of the examination will be the same but the wording and the requirements of each question will be different. Best wishes for success on your final examination. The examination must be completed in THREE hours. Answer THREE questions, including at least ONE question from each section. Answer ALL parts of multi-part questions. PLEASE TURN OVER 14 University of London

16 Introduction and Overview SECTION A: Answer at least ONE question from this section 1. Discuss the trade-off between increasing complexity and general applicability in complex spreadsheet valuation models. 2. Company A (market value $240million) intends to acquire Company T (market value $116million) for $133.4million. Company A s revenues are $100m and its operating costs are $63m. Company T s revenues are $50m, and its operating costs are $36m. Performance improvements are expected to be achieved by reducing costs at Company T. Calculate the value created (or destroyed) for the shareholders of Company A in an all-share consideration, and an all-cash consideration, if $3million per annum cost savings are achieved, and if $1million per annum cost savings are achieved, and comment on the results. 3. Table 3.1 shows the income statement and Table 3.2 shows the tax reconciliation table for a company. The company consists of a domestic subsidiary and a foreign subsidiary. The domestic statutory tax rate is 35% and the foreign statutory tax rate is 12%. Estimate the operating tax rate for the company, and comment on the value you obtain. Table 3.1 Company income statement EBITA Amortisation EBIT Interest expense Gains on asset sales 90.0 EBT Taxes Net income Table 3.2 Tax reconciliation table Taxes at statutory rate 35.00% Foreign-income adj % R&D tax credits 3.17% Audit revision, etc. 1.59% Effective tax rate 19.41% Centre for Financial and Management Studies 15

17 4. Answer all parts of the question. a) Assess the effect on equity valuation of capitalising offbalance-sheet operating leases. [70% of mark] b) A company leases many of the assets it uses. The expected lease rental expense is $30m per year. The company s cost of borrowing is 10%, and the average life of leased assets is 10 years. Estimate the value of leased assets using at least two methods, and comment on the results. [30% of mark] SECTION B: Answer at least ONE question from this section 5. Answer all parts of the question. a) A firm is expected to experience growth in the real volume of sales, and inflation is also expected to exist in future years. To value the company, explain why it is necessary to conduct projections in real and nominal terms. [50% of marks] b) Complete the following table. Inflation is 5%, and the volume of sales is unchanged from year to year. The firm has a policy of replacing assets at the rate of depreciation, which is 10 per cent per year. Comment on your results. [50% of marks] Year 1 Year 2 Sales 1,000 1,040 COGS 700 EBITDA 300 Depreciation 200 EBITA 100 Gross PPE 2,000 Cumulative depreciation 1,250 1,250 Invested capital 750 EBITDA 300 Capital expenditures 200 FCF University of London

18 Introduction and Overview EBITA growth (%) EBITA/Sales (%) ROIC (%) FCF growth (%) 6. Answer all parts of the question. a) Compare and contrast the scenario approach and country risk premium approach to incorporating emerging market risk in valuation. [70% of mark] b) In a baseline scenario, projected cash flow for a company in Year 1 is 200; cash flow grows at an annual rate of 3% in perpetuity; and the cost of capital is 8%. In the downside scenario, cash flow is 35% of what it would be in the baseline scenario; the growth rate is 3% and the cost of capital is 8% (the same as in the baseline scenario). The probability of the baseline scenario occurring is estimated to be 60%, and for the downside scenario it is 40%. (i) Estimate expected present value of company cash flow, and comment on the result. [20% of mark] (ii) What is the implied country risk premium in your answer to part (ii)? [10% of mark] 7. Answer all parts of the question. a) Compare the advantages and disadvantages of decision tree analysis and real-option valuation when valuing flexibility. [50% of mark] b) One year from now, a project will produce value of 110 with probability 0.60, or value of 70 with probability The cost of capital is 6% and the risk-free rate is 4%. The project can be expanded one year from now: expansion would have an investment cost of 15 and would increase value by 25%. Estimate the gross present value of the project, and comment on the results, using: Centre for Financial and Management Studies 17

19 (i) standard methods without allowing for flexibility [10% of mark] (ii) decision tree analysis [20% of mark] (iii) real-option valuation [20% of mark] 8. Answer all parts of the question. a) A bank earns more interest on its loans than it pays on its deposits. To what extent does this positive net interest income represent value creation for shareholders in the bank? [50% of mark] b) At the start of year 1, a bank has loans of 200. It has a required equity-to-loan ratio of 10%. The loan interest rate is 5% and the deposit interest rate is 2%. Operating expenses are 1.5 per year. Loans, deposits and operating expenses are all expected to grow at a rate of 3% per year. The tax rate is 20%. The cost of equity is 8.5%. The matched opportunity rate for loans is 4%, and the matched opportunity rate for deposits is 3.5%. Estimate the value for the bank s shareholders. [50% of mark] 18 University of London

20 Unit 1 Developing and Using a Spreadsheet Valuation Model Contents 1.1 Introduction Reorganise the Financial Statements 1.3 Free Cash Flow 1.4 Forecast Ratios Forecast NOPLAT, Invested Capital and FCF Valuation 1.7 Exercise: Updating the Spreadsheet Valuation Model 1.8 Conclusion References

21 Unit Content Unit 1 examines the structure and operation of a relatively complex spreadsheet valuation model. It shows how to collect the financial information from a conventional income statement and balance sheet, reorganise the statements to compute NOPLAT and invested capital, calculate free cash flow, build forecasts, and compute estimated valuation. The model is used for sensitivity and scenario analysis, and is updated for valuation for a later year, using more recent financial data. Learning Outcomes When you have finished reading this unit and working with the spreadsheet valuation model, you will be able to explain how to apply the elements of discounted cash flow valuation in an operational spreadsheet analyse in detail the relations between the various processes involved in the valuation process in the spreadsheet model use the developed spreadsheet valuation model for sensitivity and scenario analysis update the data and formulae in the valuation model for valuation in a later year build a complex spreadsheet valuation model Reading for Unit 1 There are no core readings from your textbook for Unit 1. The unit will guide you through the structure and operation of a spreadsheet valuation model for a consumer products company. The Excel file is provided, filename C362_U1_Year 9_Valuation.xls. The valuation is conducted with respect to Year 9, and you will update the model to conduct a valuation for Year University of London

22 Unit 1 Developing and Using a Spreadsheet Valuation Model 1.1 Introduction This unit provides a detailed examination of a complex spreadsheet valuation model. You will analyse all of the calculations and interrelations in the spreadsheet model, and then you will update the model, inputting financial data for a more recent year, and updating the formulae as required. The structure of this unit is not the same as the other units in this course; the unit takes the form of an extended worked example, followed by a series of exercises, concentrating on one spreadsheet valuation model. We hope that you will develop an understanding of the model sufficient for you to be able to construct your own spreadsheet valuation models. The workbook you will study provides a valuation of a consumer products company. The emphasis in the unit is on the mechanics of building and using a spreadsheet valuation model: collecting the relevant financial information from an Annual Report reorganising the financial statements to compute net operating profit less adjusted taxes (NOPLAT) and invested capital computing free cash flow forecasting NOPLAT, invested capital and free cash flow and finally, discounting and valuation. How to value a company, and the strengths and weaknesses of the discounted cash flow approach, are studied in the module Introduction to Valuation. This unit does not discuss the strengths and weaknesses of the discounted cash flow approach, or on how to analyse a company, its rivals and the market in which they operate in order to make informed assumptions about future prospects for growth and profitability. Having said that, by examining a complex spreadsheet valuation model you will be revising and reinforcing your understanding of the steps involved in forecasting and computing an estimated valuation. The workbook has seven sheets: Financials Supplemental Reorganized Taxes Forecasts FCF Valuation In summary, the spreadsheet valuation works like this. Information from the company income statement and balance sheet is gathered on the Financials sheet, which replicates the income statement and balance sheet, and the statement of retained earnings. The Supplemental sheet gathers additional information from the Annual Report required for the valuation, including other operating income and charges, restructuring charges, and figures for depreciation and amortisation. The Reorganised sheet computes NOPLAT and invested capital for the historical data (up to and including Year 9) from Centre for Financial and Management Studies 3

23 the Financials and Supplemental pages. NOPLAT is reconciled with net income, and invested capital is reconciled with total funds invested. These calculations use information on the marginal tax rate and effective tax rate, and on operating and non-operating taxes, which are derived on the Taxes sheet. You will examine taxes in more detail in Unit 3. The Reorganized sheet also computes forecasts of NOPLAT and invested capital for the explicit forecast period. The forecasts are constructed in the following way. The elements of NOPLAT and invested capital are assumed to be driven by net revenues. Therefore the workbook computes forecast ratios for each line item in NOPLAT and invested capital, expressing them as a percentage of net revenues (using the Year 9 values). These forecast ratios are computed on the Forecasts sheet. The valuation is computed on an as is basis, so these forecast ratios are extended into the years of the explicit forecast period. The Forecasts sheet also includes assumptions made about the future growth rates of net revenues in the explicit forecast period. The forecasts for net revenues, together with the forecast ratios, are then used to compute forecasts of the line items of NOPLAT and invested capital, also on the Reorganized sheet. The FCF sheet computes free cash flow from operations, and reconciles this with free cash flow available to investors. This is done for the historical data, and the sheet also computes forecasts for FCF into the explicit forecast period, using the same method as just described. The Valuation sheet discounts FCF for the explicit forecasting period, and also computes continuing value using the continuing value formula. Assumptions concerning weighted average cost of capital, and growth beyond the explicit forecasting period are input on the Valuation sheet. The discounted cash flow in the explicit forecasting period and continuing value produce an estimate of core operating value, from which the sheet calculates gross enterprise value, intrinsic value, and intrinsic share price. The unit will guide you through the construction and operation of the workbook, including the data inputs, the calculations, and the relations between the elements on the seven sheets. At various stages you will be advised to check your understanding of these points. You will also be asked to examine the effect of varying some elements in the workbook. Once you have gone through the complete workbook you will update the valuation for Year 10. Advice and guidance are provided in the unit. This updated valuation involves inputting new financial data, which is provided. You will also have to update the calculations. In many cases this can be done by copying the formulae for Year 9 into a new column for Year 10. We hope that by examining the workbook in this level of detail, you will develop sufficient understanding to be able to construct your own complex spreadsheet valuation models. It is important that you examine the workbook as you read through the unit. This will enable you to develop a working understanding of the mechanics of the workbook. If you only read the unit content, without working with the spreadsheets, it is less likely that you will be able to develop a good understanding of the way the spreadsheet valuation model is constructed. 4 University of London

24 Unit 1 Developing and Using a Spreadsheet Valuation Model Unit 1 concentrates on the structure and operation of the workbook. It does not examine or discuss the actual company, its rivals, or its markets, or its prospects for profitability and growth; it does not undertake any benchmarking; and it does not examine the data and calculations necessary to estimate the company weighted average cost of capital. Study Note The workbook you will use is adapted from a workbook made available by the authors of your textbook. We are grateful to Professor Wessels for his clarifications on various aspects of the workbook. Please note two important points about the workbook. 1 The workbook is provided by the publishers as a suggested solution to a series of (five) assignments. Please do not post the workbook on any public websites, so that instructors in other academic institutions can continue to use the assignments with their students. 2 In the workbook provided by the publishers, it was noted that some cells which should have included a formula in fact included a value, calculated by hand elsewhere and inserted. A formula updates if the arguments in the formula change; and if a formula is copied to another cell in the workbook, the formula applies to the referenced cells. A value does not update it is just a value. Where these cases were identified (if they were present in the Year 9 calculations), a suitable formula was inserted to replace the value. Although every attempt was made to correct these instances, please be aware of this possibility. Optional Reading This unit explains in detail what the spreadsheet valuation model does, and how it combines the various elements of the valuation method. But the unit does not provide a detailed explanation of the concepts behind valuation using the DCF approach (this is studied in the module Introduction to Valuation). If at any stage you need to revise your understanding of any of the procedures in the discounted cash flow approach, you may find it helpful to read from pages 169 to 197, as you require, in Chapter 9 Reorganizing the Financial Statements in your textbook, Valuation, by Koller, Goedhart and Wessels. These pages first outline the principles involved in NOPLAT, invested capital, and free cash flow (pages ); and then explain how to reorganise the financial statements to compute NOPLAT, invested capital and free cash flow in practice (pages ). Chapter 9 is a reading set for the module Introduction to Valuation, but, after reading any part of the text in this unit, and examining the relevant operation in the Excel workbook, you find that you are not completely clear how the spreadsheet valuation model applies these techniques, this chapter is probably the best place to look for a quick revision of the principles involved. Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 9 Reorganizing the Financial Statements. 1.2 Reorganise the Financial Statements Recall that enterprise valuation using the discounted cash flow method depends on the return on invested capital (ROIC) and free cash flow (FCF), where Centre for Financial and Management Studies 5

25 NOPLAT ROIC = (1.1) Invested Capital and NOPLAT is net operating profit less adjusted taxes. FCF is NOPLAT plus noncash operating expenses less investment in invested capital. To value an enterprise we need to focus on the income from operations, and the capital used for operations. Therefore we need to rearrange the traditional balance sheet from to Assets = Liabilities + Equity (1.2) OA OL + NOA = Total funds invested = ( D + DE ) + ( E + EE) (1.3) where the difference between operating assets (OA) and operating liabilities (OL) is invested capital. Invested capital plus non-operating assets (NOA) equals total funds invested. This is financed by debt (D) and debt equivalents (DE), and equity (E) and equity equivalents (EE). To obtain NOPLAT, we make adjustments to the income statement to account for income and expense items that are not related to operations: 1 Interest is not an operating expense, it is a financing item, so interest is not subtracted from operating profit. 2 Exclude non-operating income deriving from assets that are not included in invested capital. 3 Interest expense and non-operating income affect reported taxes. Therefore the effects of interest and non-operating income are removed from taxes in the calculation of NOPLAT Accounting statements The traditional income statement and balance sheet, derived from the company report, are replicated in the sheet Financials. We will look first at the income statement. Review Question Please check that you understand the information contained in the income statement on the Financials sheet of the workbook. For example, data for net revenues (positive) and cost of sales (negative) is entered (from the Annual Report), and Gross profit is the sum of these. In the workbook, Income tax benefit (Provision) is sometimes reported as Taxes on Income. And Income prior to minority interest in the workbook is the same as Net earnings. Investment result and Net interest appear separately in the workbook, but in an Annual Report these might be summed and presented as Financial result. Please note that depreciation and amortisation are not explicitly deducted in the Consolidated statement of income in the Annual Report for this company; instead, these items are 6 University of London

26 Unit 1 Developing and Using a Spreadsheet Valuation Model included in the line item Cost of sales (and detailed in a Note). This will be relevant for the calculation of EBITA. Review Question What is the value for Net Revenues in Year 9? And what is the value for Income prior to minority interest? From the Financials sheet in the Excel workbook, cell G6, net revenues in Year 9 are (million euros). And Income prior to minority interest, cell G22, is 628 (million euros). In a similar way, the information from the Consolidated balance sheet in the Annual Report is replicated on the sheet Financials in the workbook. Review Question For Year 9, what is the value of total assets? In the Financials worksheet, cell O23, Total assets in Year 9 is (million euros) Reorganised accounting statements The Reorganized sheet does a lot of work in this particular workbook. This sheet includes the reorganisation of the accounting statements to calculate NOPLAT (labelled After-tax operating profits, rows 5 to 18). NOPLAT is reconciled with Net income (rows 31 to 39). The balance sheet is reorganised and Invested capital is calculated in rows And invested capital is reconciled with Total funds invested in rows In addition to the reorganisation, the sheet uses supplemental information relating to income, which is to be found in the sheet Supplemental. The Reorganized sheet also includes forecasts for NOPLAT and invested capital for Year 10 to Year 15. The forecasted items are based on the values from Year 9, combined with the forecast ratios, which are to be found in the sheet Forecasts (which you will examine later in the unit). The forecast values on the Reorganized sheet then feed into calculation and forecasting of free cash flow in the sheet FCF, which then feeds into the calculation of enterprise value on the sheet Valuation. Consider first After-tax operating profit. In the cell for Net revenues in Year 9 there is a link back to Net Revenues on the Financials sheet, and there is no other supplemental information related to this item. Cost of sales also links back to Cost of sales on the Financials sheet, plus an amount for Cost of sales from the Supplemental sheet. Restructuring Charges (reported in the notes to the Consolidated statement of income), are broken down into Cost of sales; Marketing, selling and distribution expenses; Research and development expenses; and Administrative expenses. These restructuring charges are entered on the Supplemental sheet. On the Reorganized sheet, each of Centre for Financial and Management Studies 7

27 these line items refers back to the Financials sheet, plus the corresponding restructuring charge on the Supplemental sheet. Now consider Other operating income, and Other operating expenses. A breakdown of Other operating income is usually provided in Notes in the Annual Report. These items are entered on the Supplemental sheet, cells G6:G12. However, not all of them may be considered to be ongoing and to relate to core operations. To indicate this, a column of flags is used in cells H6:H12, with Yes used to indicate if an item relates to operations. Other operating income is summed in cell G15 using a logical statement, which sums the items in cells G6:G12, with an item included in the sum if the flag for Operating is Yes ; if the flag is empty, that item is not included in the sum. Study Note You could just add the relevant items together using a simple addition formula. However, classification of items into operating and non-operating items can be subjective, and if you decided to change the classification of an item, you would need to alter the addition formula to include or exclude the item. Using the flags and the conditional sum allows for flexibility in the handling of these items, so that changing the classification for an item requires inserting or deleting a Yes in the flag cells, with the conditional sum formula unchanged. In this arrangement it is more clear which items are included as Other operating income and which are not. In a similar fashion, Other operating charges are usually broken down in a Note in the Annual Report, and these are entered on the Supplemental sheet. Again, a flag is used to indicate if an item is ongoing and relates to core operations, and a conditional sum is used to obtain a total of Other operating charges (note that in fact only one item, Sundry operating expenses, is considered to come into this classification). The difference between Other operating income and Other operating charges is calculated and shown as Other operating income (net). On the Reorganized sheet there is a link back to this item. [Other non-operating income (net) is also calculated.] Scheduled amortisation is entered in the Supplemental page. This amount then links to the Reorganized sheet where it is used in the calculation of Operating profit. Review Questions Please check that you understand the information on the Supplemental sheet. Amortisation is added in row 14 of the Reorganized sheet. Why is that? As noted above, in the Consolidated statement of income, depreciation and amortisation are not explicitly broken out as discrete line items; they are included in Cost of sales. To obtain EBITA, amortisation should be added back. 8 University of London

28 Unit 1 Developing and Using a Spreadsheet Valuation Model Taxes In Unit 3 you will study taxes in more detail, including in particular how to estimate taxes attributable to operations by removing items related to nonoperating and financing items. For the moment you should note on the Reorganized sheet that there are two tax items. One is the marginal tax rate applied to EBITA (row 24). There is also an amount labelled Other operating taxes (row 25). The marginal tax rate and Other operating taxes are calculated on the sheet Taxes. For Year 10 onwards, the marginal tax rate is assumed to stay at the Year 9 rate. In addition, the Other operating taxes in Year 9 are converted into a percentage rate (of operating profit) on the Forecasts sheet (H25), and this rate is then applied from Year 10 onwards. Review Question What is the value for After-tax operating profits (NOPLAT) in Year 9? Explain the difference between this value and the value for Net Income on the Consolidated income statement. On the Reorganized sheet in cell G18, After-tax operating profit is 1000 (million euros). You have already checked that Income prior to minority interest is 628 ( Financials, cell G22). The Reorganized sheet shows the reconciliation of After-tax operating profit (1000) with this value for Net Income (628) in rows 31 to 39. The difference is explained by Nonoperating taxes, and after-tax values of Restructuring charges, Other nonoperating income, Investment result, Interest (expense) income, and Amortization. Recall that NOPLAT (Net operating profits less adjusted taxes) is an estimate of profits from ongoing, core operations. And that NOPLAT starts with earnings before interest, taxes and amortization of acquired intangibles (EBITA). Invested capital Invested capital is calculated on the Reorganized sheet, rows The relevant items are linked directly back to the values on the Financials sheet. The exception is Working cash (which for Year 9 is cell G47). Working cash is obtained as a proportion, 0.02 or 2%, of net revenues. Invested capital is then obtained as the difference between operating current assets and operating current liabilities (which equals working capital), plus property plant and equipment and other noncurrent assets, less noncurrent liabilities, to give Invested Capital without goodwill in row 64. Invested Capital with goodwill is also calculated in row 67. ROIC without goodwill provides a measure of the competitiveness of the business. ROIC with goodwill provides a measure of a company s ability to create value after paying acquisition premiums. If you jump to the Valuation sheet, cell G9, you will see that ROIC is calculated as NOPLAT divided by ROIC without goodwill. To understand the reconciliation between Invested capital (which represents the capital necessary to operate a company s core business) and total funds invested (shown in rows on the Reorganized sheet), recall that Centre for Financial and Management Studies 9