CHAPTER 19 Valuation and Financial Modeling: A Case Study Chapter Synopsis 19.1 Valuation Using Comparables A valuation using comparable publicly traded firm valuation multiples may be used as a preliminary way to estimate the value of a firm. However, this technique generally ignores important differences between firms, such as levels of operating efficiency and growth prospects. 19.2 The Business Plan While comparable firm valuation multiples provide a useful starting point, the value of a firm or project depends on its future performance. Thus, it is necessary to study the firm or project s operations, investments, and capital structure, and to assess its potential for improvements and future growth. 19.3 Building the Financial Model A financial model may be used to project the future cash flows from an investment. A pro forma income statement projects the firm s future income statements based on a set of assumptions. The financial model should also consider future working capital needs and capital expenditures. Based on these estimates, future free cash flows as well as pro forma balance sheets and statements of cash flows can be forecast.
224 Berk/DeMarzo Corporate Finance, Second Edition 19.4 Estimating the Cost of Capital To value an investment, the investment s risk needs to be assessed and an estimate of the appropriate cost of capital must be determined. One method for estimating the equity cost of capital is to use the CAPM. The unlevered beta can be used in the CAPM to estimate the unlevered cost of capital to use in the APV method. The firm or comparison firm s beta can be unlevered using: β = [ E /( E+ D)] β + [ D /( E+ D)] β [ E /( E+ D)] β. U E D E For the WACC and FTE methods, the unlevered beta can be relevered to reflect the firm s capital structure as: β = β + [ D / E]( β β ) β [1 + ( D / E)]. E U U D U The levered beta can be used in the CAPM to determine the industry equity cost of capital, and then the firm s WACC can be determined. 19.5 Valuing the Investment For a firm or project with an infinite life, free cash flows are generally forecast for several years until a constant rate of growth is expected to begin in year T. These FCFs are then discounted back to time zero individually as lump sums. Next, the firm s continuation, or terminal, value at the end of the forecast horizon must be estimated. One common method of estimating the terminal value is to assume a constant expected growth rate, g, and a constant debt-equity ratio, to calculate the discounted cash flow value of the cash flows from time T+1 to infinity, valued at time T: FCFT Enterprise Value in Year T = V = L + 1 T rwacc Another method of determining the terminal value is to use a valuation multiple based on comparable firms. It is informative to use both the discounted cash flow approach and the multiples approach when estimating a realistic terminal value estimate. While the NPV method is the most reliable approach for evaluating an investment, practitioners often use cash multiples as an alternative valuation method. The cash multiple for an investment is the ratio of the total cash received to the total cash invested: Total Cash Received Cash Multiple = Total Cash Invested The obvious weakness of the cash multiple approach is that it does not depend on the amount of time it takes to receive the cash, nor does it account for the risk of the investment. It is therefore useful only for comparing deals with similar time horizons and risk. 19.6 Sensitivity Analysis Sensitivity analysis is useful for evaluating the uncertainty of estimates used in a valuation. By computing the value based on different variable estimates, the impact of this uncertainty on the value of the firm or project can be estimated. g
Berk/DeMarzo Corporate Finance, Second Edition 225 Appendix: Compensating Management Firms may use a management incentive plan to reward management for good performance. This may be in the form of an equity stake that would be vested over a period of years. Because the payment to the managers is an equity claim, to compute its present value we must use an equity cost of capital. To compute the equity cost of capital re, we use Eq. 18.20, which applies when the debt levels of the firm follow a known schedule: s D T re = ru + ( ru rd). E We then compute the cost of management s equity share by discounting at this rate: Cost of Management's Sharet 1 Cost of Management's Sharet =. 1 + re ( t) Once we have determined the cost of management s equity share, it can be deducted from the total value of the equity. Selected Concepts and Key Terms Pro Forma Forecasts Projections of future income statements, balance sheets, or statements of cash flows for a firm or project based on a set of assumptions. Cash Multiple, Multiple of Money, Absolute Return The ratio of the total cash received to the total cash invested. Unlevered P/E Ratio A P/E ratio that is calculated by dividing continuing enterprise value by unlevered net income. Concept Check Questions and Answers 19.1.1. What is the purpose of the valuation using comparables? The purpose of the valuation using comparables is to estimate the value of a firm by comparing it to firms in a similar line of business. 19.1.2. If the valuation using comparables indicates the acquisition price is reasonable compared to other firms in the industry, does it establish that the acquisition is a good investment opportunity? No, the valuation using comparables ignores important differences among firms such as operating efficiency and growth prospects. The valuation using comparables should be used as a preliminary way to estimate the value of a firm. 19.2.1. What are the different operational improvements KKP plans to make? KKP plans to cut administrative costs immediately and redirect resources to new product development, sales, and marketing.
226 Berk/DeMarzo Corporate Finance, Second Edition 19.2.2. Why is it necessary to consider these improvements to assess whether the acquisition is attractive? Whether the acquisition is attractive and is a successful investment for KKP depends on Ideko s post-acquisition performance. Thus, it is necessary to look in detail at Ideko s operation, investments, and capital structure, and to assess its potential for improvements and future growth. 19.3.1. What is a pro forma income statement? A pro forma income statement is an income statement that is not based on actual data but, instead, depicts the firm s financials under a given set of hypothetical assumptions. 19.3.2. How do we calculate the firm s free cash flow, and the free cash flow to equity? To compute free cash flow, we first adjust net income by adding back the after-tax interest payments associated with the net debt in its capital structure, adding back depreciation, and then deducting increases in net working capital and capital expenditures. To calculate the free cash flow to equity, we add net borrowing (increases to net debt) to the free cash flow of firm, and then deduct the after-tax interest expense. 19.4.1. What is a standard approach to estimate an equity beta? The standard approach to estimating an equity beta is to determine the historical sensitivity of the stock s return to the market s returns by using linear regression to estimate the slope coefficient of the straight line. 19.4.2. How do we estimate a firm s unlevered cost of capital using data from comparable publicly traded firms? To estimate a firm s unlevered cost of capital using data from comparable publicly traded firms, we first estimate the equity cost of capital for the comparable firms, and then estimate the unlevered cost of capital for each firm based on its capital structure. The unlevered costs of capital of the comparable firms are next used to estimate the unlevered cost of capital for the target firm. 19.5.1. What are the main methods of estimating the continuation value of the firm at the end of the forecast horizon? The main methods of estimating the continuation value of the firm at the end of the forecast horizon are the multiples approach and the discounted cash flow valuation approach using the WACC method. 19.5.2. What are the potential pitfalls of analyzing a transaction like this one based on its IRR or cash multiple? There are potential pitfalls with the IRR and cash multiple methods. First, there is no single cost of capital to compare to the IRR because the firm s leverage ratio changes over time, which will also change the risk of its equity. Besides, the cash multiple does not depend on the amount of time it takes to receive the cash, nor does it account for the risk of the investment. It is therefore useful only for comparing deals with similar time horizons and risks. 19.6.1. What is the purpose of the sensitivity analysis? The purpose of using sensitivity analysis is to evaluate the uncertainty of estimates used for valuation, and the impact of this uncertainty on the value of the deal.
Berk/DeMarzo Corporate Finance, Second Edition 227 19.6.2. Table 19.20 shows the sensitivity analysis for KKP s investment in Ideko. Given this information, do you recommend the acquisition of Ideko? Yes, we recommend the acquisition of Ideko. With an assumption of an exit EBITDA multiple of 9.1, KKP will have a good profit on its $53 million investment in Ideko, and the IRR of 33.3% is very high. Even with a very low exit multiple of 6.0, KKP will approximately break even on its investment in Ideko. Examples with Step-by-Step Solutions Solving Problems All of the problems in this chapter relate to the Ideko case study discussed in the chapter, and generally involve applications that require the use of the Ideko spreadsheet. Most problems involve varying the assumptions used in a discounted cash flow valuation using the APV and FTE methods, with five years of forecasted data and a growing perpetuity or EBITDA multiple terminal value. The problems generally require manipulating the original spreadsheet used in the chapter s case study by changing one or more of the variables to achieve some specific result. Problem 1 below provides an example of what this process is like. Problems may also involve using comparable valuation multiples to value a project or firm. Problem 2 below provides an example of calculating and using valuation multiples. Examples 1. In the valuation of Ideko, direct labor is estimated as $18 per unit in the base year and growing at 4% in 2006-2010. New information suggests that labor costs should be $22 per unit and grow at 5%. How does this affect the valuation using the WACC method? Step 1. Determine what needs to be changed. The assumption affects the forecasted income statements, which affect the unlevered free cash flow calculations. Once these are updated with the new assumptions, the valuation can be revised. Step 2. Revise the pro forma income statements for 2006 2010. Changing the labor cost, changes the income statements as follows: 2005 2006 2007 2008 2009 2010 INCOME STATEMENT ($000s) 1 Sales 75,000 88,358 103,234 119,777 138,149 158,526 2 Cost of Goods Sold 3 Raw Materials (16,000) (18,665) (21,593) (24,808) (28,333) (32,193) 4 Direct Labor Costs (22,000) (26,681) (32,089) (38,327) (45,506) (53,754) 5 Gross Profit 37,000 43,012 49,551 56,642 64,310 72,579 6 Sales & Marketing (11,250) (14,579) (18,582) (23,356) (27,630) (31,705) 7 Administration (13,500) (13,254) (15,485) (16,769) (17,959) (20,608) 8 EBITDA 12,250 15,180 15,484 16,517 18,721 20,266 9 Depreciation (5,500) (5,450) (5,405) (6,865) (7,678) (7,710) 10 EBIT 6,750 9,730 10,079 9,652 11,043 12,555 11 Interest Expense (net) (75) (6,800) (6,800) (6,800) (7,820) (8,160) 12 Pretax Income 6,675 2,930 3,279 2,852 3,223 4,395 13 Income Tax (2,336) (1,025) (1,148) (998) (1,128) (1,538) 14 Net Income 4,339 1,904 2,131 1,854 2,095 2,857
228 Berk/DeMarzo Corporate Finance, Second Edition Step 3. Revise the forecasted free cash flow forecasts for 2006 2010. Free cash flows are now: A B C D E F G H I 151 2005 2006 2007 2008 2009 2010 152 Free Cash Flow ($000s) 153 1 Net Income 1,904 2,131 1,854 2,095 2,857 154 2 Plus: After-Tax Interest Expense 4,420 4,420 4,420 5,083 5,304 155 3 Unlevered Net Income 6,324 6,551 6,274 7,178 8,161 156 4 Plus: Depreciation 5,450 5,405 6,865 7,678 7,710 157 5 Less: Increases in NWC 3,325 (3,768) (4,215) (4,834) (5,408) 158 6 Less: Capital Expenditures (5,000) (5,000) (20,000) (15,000) (8,000) 159 7 Free Cash Flow of Firm 10,099 3,188 (11,076) (4,978) 2,463 Step 4. Recalculate the terminal value in 2010. Using a 9.1 EBITDA multiple, as was done in the base case in the text, results with: A B C D E F G 184 Continuation Value: Multiples Approach ($000s) 185 1 EBITDA in 2010 20,266 186 2 EBITDA multiple 9.1x 187 3 Terminal Enterprise Value 184,416 188 4 Debt (120,000) 189 5 Terminal Equity Value 64,416 Step 5. Recalculate the enterprise value and equity value. Discounting the free cash flows using the APV method results in: 215 216 217 218 219 220 221 222 223 A B C D E F G H I 2005 2006 2007 2008 2009 2010 APV Method ($ millions) 1 Free Cash Flow 10,099 3,188 (11,076) (4,978) 2,463 2 Unlevered Value V u 116,131 117,645 126,222 149,920 169,890 184,416 3 Interest Tax Shield 2,380 2,380 2,380 2,737 2,856 4 Tax Shield Value T s 10,428 8,757 6,972 5,067 2,674-5 APV: V L = V u + T s 126,559 126,402 133,194 154,987 172,564 184,416 6 Debt (100,000) (100,000) (100,000) (115,000) (120,000) (120,000) 7 Equity Value 26,559 26,402 33,194 39,987 52,564 64,416 Step 6. Summarize the result. The change in labor cost has a large impact. The 2005 equity value falls from $113 million to $27 million. Now, given the $53 million cost to acquire Ideko s equity, the deal no longer looks attractive.
Berk/DeMarzo Corporate Finance, Second Edition 229 2. Given the new forecasts in problem 1, recalculate the 2005 valuation multiples in order to determine the firm s value relative to the comparison firms. Step 1. Recalculate the 2005 valuation multiples. Variable 2005 Value in Million Sales $75 EBITDA $12.3 Net Income $4.3 Enterprise Value $126.6 Value of Equity $26.6 Multiple Variables 2005 Value P/E Value of Equity/Net Income 6.2 EV/Sales Enterprise Value/Sales 1.7 EV/EBITDA Enterprise Value/EBITDA 10.3 Step 2. Compare the multiples to the comparable firms. Ideko Luxottica Sporting Goods Ratio (Proposed) Oakley, Inc. Group Nike, Inc. Industry P/E 6.2 24.83 28.03 18.23 20.33 EV/Sales 1.7 2.03 2.73 1.53 1.43 EV/EBITDA 10.3 11.63 14.43 9.33 11.43 Step 3. Make conclusions. Now, Ideko s P/E ratio is much lower than the industry. The revised labor estimate drops the P/E down from 21.6 in the original valuation and makes Ideko s equity appear to be relatively undervalued. The EV/Sales multiple falls from 2.0 to 1.7 and is now closer to Nike and the industry. The EV/EBITDA multiple rises from 9.1 to 10.3. This is due to the fact that the level of profitability falls at a greater rate than enterprise value. The firm now has a lower relative valuation than the comparable firms, other than Nike and the industry at large.