Mand a toolkit building a valuation model

M&A TOOLKIT

Valuation:

Building a Valuation Model

© 2007-2013 IESIES Development Ltd. All Ltd. Reserved
© 2007-2013 Development Rights All Rights Reserved

FROM
FCF FORECAST
TO
“AS IS”
DCF VALUATION

© 2007-2013 IES Development Ltd. All Rights Reserved

The FCF forecast is the hard work; the valuation model is the
payoff

8 STEPS TO TURN A FCF FORECAST INTO A DCF VALUATION MODEL

1) Start with an Operating FCF1 projection
2) Calculate a WACC2
3) Calculate an NPV3 for the forecast period
4) Calculate a Terminal Value4
5) Add to get an Enterprise Value5
6) Deduct non-operating assets and
liabilities to get an Equity Value6
7) Divide by shares outstanding to get a 1
2
FCF: Free Cash Flow
WACC: Weighted Average Cost of Capital
share price; compare to actual 3 NPV: Net Present Value
4 Terminal Value: Business Valuation at the
8) Run Sensitivities end of the explicit forecast period
5 Enterprise Value: Valuation of the

business before financing
6 Equity Value: Value of the equity of the

business

A DCF Valuation starts from an Operating Free Cash Flow
projection
FREE CASH FLOW PROJECTION
RMBm 669
485
300

106

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-64
-184 -213 -174
-233
-284
-393

-587

Source: China Paradise Valuation Model

The FCF forecast is the hard work; the valuation model is the
payoff

8 STEPS TO TURN A FCF FORECAST INTO A DCF VALUATION MODEL

1) Start with an Operating FCF projection
2) Calculate a WACC
3) Calculate an NPV for the forecast period
4) Calculate a Terminal Value
5) Add to get an Enterprise Value
6) Deduct non-operating assets and
liabilities to get an Equity Value
7) Divide by shares outstanding to get a
share price; compare to actual
8) Run Sensitivities


Use the formula to calculate Weighted Average Cost of Capital

WACC = kd (1-Tc) (D/EV) + ke (E/EV)

ke = Cost of equity1
kd = Pretax cost of long term debt
Tc = Marginal Tax rate
D = Market value of debt
E = Market value of equity
EV = D+E

1Per CAPM:
ke = rf + (MRP) (β)
For “As Is” Valuation, use the TARGET’s Beta and rf = Risk free rate
gearing ratio; if there are financial engineering MRP = Market Risk Premium
opportunities, include them in synergies
β = Beta

In practice, low WACCs are regarded with suspicion
EXAMPLE WACC CALCULATION

• Inflation is 3%
• Long dated government bonds yield 5%
• The companies debt is trading at a yield to maturity 50 basis points above this
• The Market Risk Premium is estimated at 6%
• Beta for this company is 1.2
• Marginal tax rate is 30%
• The market value of the companies debt is $100m
• The market capitalisation of its equity is $400m
• There are no preference shares

• What is the Real WACC for this company?

A: 7.5%
In practice, only Investment Bankers
and fresh MBAs debate WACC – for
corporates it is usually set by CFO

Free Cash Flow is discounted by the WACC to get Present Value

Free
RMBm 669 Cash
Flow
485

300 Present
258
206 Value
106 140
54

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-36
-64
-168 -176 -131
-184 -213 -174 -194
-144
-233
-284
-393

-587

Source: China Paradise Valuation Model

The Terminal Value is the value of the business at the end of
your explicit forecast period
RMBm

669
What about
485 2017, 2018, 20
106
300

140
206
258
19, 2020, 2030
2005 2006 2007 2008 2009 2010 2011 2012
54

2013 2014 2015 2016
, 2050 etc?
-36
-64
-168 -176 -131
-184 -213 -174 -194
-144
-233
-284
-393

-587


One way to calculate Terminal Valuer is to project out the
cashflow for a long time
PRESENT VALUES OF FREE CASH FLOWS
$m
$327m

$192m $90m $42m $20m $9m $4m $2m $1m $0m

2009 2014 2019 2024 2029 2034 2039 2044 2049 2054 2059 2064 2069 2074 2079 2084 2089 2094 2099 2104

With Excel copy and paste functionality, this is easy

The most common way to calculate Terminal Value is to use the
Perpetuity Formula

Perpetuity formula: Value = K
(WACC-g) Alternatives:
•Multiple-based
Terminal ValueT = FCFT+1 ending valuation
(WACC-g) •Ending book value

EXAMPLE
• WACC is 10% A: Terminal Value in Year 10
• Perpetuity growth is 2% = $75m x 1/(10%-2%)
• FCF in year 11 is $75m = $937.5m
• What is the Terminal Value PV of Terminal Value
(in present value)? = $937.5m/(1+10%)10
= $361m

Use the Perpetuity Formula with care

PITFALLS IN USING THE TERMINAL VALUE FORMULA
• FCF must be steady
Terminal ValueT = FCFT+1 state, consistent with the
(WACC-g) growth rate forecast (Check
capex and working capital
ratios for your projected
growth rate)
g is the expected growth rate of free cash flow in perpetuity • If steady state has not been
reached, extend the explicit
g is a measure of the expected competitive advantage of the forecast period
company at the end of the forecast period • FCFT+1 is the year AFTER your
MAX: Companies with a rock solid competitive advantage, the last forecast period
economy sustainable long term growth rate (e.g. Coca Cola g=5%
at 2% inflation and 3% real GDP growth)
TYPICAL: Inflation rate for normal business
LOW: 0% for businesses with weak competitive advantages or for
cost synergies that are likely to be competed away
NEGATIVE: For disappearing businesses (music, newspapers)

TIP: Check implied ending multiples to sense check

You can pick any inflation assumption you want as long as you
are consistent
INFLATION ASSUMPTION

Inflation assumption Real Nominal Typical Perpetuity
(applied to ALL FCF items WACC WACC g% P/FCF
including revenues, costs Multiple
and investment)
Modeling US market in 7% 9% 2% 1/(9%-2%) =
US$: 2% 14.3

Modeling Chinese market 7% 13% 6% 1/(13%-6%)
in RMB:6% = 14.3

If modeling in multiple currencies with different
inflation assumptions, flex exchange rate over
time to maintain purchasing power

Add Present Value of the Terminal Value to the NPV of the
forecast period to get the Enterprise Value – the value of the
business
RMBm

$689m

72 75
68
Terminal
60 Value Sense check
55 361
ratio:
46 47 48
42
45 44 Terminal
39 Value is 52%
34 32 of Enterprise
30 30 31 31 31 29 FCF
14-18 153 Value

FCF
174
09-13

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Enterprise
Value

Calculate the Equity Value by subtracting the non-operating liabilities
and adding the non-operating assets to the Enterprise Value
CALCULATING EQUITY VALUE
5
10
e.g. Surplus e.g. Minority
30
cash or interests,
110 marketable pension deficit
securities

85

Enterprise Value Non-operating Non-operating Debt Value Equity Value
assets liabilities

Calculate the Equity Value by subtracting the non-operating liabilities
and adding the non-operating assets to the Enterprise Value
CALCULATING COMMON SHARE VALUE
10
5
85
$70m
Divided
by 3.5m
70 shares
issued =
$20/share

Equity Value Preference shares Outstanding options Ordinary shares

Valued at market Valued as if all Divide by number
price converted to of shares issued to
common stock get equivalent
share price


If you are valuing a multi-business company, build a DCF for each
business unit then add them up
MULTI-BUSINESS VALUATION 10 20
15
110 30
20

35 80

50

BU 1 BU 2 BU 3 BU 4 Cash Corporate Enterprise Debt Equity
Overheads Value Value

You run sensitivities to test your model and your financial
intuition
RUNNING SENSITIVITIES AND SCENARIOS
SENSITIVITIES
Purpose:
1) Record and save your base case
2) Select 5-8 assumptions, mixing different types
• Growth
• Margins
Understand how
• Valuation
sensitive the
3) Change each assumption one-by-one and note the %
valuation is to
change to Equity Value
different
• Select the % to change each assumption based on
assumptions
reasonable range
• Select the % to make all value changes positive
(for ease of comparison)
• Remember to return to the base case each time!
4) Sense check results
5) Create a chart to display model sensitivities
SCENARIOS
1) Identify different business scenarios
Create a realistic
2) Translate these scenarios into different financial
range for the
assumptions
valuation
3) Change all these assumptions at once
4) Note the new Equity Value under this scenario

The valuation of China Paradise is very sensitive to future gross
margin % and store costs
CHINA PARADISE SENSITIVITY ANALYSIS
% Change in value
–1% g 10%
–1% WACC 18%
–1% cash tax 2%
–10% on capex/new store? 5%
–10% inventory 8%
+10% supplier credit 18%
–10% Overheads 12%
–10% store costs 51%
+1% Gross Margin 49%
+1% LFL growth 8%

0% 10% 20% 30% 40% 50% 60%
© 2007-2013 IES Development Ltd. All Rights Reserved 24

Discounted cashflow valuation is a bankable career skill

• Discounted cashflow is the only professional valuation method;
but watch for GIGO - it is only as good as its assumptions

• Discounted cashflow valuation is a tool for understanding the
economics, key assumptions and sensitivities of a business, not
coming up with a “magic number”

• 80/20 – spend the time on the assumptions that matter; don’t
sweat the small details

• Keep the valuation model clear and flexible – you will have
many changes during the deal

Mand a toolkit building a valuation model

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