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Advanced Corporate Finance & Strategy1
, Advanced Corporate Finance & Strategy Summary
Week 1 slides
• Three types of company valuation in this course
o Discounted Cash Flow – DCF
o Real Option Valuation
o Game Theory and Option Games
• The company valuation is applied to
o Venture Capital
o Leveraged Buyouts
o Investment Banking
• Static valuation methods need to be extended
o When intertemporal synergies are important
▪ A first investment leads to new opportunities
o To determine the price in bidding situations
▪ Price is what you pay, value is what you get
• Buy-and-Build Strategies
o A long-term sequential strategy in which resources and of a platform are leveraged onto
Valuable New Field follow-on acquisitions
1 7
3
over a wider geographic,
Caseproduct or customer base
Applications 1 7
3
Why is this important? When do we need to go beyond DCF valuation?
Call for new insights in research!
Type of Valuation Example Real Options and
Games
Staged financing and
1. When valuing platform PE funds, Glencore,
growth options
Valuing acquisitions investments Vodafone
(intertem poral synergies)
VC funds and Staged financing and
2. Venture capital and (high-
(traded) growth growth options
tech) start-ups
firm s (intertem poral synergies)
Static perspective Dynamic perspective Value of a
Stand-alone basis Long-term Strategy
3. The restucturing of Portfolio of abandonm ent
restructuring
companies options
strategy
Mining, Options to stage or
Real option approach Game theory
4. Operational flexibility m anufacturing change the pace of
- Intertem poral synergies - Bidding com petition
operations production
5 Many other examples…
22
2
, Video 1 week 2
• The DCF and real options & games valuation techniques are not competing methods, not mutually
exclusive, both techniques have their merits side by side
DCF Real Options & Games
Different purpose Valuation of businesses with assets in Quantification of the firm’s strategy
place
e.g. existing businesses, factory, or e.g. toehold acquisitions
product line
Focus on different components of value Source: value of assets Source: Growth option value
Useful for: Projection of future cashflows Useful when: No historical cashflows, or
negative cash flows
e.g. for mature businesses e.g. for start-up ventures, R&D, and
exploration projects
• Real options & games allow for quantification of firm flexibility and long-term strategy, long-term
strategic choices
• DCF
o The best practice for valuing operating assets, existing businesses, factory or a product line
o You can use the DCF when the cashflows can be projected with reasonable certainty
• Real Options
o Essential to complement the management team to operationalize and quantify the firm’s
strategic choices
• Difference between DCF and Real options
o When a company solely relies on DCF analysis for their long-term strategy, they inevitability
fall into the trap of either not investing enough in uncertain but highly promising
opportunities, or not correctly staging an investment under high uncertainty
o Traditional DCF analysis considers an acquisition as a now or never deal
▪ Real options recognise the benefits of having a toehold first, by investing in a
minority stake, waiting until uncertainty unravels, before making the full acquisition
o The methods focus on different components of value
▪ DCF is for start-ups almost impossible, no historic p&l
▪ Real options also take into account negative cashflows because of strategic reasons
due to R&D and exploration projects
o DCF works well for assets in place
Under a no growth policy
• The two techniques are also used in combination
o Equity value = Net value of assets in place (excl. net debt) + growth option value
• DCF calculation schematic overview
o For a DCF calculation, identify the various operating value drivers
▪ Often estimated on the historical analysis
▪ These drivers affect the firm’s operating profitability and the asset utilization
• Jointly, they determine the firm’s free cashflows after the firm invested in
its business
▪ As the future cashflows are quite uncertain, we need to discount them
• Depending on the risk and capital structure of the firm
• Company valuation is relevant when
o For companies seeking capital
o When advising in an IPO, qualifying a loan application, and advising in corporate acquisitions
o Seeking for lucrative investment opportunities
3
,Video 2
• Free cash flow
o The cash a company generates after having made all the required expenditures, to operate,
maintain or expand its assets base, and is able to
distribute
o The value available to all the investors or grow the
business
o Depending on the operational profitability → EBIT
▪ EBIT is adjusted for corporate tax
▪ The earnings are increased for costs that are not
expenses, such as depreciation and
amortization (intangible assets)
▪ To arrive at the operational free cash flow →
EBITDA
▪ EBITDA is adjusted for changes in Working Capital
• Which equals the short-term assets minus the short-term liabilities
o This is often connected to the revenue growth, because the
growth of a company may require more working capital
▪ Capital expenditures also affect the free cashflow, how much is the company
investing in the business?
o To create the free cashflows
▪ Forecast the P&L and the balance sheet
• Trends in key drivers are used to forecast the cashflows
o A historical analysis assesses which company fundamentals influence the drivers of free
cashflow and make forward projections based on that information
o
o Steps:
▪ Evaluate company revenue
• Is there a constant growth, recurring or one-off? Volume vs price
• Differentiate between organic growth and growth via acquisitions
o Typical ratios: CAGR, YoY-growth in price and volume
▪ Evaluate COGS
• All the costs related to the firm’s production
o Typical ratios: Gross margin in % of revenue, or gross margin / unit
of volume
▪ Evaluate other operating costs
4
, • Personnel costs, marketing costs, distribution, housing, sales, and IT costs
• These costs are usually predicted as a % of revenue or per unit of volume
• Typical ratios: as % of revenues, YoY-growth or per unit of volume
▪ Next
• The revenue analysis, COGS analysis, and Other Operating Costs analysis
leads to a profitability analysis → EBITDA/ Revenue or Net profit / Revenue
▪ Next
• Tax analysis
o A key influence on cashflows are taxes
▪ In what countries are profits reported?
▪ Does the company have tax deductible items
▪ Does it has tax deferred tax assets
▪ Or liabilities
▪ Working Capital analysis
• Differentiate between operating and non-operating working capital
(debt/cash items)
• Trade working capital: accounts payable, accounts receivable and inventory
o Operating efficiency
• Working capital drivers: inventory days, trade debtor days, trade creditor
days
o How many days it takes to turn working capital into revenue
• Assess trends in operating working capital as % of revenues
▪ Capex analysis
• Determine capex patterns (incremental vs lumpy capex (for a new factory))
o YoY changes in PPE and Intangible assets
• Breakdown capex into maintenance capex and capex for growth
• Analyse other movements such as disposables, acquisitions, and
revaluations
• Assess capex as a % of revenues and fixed asset turnover
o % of revenue, or a fixed assets turnover
▪ Net sales / PPE
▪ Other aspects
• Capital structure analysis
o Define gross debt and excess cash position and evaluate funding
structure
o Leverage: net total debt and net senior debt / EBITDA(R)
o Interest coverage: Net cash interest / EBITDA(R)
o Debt service capacity: Free operating cash flow / debt service
o Solvency: Book value equity / Total interest-bearing debt
o Borrowing base
• What is the firm’s ability to meet its long-term obligations?
▪ Make a distinction between operating cash, used for day to day business, and
excess cash
• Current and quick ratio
• Free Cash Flow formula
o EBIT after taxes, plus depreciation
and amortization, - change in net
working capital, - capital
expenditures
5
, • Video summary
o Steps to value a company using a DCF
▪ Forecast P&L and balance sheet
▪ Forecast FCF
▪ Company valuation
o Key drivers
▪ Revenue growth
▪ EBITDA margin
▪ Taxes
▪ Working capital
▪ Capital expenditures
Video 3 week 2
• WACC is the best known way for DCF approaches
o Discount cash flows of the firm with weighted average costs of capital
o Useful when the capital structure is expected to remain stable
o The WACC method involves first estimating the total value of the company known as the
enterprise value, by discounting the net free cash inflows by the WACC
▪ Then you subtract the market value of the firm’s debt to arrive at the value of the
firm’s equity
o WACC is the weighted average of the (after tax) returns required by capital providers
• Another approach is the Free Cash Flow to Equity (FCFE) method
o Discount cash flows to equity with the cost of equity (to be used when valuing listed
companies and financial institutions)
o Method
▪ Estimating equity value directly, by discounting both after tax cash flows to equity
and the terminal equity value at the cost of equity
• Adjusted Present Value (APV) method
o Discount cash flows of an all equity firm and add the value of the financing side effects
o This method splits the value of the company into a discounted value of a company as an all
equity entity, plus the discounted value of the interest tax-shield at the company’s debt
o This method is useful when the capital structure of a firm is not fixed and expected to change
over time
▪ For instance, in leveraged buy outs
• The DCF framework has two distinct periods
o The forecast period, discounted with WACC
o The Continuation period, discounted with WACC (terminal value)
• 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝐹𝐶𝐹 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
6
,• WACC Method
o 1: Calculate the discount factor, WACC
▪ Rd = Risk free rate + Credit spread
▪ Re = Risk free rate + beta * market risk premium + small firm premium
▪ EV = Equity / (equity + debt)
▪ WACC is rounded to the nearest whole percentage
▪ IMPORTANT
• From Unlevered to Levered beta
𝐷
• 𝛽𝐿 = 𝐵𝑈 ∗ (1 − (1 − 𝜏𝑐) ∗
𝐸
o 2: Calculation of FCF
▪ EBIT, is multiplied to (1-tax rate) to arrive at NOPAT
• Net Operating Profit After Tax
• Taxes are already accounted for in the WACC with the tax shield
▪ NOPAT
▪ Depreciation is added, use the values of the P&L
▪ Subtract changes in operating provisions, (CHANGES)
▪ Subtract changes in Net Working Capital (difference between two years)
▪ Subtract capital expenditures, use the changes in tangible fixed assets on BS
• ADD THE DEPRECIATION!!!
▪ Calculate the Free Cash Flow
• 𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑡𝑎𝑥𝑒𝑠 − ∆𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑡𝑖𝑎𝑙 + ∆𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑒𝑥𝑇𝐹𝐴
7
,Week 2 Video 3.2 Terminal value
• 1: Perpetuity method
o Cash flow based
▪ Links cashflows to growth rates, reinvestment rates, and return on capital base
• Key value driver method
• Convergence model
• Gordon growth model
o A thoughtful estimate of terminal value is essential to any valuation because terminal value
accounts for 50% to 125% of total value
• 2: Exit multiples
o Assume that a company will be
worth some multiple of future
earnings or book value in the
continuation period
▪ P/E
▪ EV/EBITDA
• The terminal value is measured at time T
(last year of explicit forecast period), and
thus will need to be discounted back T years
to compute its present value
• The NOPAT of the terminal value is the
NOPAT of the last year of the explicit
forecast period times 1 + long-term growth
rate
• ROCB
o Return On Capital Base
▪ Return on new invested
capital in the long run
• A related way to value the terminal value is
using multiples
o The terminal value in t = Multiple
* EBITDAt
o This EBITDA multiple can be used
for similar companies in the
industry regardless of how they
are financed because it ignores
capital structure
o With an Enterprise Value / EBITDA
multiple of 7, the terminal value of
ABCt6= 7 * 189 = 1,323 million
o EBIT is also used
• To make sure there is no case of
overvaluation, checks are used:
o Choice of the appropriate terminal value formula
o Growth rate estimation
o Perform consistency checks on the entry and exit multiple
▪ Relates the exit multiple of the DCF calculation to the terminal date, at which the
company can be sold → private equity
▪ Many financial parties consider multiple arbitrage
• When the entry multiple is smaller than the exit multiple
• Enterprise value = PV (forecast period) + PV (terminal value)
• How much is attributable to the shareholders, after fulfilment of debt holders?
o Calculate the equity value
▪ For that, you subtract the firm’s net debt (company debt – cash in the last year)
8
,• Video summary
o DCF calculation
▪ Calculate the WACC
▪ Calculate the present value of cash flows during the forecast period
▪ Calculate the present value of the terminal value
o The terminal value can make up a large part of the total estimate of the firm’s value, that’s
why it is important to perform various checks on the sensibility of the terminal value
estimate
o Enterprise value is the value that is available to debt and equity holders
o Check the answer of the calculation by using a multiple
9
, Week 2 video 4 Multiple valuation
• Multiple valuations are used as a check for the other valuation approaches
• With multiples valuation you are able to estimate the value of a privately owned company based on
the prices of comparable firms
o Multiple = Price of comparable firm / Key statistic
• How to establish a peer group
o Similar risk profile
o Similar leverage
o Similar growth expectations
o Similar size
• Two classes of multiples
o Trading multiples (based on the last twelve months)
▪ Based on current market
capitalization
o Transaction multiples
▪ Based on pricing in M&A
• Earning multiples
o Relate the value of a company to a measure
of its gross profitability
o Popular multiple since it is robust, and less
distorted by differences in accounting
conventions or leverage of the firm
• Sales multiples
o Used for companies with negative earnings
▪ Such as start-ups and new ventures
• Market to book multiples
o Market price to book value per share
o Disadvantage
▪ It doesn’t take into account the actual returns that are made on the equity or
assets, it can be distorted by accounting conventions
• Industry specific multiples
o Which relate value to some industry specific metric
▪ Social media companies, such as twitter, where value is driven by the number of
users
• Note
o Applying the average price/earnings multiples to the firm’s earnings results in an estimate of
the firm’s equity value, not the firm’s enterprise value, to arrive at enterprise value, you have
to add debt
o With the other multiples, the enterprise value is derived directly
• The main limitation of a multiples valuation
o The method gives a valuation based on prices, and so it estimates that value is equal to price
paid, and that markets are efficient
• The valuation of a firm should be based on a variety of multiples that result in a value range
• To make multiples valuations trustworthy, look at the fundamental that drive the multiples, to find
out why firms differ in the same industry and with the same size
• Differences in PE ratio can be explained by differences in
o Pay-out ratio
o Cost of equity
o Expected growth
• When using multiples, you have to correct for the differences in firms
o To make a good comparison between multiples of firms within the same industry one has to
normalize the multiples for differences in their fundamentals
▪ Growth expectations, risk profile, leverage and size
10
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