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Overview of Corporate Valuation

CHAPTER TWO What Is Corporate Valuation ?
Corporate Valuation In the field of finance, corporate valuation is the process of
determining the value of a business entity.
 Overview of Corporate Valuation It is an important aspect of corporate finance, used for a wide
 Methods to compute Enterprise Value(EV) variety of purposes.
 accounting approach to EV Valuation is essential for mergers and acquisitions, where a sound
 efficient markets approach to EV decision has to be made at what price to acquire a company.
 discounted cash flow (DCF) approach The value of a company could be different for sellers and buyers, so
 Free Cash Flows Based on Consolidated Statement of Cash Flows valuation is integral part of the negotiation process.
(CSCF) It is also crucial for the effective management of a company, for
 Free Cash Flows Based on Pro Forma Financial Statements identifying its value-generating units, and formulating strategies for
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CONT… Cont..
• Combining these two figures helps establish the company’s enterprise
• Initial public offerings, portfolio management, and tax assessment are value, indicating the neighborhood you need to be in to buy the
also areas that involve a lot of corporate valuation. company.
• There are different valuation methodologies, yielding different results • Enterprise Value = Market Cap + Debt – Cash
and used in different situations. • Enterprise value is a financing calculation the amount you would
need to pay to those who have a financial interest in the firm.
• An experienced financial analyst knows how to use these methods in • That means everyone who owns equity (shareholders) and everyone
combinations in order to reach conclusive valuations. who has loaned it money (lenders).
Methods to compute Enterprise Value(EV) • So if you’re buying the company, you have to pony up for the stock
and then pay off the debt, but you get the company’s cash reserves
What Is Enterprise Value (EV)? upon acquisition.
• As its name implies, enterprise value (EV) is the total value of a • Because you receive that cash, it means you paid that much less to
company, defined in terms of its financing. It includes both the buy the company.
current share price (market capitalization) and the cost to pay off debt • That’s why you add the debt but subtract the cash when you calculate
an acquisition target’s enterprise value.
(net debt, or debt minus cash). 3 4

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What are the Components of EV? • They are interest-bearing liabilities and comprised of short-term and
long-term debt.
• Equity Value:- Valuing the shares of a company, whether for the
purpose of buying or selling a single share or valuing all of the • The amount of debt gets adjusted by subtracting cash because, when
equity for purposes of a corporate acquisition. a company has been acquired, the acquirer can use the target
company’s cash to pay a portion of the assumed debt.
• If a company plans to acquire another company, it will need to pay
that company’s shareholders by paying at least the market • If the market value of debt is unknown, the book value of debt can be
capitalization value. This alone is not considered an accurate used instead.
measure of a company’s true value, and for that reason, other items Enterprise Value (EV) Calculations
are added to it as seen in the EV equation. • A company’s enterprise value is not reflected solely in its shareholder
• Total Debt:-Valuing the company’s debt. When debt is risky, its contribution, the amount of money contributed to a business by
value depends on the value of the company that has issued the debt. shareholders; it also takes into account company debt, both short-
and long-term, and cash reserves.
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Cont… Cont..
• The accounting approach to EV moves items on the balance sheet so
• As a simple example, Company A’s stock may trade at $100 per share that all operating items are on the left-hand side of the balance sheet
while Company B’s stock trades at $20. But if Co. A has 100 million and all financial items are on the right-hand side.
shares outstanding and Co. B has 500 million shares outstanding, • Although most academics sneer at this approach, it is often a useful
then their market caps are precisely the same: $10 billion. starting point for thinking about the enterprise value.
• The efficient markets approach to EV revalues to the extent possible
100 million shares x $100 = 500 million shares x $20 items on the accounting EV balance sheet at market values.
Methods to compute Enterprise Value(EV) • An obvious revaluation is to replace the firm’s book value of equity
• The key concept in corporate valuation is enterprise value . The with the market value of the equity.
enterprise value (EV) of the firm is the value of the firm’s core • To the extent that we know the market value of other firm liabilities
debt, pension obligations, etc.
business activities and forms the basis of most corporate valuation
• this market value will also replace the book values.
models.
• The discounted cash flow (DCF) approach values the EV as the
• We distinguish between three approaches to computing the enterprise present value of the firm’s future anticipated free cash flows (FCFs)
value: 7
discounted at the weighted average cost of capital (WACC). 8

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Accounting approach (book value)to EV Then, the book valuation of the company is $20 million. If the
• The book value means the value of a business according to its company sold its assets and paid its liabilities, the net worth of the
books or accounts, as reflected on its financial statements. business would be $20 million.
• Theoretically, it is what investors would get if they sold all the Total assets cover all types of financial assets, including cash, short-
company's assets and paid all its debts and obligations. term investments, and accounts receivable. Physical assets, such as
• Therefore, book value is roughly equal to the amount stockholders inventory, property, plant, and equipment, are also part of total assets.
would receive if they decided to liquidate the company. Intangible assets, including brand names and intellectual property, can
Book Value Formula be part of total assets if they appear on financial statements.
Total liabilities include items like debt obligations, accounts payable,
• Mathematically, book value is the difference between a company's
and deferred taxes.
total assets and total liabilities.
While we would rarely use accounting numbers to value a company,
• Book value of a company=Total assets−Total liabilities the balance sheet of a company is a useful starting framework for the
• Suppose that XYZ Company has total assets of $100 million and valuation process.
total liabilities of $80 million. 9 10

In this section we show how accounting statements can help us

define the concept of enterprise value (EV).
We rewrite this balance sheet:
To show the rewriting of the balance sheet in practice, here is
• First we separate the operational versus financial items in
the 31 December 2011 balance sheet for Caterpillar Corp.
short-term assets and short-term liabilities.
(CAT):
• We move the operational current assets to the left side of
the balance sheet.
• We move all the debt (short-term debt, current portion of
long-term debt, and long-term) into one debt item.

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• In the next step we subtract liquid assets (cash and marketable Cont…
• In the left side of balance sheet we calculate the net working capital
securities) from financial debts, to get the firm ’s net financial debt. net receivable …….1953300
When we finish this step, we have all of the firm’s productive assets + inventory………………14544000
+ other current asset……994000
on the left side of the balance sheet and all of its financing on the - Account payable………….16946000
right side. - Other current liability…….1967000
= net working capital……..16158000
• The left-hand side of the resulting balance sheet is the firm ’s • In the right side of the balance sheet we calculate the net financial debt
enterprise value , defined as the value of the firm’s operational Short term debt…….9648000
+long term debt……..24944000
assets: These are the assets that provide the cash flows for the firm
-cash and cash equivalent……3057000
’s actual business activities: 13 = net financial debt……………...31535000 14

Efficient Markets Approach to Corporate Valuation

• The market approach is a valuation method used to determine the
appraisal value of a business, intangible asset, business ownership
interest, or security by considering the market prices of comparable
assets or businesses that have been sold recently or that are still
available.
• The market approach is appealing allows for a comparison of similar
companies.
• If you want to sell your house, you will likely look to determine a
price for similar homes or homes in the same neighborhood which is
essentially what the market approach is for businesses.
• The market approaches rely on transaction multiples derived from the
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• The valuator takes the estimated market multiplies it by the

subject company’s earnings to arrive at the subject company’s
value.
• At the end of 2011 Caterpillar had 624.72 million shares
outstanding, and the market price per share was $90.60.
• This suggests that the Caterpillar’s enterprise value is
$102.720 billion a far cry from the book value of the enterprise
value of $59.476 billion.

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• The efficient markets approach to the valuation of Caterpillar’s equity Cont…

and financial liabilities assumes that the market value of a company’s • One approach to bringing this enterprise value
shares or debt is simply the market value at the time of valuation. balance sheet into balance is to assume that the net
• This approach is better than the accounting approach of the previous
section and much simpler than the DCF valuations.
working capital’s book value is a reasonable
• If markets work in the sense there are many participants trading the approximation to its market value.
corporate securities, that is a lot of information about the company in • We can then re compute the market value of the firm’s
question, and the valuator has no special information why not accept long-term assets to bring the balance sheet into
the market price as the true value of the company? balance.
• Applying the efficient markets approach to the Caterpillar Enterprise
Value Balance sheet gives 102,719,878 for the right-hand side of the
enterprise value balance sheet. This means, that we have to revalue
the left-hand side of the balance sheet. 19 20

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Cont…
• Note that we could also apply the market valuation
to other components of the right-hand side of the
balance sheet
• we could try to revalue the firms financial
obligations, its other liabilities, and minority
interest.
• This is usually not done, unless there is a
convincing case that the book values for these
liabilities differ materially from their market value.
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2.4. Enterprise Value (EV) DCF  In this section we concentrate on the left-hand side of the enterprise
value balance sheet.
• Discounted cash flow (DCF) is a valuation method used to estimate the
value of an investment based on its expected future cash flows.  The idea is to value a company by considering the present value of
the FCFs, where FCF is defined as the cash flow to the firm from its
• DCF analysis attempts to figure out the value of an investment today,
assets (the word assets is used broadly, and can be fixed assets,
based on projections of how much money it will generate in the future.
intellectual and trademark assets, and net working capital).
• This applies to the decisions of investors in companies or securities,
such as acquiring a company or buying a stock, and for business
owners and managers looking to make capital budgeting or operating
expenditures decisions.
• In the previous section we valued the EV by using the market value of
the right-hand side of the firm’s enterprise value balance sheet using
the market value of its equity and perhaps the market valuation of
other elements of the firms financing. 23 24

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Defining the Free Cash Flow (FCF)  Interest payments are excluded from the generally accepted
 Free cash flow (FCF) measures a company’s financial definition of free cash flow.
performance.  Investment bankers and analysts who need to evaluate a company’s
 It shows the cash that a company can produce after deducting the expected performance with different capital structures will use
purchase of assets such as property, equipment, and other major variations of free cash flow like free cash flow for the firm and free
investments from its operating cash flow. cash flow to equity, which are adjusted for interest payments and
 Free cash flow (FCF) represents the cash a company generates borrowings.
after accounting for cash outflows to support operations and
 The free cash flow (FCF) is a measure of how much cash is produced
maintain its capital assets.
 Unlike earnings or net income, free cash flow is a measure of by the firm’s operations.
profitability that excludes the non-cash expenses of the income
statement and includes spending on equipment and assets as well
as changes in working capital from the balance sheet. 25 26

 The easiest way to define the free cash flow is as follows: What is FCFF (Free Cash Flow to Firm)?
 Free Cash Flow to Firm, is the cash flow available to all funding
Free Cash Flow=
providers (debt holders, preferred stockholders, common
Profit after taxes
stockholders, convertible bond investors, etc.). This can also be
+Depreciation
referred to as unlevered free cash flow, and it represents the surplus
+After-tax interest payments
cash flow available to a business if it was debt-free.
−Increase incurrent assets
What Is Free Cash Flow to Equity (FCFE)?
+Increase in current liabilities
 Free cash flow to equity is a measure of how much cash is available
−Increase in fixed assets at cost to the equity shareholders of a company after all expenses,
Types of free cash flow
reinvestment, and debt are paid. FCFE is a measure of equity capital
1. Free Cash Flow to the Firm (FCFF), also referred to as “unlevered”
usage.
2. Free Cash Flow to Equity, also knows as “levered”
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How Can We Predict Future FCFs? FCF Based on Consolidated Statement of Cash Flow
 The most critical aspect in valuing a company is to project its
anticipated future free cash flows. What is consolidate Financial statement
• In this case we explore two ways of deriving these cash flows. • Consolidated financial statements are financial statements of an entity
• Both methods are primarily based on accounting data. Since with multiple divisions or subsidiaries.
accounting data is historical data, we need to add some judgment • Companies can often use the word consolidated loosely in financial
about how this data will develop in the future. statement reporting to refer the aggregated reporting of their entire
• One method is to base our estimates of future free cash flows on the business collectively.
consolidated statement of cash flows (CSCF) of the firm. • However, the FASB defines consolidated financial statement reporting
• The second method is to estimate a set of pro forma financial as reporting of an entity structured with a parent company and
statements for the firm and to derive the free cash flows from these subsidiaries.
statements. • Financial statements present businesses with a broad view of their
operational and financial health.
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• Consolidated financial statements provide the same for combined What is consolidated statement of cash flows
companies though all as one business. • The consolidated statement of cash flows is part of every financial
• Consolidated financial statements combine the parent company's statement. It is the accountant’s explanation of how much cash was
financials with the financials of all its holdings in one package of generated by the business, and how this cash was generated.
financial statements. • When we use the CSCF to determine FCFs, we use the following
• The parent company, referred to in accounting as the "controlling general procedure.
entity," is the company that has majority ownership. • We accept the operating cash flows as reported by the firm.
• The subsidiary or division is referred to as the "controlled entity." • We carefully examine the investment cash flows, leaving for the
Combining the parent financials with those of any other businesses it FCF the investment cash flows related to productive activities and
owns presents a more accurate view of overall performance. eliminating those investment cash flows relating to investment by
the firm in financial assets.
• We do not count toward the FCF any of the financial cash flows.
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• We adjust the totals of the adjusted CSCF numbers by adding back Process of consolidate cash flow statement
net interest paid. First, prepare a separate cash flow statement for the parent and for
• Generally, the review of a consolidated cash flow statement is each applicable subsidiary, majority owned investment or joint
perceived as more effective than reviewing each cash flow venture.
statement separately, because it represents the total cash flows for Next, use a worksheet to adjust any line items to remove intercompany sales and
all the businesses. transfers. Confusion can result if you try to make the adjustments directly on the
• You must follow GAAP in preparing consolidated cash flow statement at the same time that you combine data.
statements, as you would when preparing each company's cash Next, add each separate cash flow statement along with the worksheet's
flow statement. adjustments. The final result is a consolidated cash flow statement.
The consolidated statement of cash flows (CSCF) is composed of three sections:
Operating cash flows, investment cash flows, and financing cash flows
The subsections of CFCF is below contain further explanations
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CSCF, Section 1: Operating Cash Flows oA classic adjustment is to add back depreciation to the firm’s
oOperating activities are those cash flow activities either generate income: Since depreciation is a non-cash charge on the firm’s
revenue or record the money spent on producing a product or service. income, it must be added back when making the adjustment for cash.
o Operational business activities include inventory transactions, oBut depreciation is just the tip of the non-cash expense.
interest payments, tax payments, wages to employees, and
payments for rent. Any other form of cash flow, such as
investments, debts, and dividends are not included in this section.
oThe operating cash flows adjust the firm’s net income for non-cash
deductions to the income and for changes in the firm’s operating net
working capital.
o Because modern accounting statements include many non-cash
items, translating the firm ’s accounts to a cash basis necessitates
many adjustments. 35 36

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CSCF, Section 3: Financing Cash Flows

SCF, Section 2: Investment Cash Flows
• The second section of the CSCF includes all investments made by the • The third section on the cash flow statement records the cash flow
firm. These investments include both investments in securities and between the company and its owners and creditors.
investments in operating assets of the firm.
• Financial activities include transactions involving debt, equity,
• Investment in securities can refer to the sale or the purchase of securities and dividends. In these transactions, incoming cash is recorded
held by the firm.
when capital is raised (such as from investors or banks), and
• Investment in securities is not part of the firm’s free cash flows, which outgoing cash is recorded when dividends are paid.
are intended to measure solely cash flows related to the firms core
business activities. • The last section of the CSCF deals with changes in the firm ’s
• Investments in fixed assets are usually related to the firm ’s FCFs. financing. For FCF purposes, we can ignore this section.
• For purposes of computing the firm’s free cash flows, we need to • ABC Corp., Consolidated Statement of Cash Flows (CSCF) Five
distinguish between financial investment cash flows (not part of the FCF) years of the consolidated statement of cash flows of ABC Corp. are
and investment in assets used to produce the firm ’s business income (part given below:
of the FCF).
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Cont…
To turn these CSCF into free cash flows:
 We keep all the items under operating activities.
 In the section for Investing Activities, we delete items that are not
related to operations. For example, we would delete “short-term
investments, net ”under Investing Activities—these represent the
purchase and sale of financial assets.
• We completely ignore the cash flows under Financing Activities
• We add back after-tax net interest to the sum of the remaining items
to neutralize the subtraction of interest from the net income.

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2.6 Free Cash Flows Based on Pro Forma Financial Statements

or it may be created as part of a specific request for cash flow
• Pro forma financial statements are financial reports issued by an information, as may be required by a prospective lender or investor.
entity, using assumptions or hypothetical conditions about events that Pro forma cash flow information is useful for estimating when there
may have occurred in the past or which may occur in the future.
may be cash shortages in the near future, so that management can
• These statements are used to present a view of corporate results to prepare by obtaining additional debt or equity funding to offset the
outsiders, perhaps as part of an investment or lending proposal. projected shortfall.
• A budget may also be considered a variation on pro forma financial Another alternative is to plan for expenditure reductions in order to
statements, since it presents the projected results of an organization avoid future cash usage. If excess cash is projected by the pro forma
during a future period, based on certain assumptions.
document, this information can also be used to plan the most
• Pro forma cash flow is the estimated amount of cash inflows and appropriate investment strategy for the cash.
outflows expected in one or more future periods. Pro forma cash flow is arguably the most essential of the various pro
• This information may be developed as part of the annual budgeting or forma documents, which can also include the income statement and
forecasting process, balance sheet,
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Cont..
since the other documents are rendered invalid if an inadequate
amount of cash is projected to be available to support
management's plans.
Another way to project free cash flows is to build a set of
predictive financial statements based on our understanding of the
company and its financial statements.

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Using the definition of free cash flows from above section :

The End

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