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University of Waterloo
Accounting & Financial Management
AFM 371
Neil Brisley

Classnote 18, Firm Valuation 2012 Finish off Convertible Bonds fron classnote 17 (tuesday) Firm valuation, with a view to looking at M&A and other deals => Ross Ch23 for background. Revise WACC and PV of a growing perpetuity. Revise also the concept of ‘Free Cash Flow’ (parts of Ross Ch. 2-4) Firm Valuation: Why? – Analyst, valuing stocks for portfolio selection/newsletter recommendations – Private Sale – Private Equity investments, Leveraged buy-outs (LBOs & MBOs), – Project Acquisition – Sell-offs, spin-offs, divestitures – Investors buying a minority interest in company – Venture Capital investment(Minority Interest) and Exit – Initial Public Offering (General Motors due Thursday) – Mergers & Acquisitions (Hostile vs. friendly, cash vs. shares) – Buyer’s vs. Seller’s perspective Investment bankers, accounting firms (M&A advisory, corporate finance), CBVs, due diligence… • Due diligence  inspections done by accountants for Investment Bankers 1 But aren’t markets supposed to be efficient? Isn’t the Market Price ‘correct’/’fair’?! “Yes, but….” Publicly traded Firms, Privately held firms Measuring Value, Creating Value. Changes of ownership & control, structure & form, focus & strategy. Synergy. • The rationale of takeover bids is  “2 + 2 = 5”; create value Globe & Mail, Wall Street Journal….. Analyst reports, earnings estimates Business Valuation Techniques • Asset Value Techniques: e.g., Book value + adjustments. How useful is a Balance Sheet?! • Interested in economic value, not just accounting value, so by adjustments they mean valuing up or down compared to FMV -liquidation/break-up value -replacement value • Discounted cash flow (DCF) approaches: – Dividend discount models (DDM) to value the equity – The cash flow for that you’re valuing are dividends, at the rate of cost of equity. – However, this is not THAT useful because dividends are just part of the story – Discounted free cash flows to equity (FCFE – direct approach, cashflows after interest payments) to value the equity. Used mainly in Private Equity buyouts. We will not study this method for this course. 2 – Discounted free cash flow to firm (FCFF – indirect approach, cashflows before interest payments) to value the whole firm, deduct any other claims and hence calculate the value of equity. Relative valuation, (market-based valuation) using ‘multiples’ from comparable firms, ‘comps’ Estimated Value (my firm)alue driver (my firm)alue (comparable firm) Value driver (comparable firm) – P/E (capitalization of earnings) – Applying industry P/E ratios to the firm to value it – So valuing firm based on similar firms – But only values the EQUITY part of the firm – Because ur using P/E ration, and earnings is EQUITY because it belongs to shareholders – Total Enterprise Value/EBITDA (capitalization of cashflow) – So value it first as a big lump (the whole firm) – Then knocks off the debt part and says the rest is equity • Mergers & acquisitions: special considerations e.g. ‘Premium paid’ analysis 3 Dividend Discount Models • The value of equity (V ) es the present value of the (expected) future stream of dividends V = Div /(1+r) + Div (1+g )/(1+r) + Div (1+g )(1+g )/(1+r) +... 3 e 1 1 2 1 2 3 If growth is constant (g =2g = 3 . . = g) , the valuation formula reduces to: V e Div /1r - g) What discount rate should we be using here, k or WACCe Why? • Some estimation problems: – firms may not (currently) pay dividends – dividend payments may be ‘managed’ (e.g., for stability) – how to estimate future growth in dividends? Do we like this method? Discounted Free Cash Flow to the Firm (FCFF) We will be using this method in this course. FCFF ignores cash flows related to financing but incorporates financing into discount rate (using WACC). Calculates Total Enterprise Value of Firm (all the debt and equity) as PV of FCFF. PV methodology, very similar idea to Dividend Discount Model 4 Once we compute Total Enterprise Value of firm in this way, subtract value of debt, prefs and other financial obliga
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