## Wednesday, 13 June 2012

### Understanding Valuation Principles

The basics of valuation are:

1.  The Time Value of Money:  This states that \$1 received today has a different value from \$1 received a year ago or \$1 received a year from now.

2.  Present Value:  This is the concept that money spent tomorrow must be worth less today because of the time value of money.  It is calculated by using the formula

PV = CF  /  (1+r)^n

where

PV = present value
CF = cash flow for the period
r = discount rate
n = period

Methods of valuation are:

1. Replacement method
This method tends to be the simplest to explain but the most time-consuming to produce.

This method would measure all the costs involved in creating an exact duplicate company.  Those costs might include:
Land
Buildings
Machinery
Equipment
Working capital.

2.  Capitalization of Earnings
This is one of the more common and relatively straightforward methods of valuation.This method uses a risk rate to assess the value needed to generate the same amount of income as the business being valued.

A company is expected to generate exactly \$10,000 each year in income indefinitely.  Assuming that the buyer can earn a guaranteed rate of interest of 5% elsewhere, an investment of \$200,000 would earn \$10,000 in interest each year.  Therefore, the company has a value of \$200,000.

Unfortunately, such risk-free situations rarely exist.  Thus, with increased risk, a higher capitalization rate would have to be assessed to estimate fair value.  These rates vary, and some might argue that they are entirely arbitrary.  The result will prove highly sensitive to this rate.  As a result, many believe the capitalization of earnings method is problematic.

3.  Discounted Cash Flow Valuation
This is one of the most commonly used methods.

The entire process can be condensed into four steps:
1.  Calculate projections for future cash flows.
2.  Calculate the cost of capital, or the discount rate.
3.  Calculate the present value for each year's cash flow.
4.  Finally, take total of those present value cash flows.

Completing these four steps provides a very close estimate of the valuation for the company.  The sum of these discounted cash flows is the company's valuation ... well, almost.

However, the company doesn't simply dissolves at the end of the DCF study period.  The company continues to operate long after those projections end, meaning there is residual value that has to be considered.

To account for what happens after the projections end, the concept of terminal value is employed.  Terminal value is a concept used to calculate the value of an asset that continues after the projections end, or into perpetuity.

The method of choice involves using the present value of a perpetuity.  A perpetuity is an instrument that makes payments year after year without end.  You can use the formula to calculate a perpetuity that assumes growth or a simpler formula to calculate one without growth.  The two formulas are given here:

Perpetuity without growth = CF / r
Perpetuity with growth = CF / (r - g)

where

CF = cash flow
r = discount rate
g = growth rate

For example:
• Given the 5 year cash flow projections.
• Find the present value of these 5 year cash flows.
• The next step is to get a year 6 cash flow estimate.  Having this cash flow estimate, assume it stays constant each year after that or it grows at a low rate.
• Then calculate the present value of that perpetuity.  The present value of this perpetuity is treated as the value at the beginning of year 6.
• Then calculate the present value of that perpetuity in today's dollars by discounting it back 5 years by using the present value formula.
• Add the present value of perpetuity to the total discounted cash flows for the first five years.
• That results in the company valuation and at this point, the analysis of this company has concluded.

A simple 10-Year Valuation Model
A step by step DCF model for calculating the equity value of a company (Source: Morningstar, Inc.)

Step 1:  Forecast free cash flow (FCF) for the next 10 years.

Step 2:  Discount these FCFs to reflect the present value.

Step 3:  Calculate the perpetuity value, using the FCF of the 10th year, and discount it to the present.

• Perpetuity Value = FCF(10th Year)  x  (1 + g)  /  (R - g)
• Discounted Perpetuity Value = Perpetuity Value / (1 + R) ^ 10

Step 4:  Calculate total equity value by adding the discounted perpetuity value to the sum of the 10 discounted cash flows (calculated in step 2)

• Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash Flows

Step 5:  Calculate per share value by dividing total equity value by shares outstanding:

• Per Share Value = Total Equity Value  / Shares Outstanding

4.  Comparable Multiple Valuation
The final method of valuation is the most commonly used and probably the easiest to use as well.
It is based on benchmarking one company against an industry-average multiple such as the P/E (price-to-earning) ratio.  This could also be applied to other variations on this multiple, such as P/EBIT or P/EBITDA.

Generally speaking, if a company's P/E ratio is greater than the industry average, it is fair to say that the company is overvalued.  If the company's P/E ratio is less than the industry average, it is fair to say that the company is undervalued.  However, be caution, no rules are without exception.    Many companies are seemingly undervalued, but for good reason.  For example, a company might be a party in a pending lawsuit, and the market has undervalued the company because it is unclear what the ruling will be.

The comparable multiple method of valuation forms at least a starting point for making some basic assumptions about a company's value.