Cross-Border Valuation

U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have been converging over time.

The valuation of companies and subsidiaries in foreign countries has become easier.

Four issues need to be considered when analyzing foreign companies:

1. making forecasts in foreign and domestic currencies,
2. estimating the cost of capital in a foreign currency
3. incorporating foreign-currency risk in valuations, and 
4. using translated foreign-currency financial statements

For a given company, forecast the cash flows in the most relevant currency.

Use either the spot-rate method or the forward-rate method to convert the value of the cash flows into that of the parent company.

It is important to use consistent monetary assumptions in the process (e.g., concerning inflation and interest rates).

When estimating the cost of capital, use the equity premium from a global portfolio without an adjustment for currency risk.

When translating statements into another currency, there are three choices:

1. the current method, 
2. the temporal method, and,
3. the inflation-adjusted current method.

Using, the current method is the most appropriate approach.

Valuing High Growth Companies

The recommended standard valuation principles apply to high-growth companies too.

There is a difference in the order of the steps of the valuation process and the emphasis on each step.

1.  The analyst should forecast the development of the company's markets and then work backward.

2.  The analyst should create scenarios concerning the market's possible paths of development.

3.  When looking into the future, the analyst should also estimate a point in time at which the company's performance is likely to stabilize and then work backward from that point.

4.  By then, the company will have captured a stable market share; and one part of the forecasting process requires determining the size of the market and the company's share.

5.  Then, the firm must estimate the inputs for return:  operating margins, required capital investments, and ROIC.

6.  Finally, the analyst should develop scenarios and apply to the scenarios a set of probability weights consistent with long-term historical evidence on corporate growth.




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Time  ------->

Today ..... Rapid Growth ...... Growth Stabilizes .......

Today .....Growing Market Share .....Stable Market Share

Today..... How big is the market? .... How big is the market and the company's share?


Calculating the return:

1.  What is its total revenue?
2   What are its operating margins?
3.  What are its net operating profit after adjusting for tax?
4.  What are its capital investments?
5.  Calculate its ROIC

Valuing companies in Emerging Markets

Valuation is usually difficult in emerging markets.

There are unique risks and obstacles not present in developed markets.

Additional considerations include

• macroeconomic uncertainty, 
• illiquid capital markets, 
• controls on the flow of capital into and out of the country, 
• less rigorous standards of accounting and 
• disclosure, and high levels of political risk.

To estimate value, three different methods are used:

1. a discounted cash flow (DCF) approach with probability-weighted scenarios that model the risks the business faces,
2. a DCF valuation with a country risk premium built into the cost of capital, and 
3. a valuation based on comparable trading and transaction multiples.

For developed nations, the analyst must:

• develop consistent economic assumptions,
• forecast cash flows, and 
• compute a WACC.

Computing cash flows, however, may require extra work because of accounting differences.

If done correctly, the two DCF methods (1 and 2 above) should give the same estimate of value.

Valuing Banks

There are four complications in the valuation of banks:

1. the latitude managers have with respect to accounting decisions,
2. lack of transparency,
3. the level of leverage, and 
4. the fact that banks are multibusiness companies.

Those businesses include

1. borrowing and lending,
2. underwriting and placement of securities,
3. payment services, 
4. asset management, 
5. proprietary trading, and 
6. brokerage.

DCF on operations approach is not appropriate

In valuing a bank, a discounted cash flow (DCF) on operations approach is not appropriate because interest rates revenue, and costs, are part of operating income.



Equity DCF method is more appropriate

The equity DCF method is more appropriate, and the analyst should triangulate the results with a multiples-based valuation.

The equity approach uses a modified version of the value driver formula in which

• return on equity (ROE) and return on new equity (RONE) replace ROIC and RONIC, and 
• net income replaces NOPLAT:

Current Value at time t = Net Income at time t+1  *  [1 - (g/RONE)] / ke - g

ke = cost of equity


Problems and complications in bank valuations

Problems associated with applying the equity DCF valuation method include

• determining the source of value, 
• the effect of leverage, and 
• the cost of holding equity capital.

Economic spread analysis can help determine the sources of value creation.

Other complications in bank valuations are

• monitoring the yield curve and forward rates, 
• estimating loan loss provisions, 
• approximating the bank's equity risk capital needs, and 
• constructing separate statements for each of the bank's activities.

Valuing Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of increases and decreases.

The earnings of such companies fluctuate because of large

• changes in the prices of their products or 
• changes in volume.

Volatile earnings introduce additional complexity into the valuation process, as historical performance must be assessed in the context of the cycle.


The share prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies.

However their discounted cash flow (DCF) valuations are much more stable.



Why are the share prices of cyclical companies more volatile?

Earnings forecasts may be the reason that the former is more volatile than the latter.

Analysts' projections of the profits of cyclical companies are not very accurate, in that they tend not to forecast the downturns and generally have positive biases.

Analysts may produce biased forecasts for these cyclical firms from fear of retaliation from the managers of the firms they analyse.

The behaviour of the managers may play a role in the cyclicality.

They tend to increase and decrease investments at the same time (i.e., exhibit herd behaviour).

Three explanations for this behaviour are:

• cash is generally more available when prices are high,
• it is easier to get approval from boards of directors for investments when profits are high, and 
• executives get concerned about the possibilities of rivals growing faster than their firms.

An approach for evaluating a cyclical firm

The following steps outline one approach for evaluating a cyclical firm:

• construct and value the normal cycle scenario using information about past cycles;
• construct and value a new trend line scenario based on the recent performance of the company;
• develop the economic rationale for each of the two scenarios, considering factors such as demand growth, companies entering or exiting the industry, and technology changes that will affect the balance of supply and demand; and 
• assign probabilities to the scenarios and calculate their weighted values.

Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

1. how much to invest,
2. how much debt to have, and 
3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

1. using equity,
2. straight debt,
3. convertibles and
4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.




Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.




Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

• are a useful summary indicator of capital structure health and 
• are a means of communicating information to shareholders.

The two main determinants of credit ratings are

• size and 
• interest coverage.

Two important coverage ratios are

• the EBITA to interest ratio and 
• the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.




Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

• the costs of the choices and 
• the possible signals the choices send to investors.

Methods to manage capital structure include

• changing the dividends, 
• issuing and buying back equity, and
• issuing and paying off debt

When designing a long-term capital structure, the firm should

• project surpluses and deficits, 
• develop a target capital structure, and 
• decide on tactical measures.  

The tactical, short-term tools include

• changing the dividend,
• repurchasing shares, and 
• paying an extraordinary dividend.

Divestitures: Managers should devote as much time to divestitures as they do to acquisitions.

Managers should devote as much time to divestitures as they do to acquisitions.

However, managers tend to delay divesting, which leads to the loss of potential value creation.

Divestments can create value both

• around the time of the announcement and 
• in the long run.

A divestiture creates value because of the "best owner" principle whereby the old owner's culture or expertise is not well suited for the needs of the divested business.

A mature parent company divesting an innovative growth division is the typical example; however, companies ripe for divestiture could be at any stage in their life cycle.




Factors to Consider in Divesting

Considerations in divesting are

• possible losses from synergies and shared assets and systems;
• disentanglement costs, such as legal and advisory fees and fiscal changes;
• stranded costs;
• legal, contractual, and regulatory barriers; and 
• the pricing and liquidity of assets.

The costs from synergy losses, may be subtle, and existing contracts may have to be renegotiated.  

Evidence shows that the level of liquidity of the divested assets plays a role in the amount of value created.



Private or Public Transactions

Divestitures

• can be private transactions, such as trade sales and joint ventures, or 
• they can be public transactions.

Private transactions generally lead to more value creation for the seller.

Public transactions include

• IPOs, 
• carve-outs, 
• spin-offs (demergers), 
• split-offs, and 
• the issuance of a tracking stock.

Public transactions can be beneficial over the long term if the industry is consolidating.

Several types of public transactions often generate negative returns, however, and the divestiture is usually temporary

In the case of carve-outs, for example,

• the market-adjusted long-term performance for carve-out parents and subsidiaries is usually negative, and 
• usually minority carve-outs are eventually fully sold or reacquired.

Alternative Measures of Return on Capital

The primary measure of return on capital is return on invested capital (ROIC).


ROIC = net operating profit less adjusted taxes (NOPLAT) divided by invested capital.

ROIC correctly reflects return on capital in most cases, but special circumstances require alternative measures.



Intangible assets

More specifically, investments in intangible assets are expensed, which can introduce a negative bias in ROIC and lead managers to make incorrect decisions concerning how to create value.




Three issues to focus on handling such complexities

1.   When does ROIC accurately reflect the true economic return on capital?

• When does a more complex measure, such as cash flow return on investment (CFROI) make sense?

2.  How should one deal with investments in R&D and marketing and sales that are expensed when they are incurred?

• Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business.

3.  How should one analyze businesses with very low capital requirements?

• Here it is recommended to use economic profit, or economic profit scaled by revenues, to measure return on capital.

Investments in R&D and other intangibles should be capitalized

Investments in R&D and other intangibles should be capitalized for three reasons:

• to represent historical investment more accurately
• to prevent manipulation of short-term earnings, and 
• to improve performance assessments of long-term investments.

These change only the perceptions of performance, however, and will not change the value of the firm.
Since free cash flow (FCF) includes both operating expenses and investment expenditures, capitalizing an expense will not affect FCF.



The process for capitalizing R&D

The process for capitalizing R&D has three steps:

• build and amortize the R&D asset using an appropriate asset life,
• make the appropriate upward adjustment on invested capital, and,
• make the appropriate upward adjustment on NOPLAT.

These adjustments can be applied to other expenses, such as an expansion of distribution routes.



Drawbacks of such adjustments

A couple of drawbacks of making too many such adjustments are

• the increased ability to manipulate short-term performance and 
• the incentives for managers not to recognize when to write down an asset created from a capitalized expense.

Computing Operating Taxes

In estimating value, the followings need to be determined:

• the portion of taxes due from the operating activities,
• then determine the operating cash taxes, and 
• finally, estimate the value of the corporation recognizing that some taxes are deferred.

The available information on the analyzed firm will be incomplete, therefore, operating cash taxes can only be estimated and the estimates will have errors.

Using either the company's statutory tax rate or the company's effective rate with no adjustments is not appropriate for computing operating taxes.



Adjustments for Computing Operating Taxes

1.  One suitable approach is to compute taxes as if the company were financed entirely with equity.

• To accomplish this task, begin with reported taxes and undo financing and nonoperating items one by one.
• Make estimates based on the tax rates in the various jurisdictions in which the firm operates.  

2.  Estimates of operating taxes actually paid in cash provide a better input for valuation than those estimates that include accruals.

• As part of the estimation process, subtract the increase in net operating deferred tax liabilities from operating taxes.
• Information for this process should be in the tax footnote.
• The reorganized balance sheet needs to properly assign deferred tax assets and deferred tax liabilities.

For each deferred tax account, there are four valuation methodologies:

1. value the account as part of NOPLAT,
2. value the account as part of a corresponding nonoperating asset or liability,
3. value the account as a separate nonoperating asset, and
4. ignore the account as an accounting convention.

Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

Non-operating items, Provisions and Reserves

Strict accounting rules exist for dealing with nonoperating expenses and one-time charges.

For determining value, however, these entries and the financial statements require adjustments.

These entries provide relevant information concerning past performance and future cash flows.



Assessing impact of nonoperating charges

A three-step process can aid in assessing the impact of nonoperating charges:

1. reorganize the income statement into operating and nonoperating items, 
2. search the notes for embedded one-time items, and 
3. analyze each extraordinary item for its impact on future operations.

Noncash expenses usually

• lower an asset or 
• increase a provision account in the liabilities.

In evaluating a business, there are four types of provisions:

1. ongoing operating provisions,
2. long-term operating provisions,
3. non-operating restructuring provisions, and
4. provisions created to smooth income.

Reorganizing the Financial Statements

A proper assessment of financial performance requires reorganizing financial statements to avoid traps like double counting, omitting cash flows, and hiding leverage.



ROIC = NOPLAT / (Invested Capital)

FCF = NOPLAT + Noncash operating expenses - Investments in invested capital.

Invested Capital (for a simplistic firm)
= Operating Assets - Operating Liabilities = Debt + Equity

Total Funds Invested (for a more realistic firm)
= Invested Capital + Nonoperating Assets
= (Operating Assets - Operating Liabilities) + Nonoperating Assets
= (Debt + Equity) + Nonoperating Assets
= (Debt and Debt Equivalents) + (Equity and Equity Equivalents)


(NOPLAT is.Net operating profit less adjusted taxes)



In practice, there are difficulties in categorizing assets as operating or nonoperating and right-hand balance sheet items as debt or equity, and this makes computing the values in these equations difficult.

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Excess Cash

Excess cash should not be included in invested capital because it is not necessary for core operations, and including it will depress ROIC.

Financial subsidiaries

The operations of those subsidiaries require a separate analysis from those of the manufacturing operations, because financial institutions have different capital and leverage norms.

Advanced analytical issues

Advanced analytical issues include 

• operating leases, 
• pensions and other retirement benefits, 
• capitalized research and development, and 
• nonoperating charges and restructuring reserves.

Operating leases:  The implied value of those leased assets that are not capitalized can be estimated.  A more appropriate measure of leverage can be obtained with the following equation:

Asset Value at time t-1 = Rental Expense at time t / [kd + (1/Asset Life)]

Pensions and other retirement benefits:  Like excess cash, excess pension assets and pension shortfalls should not be included in invested capital.

Research and development:  Research and development should be included in invested capital.

Nonoperating charges and restructuring reserves:  Provisions fall into four basic categories:

• ongoing operating provisions,
• long-term operating provisions,
• nonoperating provisions, and,
• income-smoothing provisions.

Each requires an adjustment to return or invested capital or both.

Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

From Enterprise Value to Value per Share

Enterprise Value is the value of the entire company.


1.   It equals the sum of value of core operations plus value of nonoperating assets.

Enterprise Value or EV = Value of Core Operations + Value of Nonoperating assets


2.  Subtracting debt, debt equivalents, and hybrid securities, and making other adjustments, provides an estimate of the value of equity.

Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).


3.  The value of equity divided by undiluted shares outstanding gives value per share

Value per share = Value of equity / Undiluted shares outstanding




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Non-operating assets

The valuation must carefully evaluate the nonoperating assets, which consist of

• excess cash and marketable securities, 
• nonconsolidated subsidiaries and equity investments, 
• loans to other companies, 
• finance subsidiaries, 
• discontinued operations, 
• excess real estate, 
• tax loss carry forwards, and 
• excess pension assets.

Debts and debt equivalent

Debt and debt equivalents consist of

• debt of all kinds (for example, bonds, bank loans and commercial paper);
• operating leases; 
• securitized receivables; 
• unfunded pension liabilities; 
• contingent liabilities; and
• operating and nonoperating provisions.

Hybrid securities

Hybrid securities consist of

• convertible debt and 
• convertible preferred stock.  

ESOS and noncontrolling interest

Employee stock options and noncontrolling interests require additional adjustments.



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Example:

A corporation has a 2 million shares outstanding.

Given the following information (all in millions), what is its value per share?

DCF of operations = $320m
Financial subsidiary value = $25m
Bonds = $185m
Discontinued operations = $2m
Securitized receivables = $4m
Operating leases = $6m


Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).



Financial subsidiary value & Discontinued operations = Nonoperating assets
Bonds, Securitized receivables & Operating leases = Debt and debt equivalent


Value of Equity
= ($320 )+ ($25 + $2) - ($185 + $4 + $6)
= $150m

Value per Share
= $150 m / 2m shares 
= $75 per share.

Analysing Performance begins with an analysis of the Key Drivers of Value: ROIC and Revenue Growth.

The key drivers of value are:

• ROIC, and
• Revenue Growth.

The analysis of performance and competitive position begins with an analysis of these key drivers of value.

After having done that analysis, then do an assessment of the financial health of the firm to show whether it can make short-term and long-term investments



ROIC

It is useful to analyze ROIC with and without goodwill.


ROIC
= (1- Operating Cash Tax Rate) x (EBITA/Revenues) x (Revenues/Invested Capital)
= (1 - Operating Cash Tax Rate ) x EBITA / Invested Capital
= NOPLAT / Invested Capital



Revenue Growth

Revenue growth is one of the determinants of cash flows.

Organic revenue growth should be distinguished from growth derived from other factors such as currency effects, acquisitions, or divestitures.



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Additional Notes:

Financial Ratios

A comprehensive model does a line item analysis, which converts every line in the financial statements into a ratio.

Ratios include common size entries computed in terms of assets or revenues for the balance sheet and income statement, respectively, and also days ratios found by the following general expression:

Days = 365 x (Balance Sheet Item / Revenues)



Efficiency Measures

Other measures provide insights into efficiency relative to other firms

One such expression is a breakdown of labour costs per unit:

Labour Expenses / Units of Output
= (Labour Expenses / Number of Employees) / (Units of Output/Number of Employees)



Power and danger of leverage

The following equation helps illustrate the power and danger of leverage

ROE = ROIC + [ROIC - (1 - T) x kd ] x D/E

T = tax rate
kd = cost of debt

It is important to note how the market debt-to-equity compares to peers in terms of the coverage and the level of risk the firm takes.

Forecasting Performance

Typically, forecasting involves making projections of cash flows to some point where the company has a steady state going forward  



The point when the Steady State going forward is reached

This steady state going forward is characterized by two properties

• the company grows at a constant rate with a constant reinvestment ratio, and 
• the company earns a constant rate of return on existing capital and new capital invested.

The Explicit Forecast Period

The horizon to the steady state, called the explicit forecast period, is usually 10 to 15 years.

This explicit forecast period should be divided into

• a first forecast period of five to seven years, where the statements will include many details,and,
• the remaining years' forecasts where the statements are simpler with less detail, which avoids the error of false precision.

Such forecasts require assumptions concerning a host of variables, including the return earned on invested capital and whether the company can stay competitive.



Steps in the Forecasting Process

There are six steps in the forecasting process.

1. Prepare and analyze historical financial statements and data.
2. Build the revenue forecast consistent with historical economy-wide evidence on growth.
3. Forecast the income statement using the appropriate economic drivers.
4. Forecast the balance sheet entries.
5. Forecast the investor funds into the balance sheet.
6. Calculate ROIC and FCF.

Additional issues include

• determining the effect of inflation,
• nonfinancial drivers, and 
• which costs are fixed and which are variable.

Estimating Continuing Value of a Company

There are two parts to the estimated value of a company based on future cash flows:

1. a portion of the value based on the initial, explicit forecast period, and,
2. a portion of the value based on continuing performance beginning at the end of the explicit forecast period.

Estimated value of a company
= Estimated Operating Value of the initial, explicit forecast period + Continuing Value beginning at the end of the explicit forecast period.


The continuing value (CV) 

• often exceeds half of the total estimated operating value, and 
• when early years have negative cash flows, the continuing value can exceed the total estimated operating value.

Two formulas for estimating continuing value

There are two formulas for estimating continuing value:

• the discounted cash flow (DCF) formula, and
• the economic-profit formula.

Other methods for estimating continuing value exist.

The convergence formula is related to the preceding formulas, for example, and it assumes that excess profits will eventually be competed away.

Some methods do not depend on the time value of money.  Those methods include

• using multiples such as P/E, 
• estimates of liquidation value and 
• estimates of replacement costs.

Valuing by Parts provides greater insights into where and how the company is generating value

Many large companies have multiple business units, each competing in segments with different economic characteristics.

Even pure-play companies often have a wide variety of underlying geographical and category segments.

If the economics of a company's segments are different, you will generate more insights by valuing each segment and adding them up to estimate the value of the entire company.

Trying to value the entire company as a single enterprise will not provide much insight, and the final valuation will likely be noisier than valuing by parts.



Valuing by parts generate better valuation estimates and deeper insights

Consider a single case where a faster-growing segment has lower returns on capital than a slower-growing segment.

If both segments maintain their ROIC, the corporate ROIC would decline as the weights of the different segments change.

Valuing by parts generate better valuation estimates and deeper insights into where and how the company is generating value.

That is why it is standard practice in industry-leading companies and among sophisticated investors.



Steps for valuing a company by its parts

Four critical steps for valuing a company by its parts are:

1. understanding the mechanics of and insights from valuing a company by the sum of its parts,
2. building financial statements by business unit - based on incomplete information, if necessary,
3. estimating the weighted average cost of capital by business unit, and 
4. testing the value based on multiples of peers.

To value a company's individual business units, you need income statements, balance sheets, and cash flow statements.

Ideally, these financial statements should approximate what the business units would look like if they were stand-alone companies.

Creating financial statements for business units requires consideration of several issues, including

1. allocating corporate overhead costs,
2. dealing with inter-company transactions,
3. understanding financial subsidiaries, and 
4. navigating incomplete public information.

Inflation

Inflation makes analyzing performance and making comparisons difficult.

Inflation usually impedes the creation of value.

Inflation lowers the value of monetary assets and the firm can rarely pass along the full effects of inflation to customers.

Typically, ROIC does not increase enough to compensate the firm for inflation.

The increase in inflation from the 1960s to the 1970s was accompanied by a decline in P/E ratios.



Periods of High Inflation

During periods of high inflation, the problem becomes much worse.

During periods of high inflation, the following distortions can occur and need to be corrected:

1. overstated growth,
2. overestimated capital turnover,
3. overstated operating margins, and 
4. distorted credit ratios.

When making forecasts in periods of high inflation, adjustments can be make in either nominal or real terms.but consistent financial projections require elements of both nominal and real forecasts.

Five steps for making forecasts in periods of high inflation are:

1. forecast operating performance in real terms,
2. build financial statements in nominal terms,
3. build financial statements in real terms,
4. forecast free cash flow in real and nominal terms, and 
5. estimate discounted cash flow (DCF) value in real and nominal terms.

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure