Vous êtes sur la page 1sur 50

Corporate valuation

Illustration of DCF approach

In this section, the DCF approach of valuation is applied to Bharat Hotels


Company (BHC) which is a major hotel chain in India.
The company operates 35 hotels of which 14 are owned by it and the rest
are owned by others but managed by BHC.
BHCs principal strategy has been to serve the high end of the
international and leisure travel markets in major metropolises, secondary
cities and tourist destinations.
It plans to continue to develop new business and leisure hotels to take
advantage of the increasing demand which is emanating from the larger
flow of commercial and tourist traffic of foreign as well as domestic
travelers.
BHC believes that the unique nature of its properties and the emphasis on
personal service distinguishes it from other hotels in the country.
Its ability to forge management contracts for choice properties owned by
others has given it the flexibility to swiftly move into new markets while
avoiding the capital intensive and time consuming activity of constructing
its hotels.

Illustration of DCF approach..

BHCs major competitors in India are two other major Indian hotel
chains and a host of other five star hotels which operate in the
metropolises as an extension of multinational hotel chains.
The foreign hotel majors are considerably stronger than the Indian
hotels in terms of financial resources, but their presence in the
country has historically been small.
With the government committed to developing India as a
destination for business and tourism, several hotel majors have
announced their intention to establish or expand their presence in
the country.

Illustration of DCF approach..

BHCs operating revenues and expenses for the year just


concluded (year 0) were as follows:
Operating Revenues
Rupees (in
million)
Room rent
1043
Food and beverages
678
Management fees for
managed properties
73
Operating Expenses
Materials
258
Personnel
258
Upkeep and services
400
Sales and general administration
400

Illustration of DCF approach..

BHCs assets and liabilities (in million rupees) at the end of year 0 were as
follows:
Owners Equity and Liabilities
Assets
Net worth
1126
Net fixed assets
1510
Debt
900
Gross Block: 2110
Accumulated Depreciation 600
Current Assets
516
2026
2026
BHC had no operating assets.
At the end of year 0, BHC owned 2190 rooms.
It has planned the following additions for the next 7 years.
Most of the land needed by the company for these additions has been
already acquired.

Illustration of DCF approach..

Year
Rooms
Investment (in million
rupees)
1
90
200
2
130
300
3
80
240
4
130
500
5
186
800
6
355
1400
7
150
800
For the sake of simplicity assume that the addition will take place at the
beginning of the year.

Illustration of DCF approach..

For developing the financial projections of BHC, the following assumptions may be made.
The occupancy rate will be 60% for year 1. Thereafter, it will increase by 1% per year for
the next 6 years.
The average room rent per day will be Rs. 2500 for year 1. it is expected to increase at
the rate of 15% per year till year 7.
Food and beverage revenues are expected to be 65 per cent of the room rent.
Material expenses, personnel expenses, upkeep and services expenses, and sales and
general administration expenses will be, respectively, 15, 15, 18, and 18 per cent of the
revenues (excluding the management fees).
Working capital (current assets) investment is expected to be 30 percent of the revenues.
The management fees for the managed properties will be 7 percent of the room rent. The
room rent from managed properties will be more or less equal to the room rent from
owned properties.
The depreciation is expected to be 7 percent of the net fixed assets.
The after-tax non-operating cash flows (in million rupees) will be as follows: 300 (year 2),
600 (year 5), 800 (year 6).
Given the tax breaks it enjoys, the effective tax rate for BHC will be 20 percent.
There will be no change in deferred taxes.

Illustration of DCF approach..

Besides financial projections, the following information is relevant for


valuation.
The market value of equity of BHC at the end of year 0 is Rs. 17100
million. The imputed market value of debt is Rs. 900 million.
BHCs stock has a beta of 0.6775.
The risk-free rate of return is 12% and the market risk premium is 8%.
The post-tax cost of debt is 9%.
The free cash flow is expected to grow at a rate of 14% per annum
after 7 years.
DCF Valuation
Given the above information, the discounted cash flow approach may
be applied for valuing BHC.
Free Cash Flow Forecast: Based on the information provided
above, the forecast for revenues and operating expenses is developed
in the first three panels of the table.

Illustration of DCF approach..


Table :
Year
5

Financial Projections
1

7
PANEL I*

A.
B.
C.

Rooms
Occupancy rate
Average room rent
(in rupees)

228
0
0.60
250
0

241
0
0.61
287
5

2490
0.62
3306

2620
0.63
3802

2806
0.64
4373

316
1
0.65
502
8

3311
0.66
5783

377
1

4613

PANEL II *
D.
E.
F.
G.
H.

Room rent from


owned properties
Food and beverage
revenues
Revenue from
owned
properties(D+E)
Management fees
from managed
properties
Total revenues

124
8
811
205
9
87
214

154
3

1863

2291

2867

1211

1489

1864

100
3

3074

3780

254
6

130
3204

160
3940

108

2998

4731

245
1

7611

200
4931

622
2

323
7934

264

Financial Projections
Year

1
5

7
PANEL III*

I.
J.
K.
L.
K.

Material
expenses
Personnel
expenses
Upkeep and
service expenses
Sales and
general admn
expenses
Total operating
expenses

309
309

382
382

461
461

567
567

710
710

933
933

1142
1142

371

458

553

680

852

1120

1370

371

458

553

680

852

1120

1370

1360

1680

2028

2494

3124

4106

5024

Financial Projections----Year
4

1
5

7
PANEL IV*

L.
M.
N.
O.
P.
Q.
R.
S.
T.

EBDIT(H-K)
786
Depreciation
120
EBIT
666
NOPLAT
533
Gross cash flow
653
Gross
investments
(Fixed assets +
302
current assets)
Free cash flow
351
from operations
(P-Q)
Non-operating
351
*(All flow
figures are in million
cash

974
132
842
674
806

1176
140
1036
829
969

446

398

360

571

300
660
571
rupees)

144
6
166
128
0
102
4
119
0

1807
210
1597
1278
1488
1085

238
0
293
208
7
167
0
196
3

291
0
329
258
1
206
5
239
4

184
8

121
6

403
712
478

600
1033

Financial Projections------Table : Current Assets, Fixed Assets and


Depreciation (in million rupees)

Year
4
A.
B.
C.
D.
E.
F.
G.

1
5

Current assets*
Current assets
addition*
Gross block*
Capital exp.*
Acc. deprn.*
Net block (C+D-E)
Depreciation

*At beginning of year

7
516

618

764

924

1134

102
2110
200
600
1710
120

146
2310
300
720
1890
132

158
2610
240
852
1998
140

212
285
0
500
984
236
6
166

285
3350
800
1150
3000
210

141
9

186
7

448
415
0
140
0
136
0
419

416
555
0
800
165
3
469
7

DCF Valuation of Free Cash Flows

Cost of capital : BHC has two sources of finance, equity and debt.
The cost of capital for BHC is
Cost of capital = (weight of equity x cost of equity) + (weight of debt
x cost of debt)
The weights of equity and debt, based on market values, are as
follows:
Weight of equity = 17100/18000 = 0.95
Weight of debt = 900/18000 = 0.05
The cost of debt is given to be 9 %. The cost of equity using the
capital asset pricing model is calculated below:
Cost of equity of BHC = Risk-free rate + Beta of BHC (Market Risk
Premium)
= 12 + 0.6775(8) = 17.42%
Given the component weights and costs, the cost of capital for BHC is:
(0.95)(17.42) + (0.5)(9) = 17.00%

DCF Valuation of Free Cash Flows

Continuing Value: The continuing value may be estimated using


the growing free cash flow perpetuity method.
The projected free cash flow for year 7 is Rs. 1178 million.
Thereafter it is expected to grow at a constant rate of 14% per
year.
Hence the expected continuing value at the end of the 7th year is
given by
CV7 = FCF8/ (k-g) = 1174(1.14) / (0.17 0.14) = RS.
44764 million

DCF Valuation of Free Cash


Flows
Calculation and interpretation of results:
The value of equity is equal to
Discounted FCF during the Explicit Forecast Period +
Discounted Continuing Value + Value of Non- operating
Assets Market Value of Debt Claims.
= {351/1.17 + 660/ (1.17)2 + 571/(1.17)3 + 478/(1.17)4 + 1033/
(1.17)5 + 915/(1.17)6 + 1178/(1.17)7 }
+
44764 / (1.17)7
+
0
900
=
Rs 16619 Mio

DCF Valuation of Free Cash Flows

Since the discounted continuing value [44764/(1.17) 7 = Rs. 14906


million] looms large in this valuation, it is worth looking into it further.
Its key determinant appears to be the expected growth rate in the
free cash flow beyond the explicit forecast period.
This has been assumed, in the preceding analysis to be 14 years.
What happens to the estimate of equity value if the growth rate
happens to be different?
The sensitivity of the estimate of equity value to variations in the
growth rate in a range of, say, 12% to 15% is shown below:
Growth rate
Equity value
estimate
(per cent)
(in million
rupees)
12
10500
13
12795
14
16619
15
24269

Comparable Company Approach

The comparable company approach involves valuing a company


on the basis of how similar publicly held companies are valued.
It is typically a top-down approach and involves the following
steps:
Analyze the economy
Analyze the industry
Analyze the subject company
Select comparable companies
Analyze subject and comparable companies
Analyze multiples
Value the subject company

Comparable Company Approach..

Analyze the economy


The first step in the comparable company approach is to analyze the economy.
An analysis of the economy provides the basis for assessing the prospects of
various industries and evaluating individual companies within an industry.
Such an analysis calls for, inter alia, examining the following factors and
forecasting their growth rates : gross national product, industrial production,
agricultural output, inflation, interest rates, balance of payment, exchange rate
and government budget (as well as its composition).
Analyze the industry
The second step in the comparable company approach is to analyze the
industry to which the subject company belongs.
This analysis should focus on the following:
The relationship of the industry to the economy as a whole.
The stage in which the industry is in its life cycle.
The profit potential of the industry.
The nature of regulation applicable to the industry.
The relative competitive advantages of procurement of raw materials,
production costs, marketing and distribution arrangements, and technological
resources.

Comparable Company Approach..

Analyze the subject company


The third step is to carry out an in-depth analysis of the
competitive and financial position of subject company.
The key aspects to be covered in this examination are as follows:
Product portfolio and market segments covered by the firm.
Availability and cost of inputs.
Technological and production capability.
Market image, distribution reach, and customer loyalty.
Product differentiation and economic cost position.
Managerial competence and drive.
Quality of human resources.
Competitive dynamics.
Liquidity, leverage and access to funds.
Turnover margins and return on investment.
Key success factor(s).

Comparable Company Approach..

Select Comparable Companies


After the subject company is studied, the next step is to select
companies which are similar to the subject company in terms of
the lines of business, nature of markets served, scale of operation
and so on.
Often, it is hard to find truly comparable companies because
companies are engaged in a variety of businesses, serve different
market segments, and have varying capacities.
Hence, in practice, the analyst has to make do with companies
which are comparable in some ways.
He should make every effort to look carefully at 10 to 15
companies in the same industry and select at least 3 to 4 which
come as close as possible to the subject company.
Understandably, a good deal of subjective judgement is involved
in this process.

Comparable Company Approach..

Analyze the Financial Aspect of the Subject and Comparable


Companies
Once the comparable companies are selected, the historical financial
statements (balance sheets and income statements) of the subject and
comparable companies must be analyzed to identify similarities and differences
and make adjustments so that they are put on a comparable basis.
Adjustments may be required for differences in inventory valuation methods,
for intangible assets, fro off-balance sheet items, and so on.
The purpose of these adjustments is to normalize the financial statements.
Analyze the Multiples
After normalizing the financial statements of the subject and comparable
companies the next step is to look at the multiples for these companies.
The multiples commonly considered are:
Price to cash flow
Price to earnings
Price to EBIT
Price to EBDIT
Price to sales
Price to book value

Comparable Company Approach..

Value the Subject Company


The final step in this process is to decide where the subject
company fits in relation to the comparable companies.
This is essentially a judgmental exercise.
Once this is done, appropriate multiples may be applied to the
financial numbers (earnings, EBIT and so on) of the subject
company to estimate its value.
If several bases are employed, the several value estimates may be
averaged (for this purpose a simple arithmetic average or a
weighted arithmetic average may be employed).

Comparable Company Approach..


Illustration
The following financial information is available for company D, a bulk
drug manufacturer:
Earnings before depreciation interest and taxes (EBDIT)
Rs 18 million
Book value of assets
Rs 90
million
Sales
Rs 125
million
Based on an evaluation of several bulk drug companies, companies A, B
and C have been found to be comparable to company D.
The financial information for these companies is given below.
Taking into account the characteristics of company D vis--vis companies
A, B and C, the following multiples appear reasonable for company D.
MV/ EBDIT = 17
MV/Book value = 3.0
MV/ sales = 2.2
Applying these multiples to the financial numbers of company D, gives
the following value estimates.

Comparable Company Approach..


EBDIT*
Book value of assets*
Sales*
Market value*(MV)
MV/EBDIT
MV/Book value
MV/Sales

12
75
80
150
12.5
2.0
1.9

15
80
100
240
16.0
3.0
2.4

20
100
160
360
18.0
3.6
2.3

*In million rupees


1. MV = 17 x EBGIT = 17 x 18 = Rs. 306 million
2. MV = 3 x Book value = 3 x 90 = Rs. 270 million
3. MV = 2.2 x Sales = 2.2 x 125 = Rs. 275 million
A simple arithmetic average of the three value estimates is:
(306 +270+275)/3 = Rs. 283.7 million

Adjusted Book Value Approach

The adjusted book value approach to valuation involves determining the


fair market value of the assets and liabilities of the firm as a going
concern.
It may be distinguished from other approaches relying on the balance
sheet.
For example, it is different from the conventional book values.
Likewise, it is distinct from the market price to book value method, an
approach that depends on the market value of securities.

Value of Assets

The first step in the adjusted book value approach is to value the assets of
the firm.
The key considerations in valuing various assets are discussed below:
Cash
Cash is cash.
Hence there is no problem in valuing it.
Indeed it is gratifying to have an asset which is so simple to value.

Adjusted Book Value Approach


Debtors
Generally debtors are valued at their face value.
If the quality of the debtors is doubtful, prudence calls for making
an allowance for likely bad debts.
Inventories
Inventories may be classified into three categories: raw materials,
work-in-process, and finished goods.
Raw materials may be valued at their most recent cost of
acquisition.
Work-in-process may be approached from the cost point of view
(cost of raw materials plus the cost of processing) or from the
selling price point of view (selling price of the final product less
expenses to be incurred in translating work-in-process into sales).
Finished goods inventory is generally appraised by determining
the sale price realizable in the ordinary course of business less
expenses to be incurred in packaging, holding, transporting,
selling, and collection of receivables.

Adjusted Book Value Approach


Other Current Assets
Other current assets like deposits, prepaid expenses, and accruals
are valued at their book value.
Fixed Tangible Assets
Fixed tangible assets consist mainly of land, buildings and civil
works, and plant and machinery.
Land is valued as if it is vacant and available for sale.
Buildings and civil works may be valued at replacement cost less
physical depreciation and deterioration.
Plant and machinery, too, is valued at replacement cost less
physical depreciation and deterioration.
As an alternative, the value of plant and machinery may be
appraised at the market price of similar (used) assets plus the cost
of transportation and installation.

Adjusted Book Value Approach


Non-operating Assets
Assets not required for meeting the operating requirements of the
business are referred to as non-operating assets.
The more commonly found non-operating assets are financial
securities, excess land, and infrequently used buildings.
These assets are valued at their fair market value.
Intangible Assets
Intangible assets pose a problem.
As they cannot be ordinarily disassociated from the business and
sold separately, the market approach is not very helpful in valuing
them.
Therefore, one may use the cost approach or the income
approach.

Adjusted Book Value Approach


Liabilities

Valuing liabilities is relatively easier. The key considerations in


assessing the broad categories of liabilities are discussed below:
Long-term Debt
Long-term debt, consisting of term loans and debentures, may be
valued with the help of the standard bond valuation model.
This calls for computing the present value of the principal and
interest payments, using a suitable discount rate.
Current Liabilities and Provisions
Broadly defined, current liabilities and provisions consist of shortterm borrowings from banks and other sources; amounts due to the
suppliers of goods and services bought on credit; advance payments
received; accrued expenses; provisions for taxes, dividends,
gratuity, pension, etc.
Current liabilities and provisions are typically valued at face value.

Adjusted Book Value Approach


Ownership Value

The value of total ownership is simply the difference between the


value of assets and the value of liabilities.
Ordinarily there is no need to add a premium for control because
assets and liabilities are valued in economic terms.
On the contrary, it may be appropriate to apply a discount for the
marketability factor. Why?
While it may be easier to sell an entire business, it may not be easy to
locate informed and willing buyers on a timely basis.
Hence a discount may have to be offered.
How should a minority interest in a closely-held business be assessed?
For valuing such an interest a higher discount factor should be applied.
The discount factor must reflect the concern for marketability as well
as the weak position of minority interest.

Cash Flow return on investment (CFROI)

Instead of computing the value of the enterprise as the present value of all future
free cash flows, as in the DCF model, one can instead calculate a return ratio that
expresses the companys current or future ability to produce free cash flow.
A popular method for this is known as cash flow return on investment (CFROI).
Originally designed by the Holt Value Consultants, CFROI can be defined as the
sustainable cash flow a business generates in a given year as a percentage of
the cash invested in the companys assets.
You can think of CFROI as a weighted average internal rate of return (IRR) of all
the projects within the company.
Usually, it is expressed as:
Gross Cash Investment =
CF1 / (1+CFROI) + CF2/(1+CFROI)2 +----- + CFn /(1+CFROI)n + TV/
(1+CFROI)n

Where Gross Cash Investment is the total inflation-adjusted gross cash


investment made by all lenders and investors,
CF is the inflation-adjusted annual cash flow,
TV is the inflation-adjusted terminal value of all future cash flows from year n to
infinity, and n is the average economic life of the firms assets.
The calculated CFROI can be compared with the firms current or real (inflationadjusted) historical cost of capital or against real industry rate of returns.

Real Options Valuation

Since the publication of Fisher Black and Myron Scholes groundbreaking article The pricing of options and corporate liabilities in
1973, option valuation has been used frequently by investors,
traders and others to calculate the theoretical value of stock
options, interest rate options, and all other kinds of options traded
all over the world.
It is only in the last few years that option valuation has been
recognized as an alternative to standard net present value
calculations in the valuation of investment opportunities in real
markets and as a company or project valuation tool.
A financial option gives its owner the right to buy (call option) or
sell (put option) a certain specified underlying asset (a stock, bond,
amount of gold, etc,) at a specified price (the exercise price) within
a certain period of time (the exercise period), but with no obligation
to do so. For this right the owner pays a premium (the price of the
option).

Real Options Valuation

The idea behind real options is similar to the idea of financial options.
Consider for example a company that has identified an opportunity (an
option), a project with a certain required investment today and a certain
additional investment in six months time (the exercise price).
In six months time, if the opportunity looks promising, i.e. the expected net
present value of the project is higher than the exercise price (the investment)
of the option, the option is exercised and the project goes ahead.
If the project does not look promising, i.e., the net present value of the project
is lower than the exercise price (the investment) of the option, the option is
not used and the only loss is the price of the option paid, the premium.
The point of real options valuation is that it takes into consideration the
flexibility that is inherent in many projects (or in entire companies) in a way
that a DCF valuation does not.
With real options, management possibilities to expand an investment or to
abandon a project are given a correct value.
Or, stated differently, real option valuation might produce positive net present
values where standard net present value calculations produce negative ones.
This is because the flexibility of the project or the investment is given a value.

Real Options Valuation

Specifically, real options valuation is a powerful tool in investmentintensive industries where companies make investments in sequences
involving a high degree of uncertainty.
A small investment today that gives the opportunity to either continue
with a larger investment later or abandon the project altogether is much
like a stock option where a small premium is paid today in order to have
the opportunity, but not the obligation, to buy the stock later.
Examples of such industries include energy (particularly oil and gas), all
R&D-intensive industries such as biotechnology, pharmaceutical and hightech, as well as industries with high marketing investments.
Recently, a number of financial authorities have argued that real options
valuation is a valuable tool for the valuation of almost any type of
company.
The idea is that all unexplored avenues for future cash flow, for example
possible new products, new segments or new markets, could or even
would be best valued through real options valuation.
They want to divide the valuation of a company in the following manner :

Real Options Valuation


Enterprise Value =
Value of existing operations (= value of all discounted future cash flows from
present projects)
+
Value of the company's portfolio of Real Options (= value of future potential
projects)
The value of existing operations is calculated by using one of the valuation models
mentioned in this chapter, for example the DCF model.
Since we lift the value of future potential operations out of the calculation, the
projections for future free cash flow are easier to perform.
Thereafter, the value of the companys various other business opportunities in its
industry or in adjacent industries is calculated using real options valuation.
The two values are then simply added together to give the total enterprise value.

Residual income model

The term residual income (sometimes called economic profit) refers to


the real profit a company produces in contrast to the accounting profit
as decided by accounting principles. Residual income takes into
consideration not only the companys cost of debt but also the
companys cost for equity financing, i.e. the opportunity cost of capital
for equity investors.
This has the important implication that a company must not only
break even but also make a profit large enough to justify the cost of
capital it is using. Residual income can mathematically be expressed
as :
RI = (RE CE) * BVt

Where RI is the residual income R E is the return on equity, CE is the cost


of equity and BVt is the book value of the equity at the beginning of
the year t.

Residual income model

A residual income model values a company by using a combination of the


companys book value and a present value of the companys future residual
income. It can be expressed as :
Enterprise Value = BV + (RI/(1+CE)1 + (RI/(1+CE)2 + ------ +RI/(1+CE)t + TV/
(1+CE)t
Where BV is the current book value of equity for the company and RI is the
future residual income. i.e. the amounts by which profits are expected to
exceed the required rate of return on equity, C is the cost of equity and t is
the number of years in the explicit period.
And where TV is calculated as :
TV = BVt * RIt / (CE g)

Where BV is the book value at time t, RI is the residual income in year t, C


is the required rate of return on equity and g is the constant growth rate
from year t to infinity.

Residual income model

Unlike models that discount dividends or cash flow, in which usually a


significant portion of the estimated value comes from its so-called terminal
value far away in the future, a residual income model usually derives most
of its value from years in the not too distant future.
This is because of its reliance on book value, which obviously can be taken
directly from the balance sheet.
In fact, in many cases the terminal value can be deemed to be zero since
the additional value represents such a small portion of the total value.
This is a significant advantage over the DCF model since forecasting and
estimating errors tend to magnify over time and forecasting 10-15 years
into the future can hardly be anything else than an educated guess.
Another advantage is that the residual income model is entirely based on
accounting standards with numbers easily available. However, the main
disadvantage of the residual income model is that being based on
accounting standards, it often fails to reflect the true economic value of
assets and cash flows.

Economic value added (EVA)

A slightly altered approach of the residual income model is the so-called


Economic Value Added approach, popularly called EVA, which was
developed by the consultancy Stern, Stewart & Co.
According to this approach, the enterprise value equals the current
capital stock plus the value of all future EVA, discounted to the present.
The EVA for a given year is the excess return the company enjoys, once all
operating as well as capital costs are covered.
It is calculated as the difference between the return on capital and the
cost of capital, multiplied by the capital stock at the beginning of the year.
In other words, in order for the enterprise value to be larger than invested
capital, return on invested capital (ROIC) has to exceed the cost of capital
over time .
EVA is a fine tuned variant of residual income or economic profit where a
number of adjustments transform financial statement items into statistics
suitable for valuation.
Specifically, NOPAT (Net Operating Profit After Taxes) and the capital stock
at the beginning of the year need adjustment.

Economic value added (EVA)


Generally, the adjustments fall into any of the following categories :
Conversions from financial to cash accounting.
Conversions from a liquidating perspective to a going-concern
perspective.
Removal of unusual losses or gains.
Economic value added for one year is expressed as :
EVA = NOPAT (WACC x K)
Where EVA is economic value added,
NOPAT is net operating profit after taxes, but before financing costs and
non- cash book-keeping entries (except depreciation),
WACC is weighed average cost of capital and
K is the capital stock at the beginning of the year, i.e., the sum of all the
firms financing apart from non-interest-bearing liabilities such as
accounts payable, accrued wages and accrued taxes.

Economic value added (EVA)


Alternatively, EVA is expressed as :
EVA = (ROIC WACC) x K

Where

Where EVA is economic value added for year one, ROIC is the
return on invested capital for year one, WACC is the weighted
average cost of capital, K is the capital stock in the company at
the beginning of year one and NOPAT is net operating profit after
taxes for year one.
The result of these calculations states whether the company has a
positive or a negative EVA, in other words whether the company is
creating or destroying value.

ROIC = NOPAT / K

Economic value added (EVA)


In accordance with EVA (and as seen from the formula), a company can only create
value in the following ways:
Increase ROIC and hold WACC and invested capital constant.
Decrease WACC and hold ROIC and invested capital constant.
Increase the invested capital in projects/activities yielding a ROIC greater than WACC.
Withdraw capital from projects / activities that yield a ROIC lower than WACC.
Create longer periods where the company is expected to earn a ROIC greater then
WACC.
However the goal of the management and board of a company is not to maximize the
EVA of one single year but to maximize enterprise value, where enterprise value
equals the present value of all future EVA plus the capital stock invested in the
company.
The aggregated future EVA is generally called Market Value Added (MVA).
For publicly traded companies, this can be seen as the difference between a
companys market value and the total invested capital in the company.
Or expressed differently, the MVA is the market expectations of future EVAs. When
calculating enterprise value, the formula is :

Economic value added (EVA)


EV = K0 + EVA1 / (1+WACC)1 + EVA2 / (1+WACC)2+ ------ + EVA n /
(1+WACC)n +
TV / (1+WACC)n
Where
TV = K*n + (ROICn WACC) X K*n X (1/(WACC g)
Where EV is enterprise value,
EVA is economic value added,
K is the capital stock in the company,
WACC is the weighted average cost of capital,
TV is terminal value,
ROIC is return on invested capital,
K* is the equilibrium value of the capital stock in the terminal year,
n is the number of years that the company can enjoy a return on
invested capital greater than its cost of capital, and
g is the growth rate of future EVA from year n to infinity.

Economic value added (EVA)

Enterprise value = present value of future cash flows

= invested capital + present value of future EVAs

While EVA has several purposes, its main use is a period-by-period


performance measurement where DCF valuation usually falls short.
The EVA method is particularly useful in compensation programs such as
a value-based management (VBM) programmes since EVA may be
computed separately for different business units, departments, product
lines or geographic business segments within the organization.
It is a great strength that EVA provides a link between performance
measurement and corporate valuation .
This ensures evaluation and rewards to management and employees in
a way consistent with how financial markets actually value companies.

Net Asset Valuation

This is perhaps the simplest form of company valuation.


Basically, Net Asset Valuation is the difference between the
assets and liabilities based on their respective balance
sheet values, adjusted for certain accounting principles.
In other words, it is the adjusted value of the equity on the
balance sheet.
The reason why Net Asset Values are generally lower than
market values is that many value-creating items are not
accommodated in the balance sheet for accounting
reasons.
For Example, investments in marketing, education of
employees, R&D, etc, are generally not activated on the
balance sheet but they all create value.
The most extreme example is consultancy; it may have
very few tangible assets but can still be very valuable due
to its people, brand name, process, etc.

Net Asset Valuation


In addition, accounting generally estimates asset values with
caution.
For example, computers are often written off in three years but
they may still hold a value after that.
However, the main source of the discrepancy between book
values and market values is that the former do not take into
account all future excess returns the management should be
able to generate on these assets.
There are, however, certain industries where the Net Asset
Value method does give an accurate estimate of corporate
value. Typically, this is when the companys future cash flows
stem from squeezing a margin off the collective value of assets
such as securities or real estate. Consequently, it can make
sense to value banks, real estate and investment companies
using the net asset value approach.

Venture Capital (VC) valuation

A specific form of valuation often used when valuing young firms is called
VC valuation or target ownership approach.
The approach starts from the end by estimating an exit valuation and then
calculating a value today based on the required returns for the investor.
In its simplest form, the approach uses the following formula:
Post-money valuation = Terminal value at exit year n / Required ROI
Where
Post-money valuation is the company value after the investment is made
(Post-money valuation = Pre-money valuation + the capital invested),
Terminal value is the expected value of the company at an exit date at
some point in the future and
Required ROI is the return investor demands from investing in the specific
company at the specific time.

Venture Capital (VC) valuation

The terminal value is the value you could expect the company to
be worth at exit (an IPO or trade sale) in a few years from now.
The terminal value can, in theory, be calculated using any
valuation approach but in practice, one or several multiples are
often used and applied to the companys sales, earnings, etc.
Let us say that a company is expected to have sales of 30 mio in
five years time (usually, the investors discount the revenues
forecasted by management by 40-70%) and that well-managed
companies in the same industry have net margins of 10%.
If we assume the company will be able to reach the same margins
then this would give net earnings of 3mio in five years time.
If the most similar company has an earnings multiple ( P/E) of 20
and if we apply this to the company being valued, we get a
terminal value in five years time of 60mio (P/E 20 X 3mio).

Venture Capital (VC) valuation

When applying another companys multiple, it is important to understand the


circumstances surrounding the companys valuation:
Is the multiple from a listed company? Typically, a discount of approximately
30% will be put on non-listed company valuations.
Is the valuation multiple based on an industrial acquisition of a company? If so,
there might be a synergy component specific to that acquisition that cannot be
applied to your company.
Venture capitalists and other early-stage investors generally demand very high
returns on their investments.
This is because early-stage investing is highly risky and many companies
never even come close to revenues or earnings predicted in the business plan.
Accordingly, investors never come close to the returns hoped for and in some
companies might lose the entire investment.
In a typical portfolio of 10 start-up companies, investors can expect 3 to 5 to
fail completely and another 3 to 4 to give the investor his or her money back.
Hence, the return for the entire portfolio typically comes from 1 or 2 companies
that need to be very successful in order for the portfolio return to be
reasonable.

Venture Capital (VC) valuation

Generally, the risk decreases as the company matures.


Depending on when the investment is considered, the discount rate in the
early stages can vary between 30 to 70%, or put differently, investors
want a return of 10 to 30 times their investment capital at exit.
Using 20 X invested capital and our terminal value of 60 mio / 20 =
3mio.
If the entrepreneur were looking at raising 1m, this means that the
investor, in order to meet the required ROI, would need to own 33% of the
company ( 1m invested / 3m valuation ).
In this example, we simplified matters by assuming that one financing
round was all it was needed to bring the company to an exit.
In reality, companies will often take several rounds of financing and each
round dilutes the ownership of existing shareholders.
Also, options might be offered to incentivize key employees which will
further dilute the ownership at exit.
Both these factors will affect the VC valuation but the basic concept
remains the same.
This type of valuation which is purely from a VC investors perspective,
needs to be complemented with other types of valuation.