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Alexander Groh 1
Structure
• Introduction
• Fundamentals of Valuation
• Tax Shields and Cost of Capital
• Multiples and Hurdle Rates
• Free Cash Flow Valuation and the LBO Model
• Modelling a Company‘s Free Cash Flows
• Summary
• Recommended Literature:
– Koller/Goedhart/Wessels: Valuation, New Jersey, Wiley, 2005
– Arzac: Valuation for Mergers, Buyouts, and Restructuring, New Jersey, Wiley,
2005
Alexander Groh 2
Meaning of Valuation for
Financial Investors
• Finding a Bidding-Range in transaction processes
– It is not the point to find „the fair value“
– If the bid is too low „you are out!“
– If the bid is too high you´ll have problems with built expectations and
with your own company´s governance
• Finding a price for expected Exit
Alexander Groh 3
Meaning of Valuation for
Financial Investors
Essentials of Deal-Making:
Luck Valuation
Tax-Modell
Alexander Groh 4
Valuation Methods
Real Options-
Approach
Comparing Market Values
Discounting expected of quoted companies
Cash Flows Value
Comparing similar
Net Asset Value recent M&A-Transactions
Liquidation Value
Alexander Groh 5
Fundamental Valuation Principle
for a Financial Investor
Calculate Present Value of future Cash Flows !!!
Example:
V0 = 1€
V1 = 1€ ∗ (1 + r )
V2 = V1 ∗ (1 + r ) = 1€ ∗ (1 + r ) ∗ (1 + r ) = 1€ ∗ (1 + r )
2
Vn = Vn−1 ∗ (1 + r ) = 1€ ∗ (1 + r ) ∗ (1 + r ) = 1€ ∗ (1 + r )
n
Alexander Groh 6
Example
What is the Present Value of 100 mn € to be received
by redemption of a Zero-Bond in five years?
V5 = 100 mn € = V0 ∗ (1 + r )
5
100 mn €
V0 =
(1 + r ) 5
r = 5% r = 10% r = 15%
Alexander Groh 8
Perpetuities and Multiples
Alexander Groh 9
Example
Calculate the Net Present Value of a 10 mn € Perpetuity !!!
CF 10 mn €
V0 = = = 10 mn € ∗ Multiple
r r
V0 = 200 mn € V0 = 100 mn € V0 = 67 mn €
Alexander Groh 10
Growing Perpetuities
Imagine a Perpetuity that grows every year at a constant
growth rate g
CF1 CF2 CF3 CF∞
V0 = + + + +
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) ∞
CF1 = CF0 ∗ (1 + g)
CF2 = CF1 ∗ (1 + g) = CF0 ∗ (1 + g) 2
Alexander Groh 11
Growing Perpetuities
V0 = + + ++
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) ∞
1+ g Multiple of a
V0 = CF ∗
r −g Growing Perpetuity
Alexander Groh 12
Growing Perpetuity Multiples
1+ g
Multiple of a Growing Perpetuity =
r−g
r = 15%
g = 5% g = 7% g = 10%
Alexander Groh 13
The Principle Valuation Tasks
Alexander Groh 14
Discount Rates
Alexander Groh 15
Cost of Capital
Remind the Interest
C-Class Tax Shield
B-Class Cost
Entity Debt of Weighted
Value, Debt Average
Paid to Senior Cost
Seller of
Pref. Cost Capital
Equity of (WACC)
Common Equity
Alexander Groh 16
Cost of Debt
flat Yield-Structure
„normal“ Yield-Structure
Maturity T
Alexander Groh 17
Credit Spread-Term Structure
10,00%
1,00%
Added
Spreads
0,10%
0,01%
17 19
11 13 15 B Rating
5 7 9
1 3 A
Maturity AAA
Alexander Groh 18
Tax Shield of Debt
Company Newco
all Equity
financed Assets Equity
Tax
(on PBT)
PBT = EBIT
PAT
Alexander Groh 19
Tax Shield of Debt
Newco
Debt finance included
Equity
Assets
Debt
Interest
Tax Savings =
Tax
(on PBT)
EBIT Interest X Corporate Tax Rate
PBT
PAT
Alexander Groh 20
Leverage and Tax Shield
Newco Newco
Equity
Assets Equity Assets
Debt
PAT Equity
PAT Equity
Alexander Groh 21
Cost of Equity
• Academics estimate Cost of Equity with Capital Market Models
– CAPM (Capital Asset Pricing Model)
– APT (Arbitrage Pricing Theory)
• Models can surely help to find benchmarks !
• To use the models correctly you will need many information, calculations and
experience !
– Betas
– Return of Market Portfolio
• Models are sensitive to time horizon and basis-effects !
• We are valuing non quoted companies generally !
• It is questionable to find Equity Costs for Private Equity Investments by
models that assume fully diversified portfolios and perfect markets !
Alexander Groh 22
Multiples and Hurdle Rates
• We often use Multiples and Hurdle Rates
Operating
Costs
Depre-
ciations
PAT PE Investor
Alexander Groh 23
Multiples and Hurdle Rates
• P/E Ratio
Interest Banks
Tax State
Alexander Groh 24
Multiples and Hurdle Rates
• EBIT Multiple
Interest Banks
Alexander Groh 25
Multiples and Hurdle Rates
• EBITDA Multiple
Depre-
ciations
Interest Banks
EBITDA X EBITDA Multiple
EBIT Tax State
Results in
PAT PE Investor “Entity Value”
Tax State
Alexander Groh 27
Cash Flow Definition and
Investments for Growth
Operating
Costs
Depre-
ciations
Net
Sales Investments
+
„Corrections“
Core
Activities
EBITDA
EBIT Cash
Flow
(generated by
the Company)
Alexander Groh 28
Free Cash Flow Definition
Tax
(as if the
company
had no
Cash debt)
Flow
(generated by
the Company) Free
Could flow to the Investors
Cash
if the company had no debt!!!
Flow
Alexander Groh 29
Entity vs. Equity Valuation
Equity-
Value
Entity-
=
Value Value
of
Net Debt
Alexander Groh 30
Cash Flow Definitions
Tax Tax Tax
(as if the (real (real
company
payment) payment)
had no
Cash debt) Cash Cash
Flow Flow Cash Flow Interest
(generated by (generated by (generated by
the Company) Free the Company) Flow for the Company)
Cash Debt
Flow Service Cash
Flow for
Redemption
Alexander Groh
Linking FCF and
PE Cost of Capital
Alexander Groh 32
PE Cost of Capital
D E E
Newco WACC = (1 − τ) ∗ r ∗ + r ∗ D
V V
Equity
Hurdle Cost
Rate Debt/ of
(constant) Equity Tax Rate Debt WACC
Assets 30% 1 40% 8% 17%
Debt 30% 2 40% 8% 13%
30% 3 40% 9% 12%
30% 4 40% 10% 11%
30% 5 40% 11% 11%
30% 6 40% 12% 10%
30% 7 40% 13% 11%
30% 8 40% 14% 11%
Alexander Groh 33
Return Determinants of Private
Equity Investments
Market Value Added
Debt
Debt
Debt
Entity Debt
Debt
Value,
Deleverage
Paid to Equity
Equity
Seller Equity
Equity Equity
Year 0 Transaction 1 2 3 4
Structure
Alexander Groh 34
Changing Cost of Capital
Debt
Entity Debt
Debt WACC
Value, is not
Paid to Constant!!!
Seller Equity
Equity Equity
Year 0 Transaction 1 2
Structure
Alexander Groh 35
Changing Cost of Capital
Alexander Groh 36
Debt Capacity
Alexander Groh 37
Equivalent Multiples
Alexander Groh 38
Modelling a Corporation´s
Free Cash Flows
16
14
mn €
12
10
8 12
15 15 15 15 ...
6 10
4
2
0
2009 2010 2011 2012 2013 2014
Year
Alexander Groh 39
Duplicating a Corporation´s
Free Cash Flows
Present Value = Present Value of Variable Cash Flows +
Present Value of Perpetuity
10 mn € 12 mn € 1 15 mn €
V0 = + + ∗
(1 + r ) (1 + r ) 2
(1 + r ) 2
r
r = 5% r = 10% r = 15%
NPV(Perp.) = 272 mn € NPV(Perp.) = 124 mn € NPV(Perp.) = 76 mn €
V0 = 293 mn € V0 = 143 mn € V0 = 93 mn €
Alexander Groh 40
Using an Average of
Free Cash Flows ???
10 mn € + 12 mn € + 15 mn €
3 12,33 mn €
V0Average = = = 123,3 mn €
r 0,1
V0Average 123,3
= = 86%
V0 143
Alexander Groh 41
Modelling Free Cash Flows
• Modelling the Free Cash Flows is the only way to come to a
fair bid:
– Analyze historical performance first !!!
– Calculate Key Value Drivers
– Understand strategic position
– Develop performance scenarios
– Forecast individual line items
– Check overall forecast for reasonableness
Alexander Groh 42
Calculate Key Value Drivers
• Use (part of the) ROIC-tree for example:
Operating Margin
= (EBIT/Revenues)
= 1- (...)
Depreciation Selling, General and
Cost of Goods Sold/
Revenues + Expenses/
Revenues
+ Administrative
Expenses/Revenues
Alexander Groh 43
Develop Performance Scenarios
• Get as many research reports as possible !
• Read the businessplan critically !
• Get information from consultants, market researchers,
competitors and professionals !
• Perform best-, worst- and most likely scenarios !
– Perform sensitivity analysis !
– Interpret the result of different scenarios and sensitivity analysis
carefully !
• Discuss possible scenarios in your management team !
Alexander Groh 44
Get Help by
Mathematical Tools
2005 2006 2007 2008 2009
Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate
Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues
SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)
Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)
EBIT 14,00 14,89 15,34 15,80 16,28
Alexander Groh 45
Get Help by
Mathematical Tools
Play with the assumptions
for sensitivity analysis !!!
Alexander Groh 46
Simulation of Possible Scenarios
Forecast: Revenues 2004
1.000 Trials Frequency Chart 4 Outliers
,030 30
,023 22,5
,015 15
,008 7,5
Mean = 112,65
,000 0
100,00 106,25 112,50 118,75 125,00
Euro
,023 22,5
,015 15
,008 7,5
Mean = 60,31
,000 0
52,50 56,25 60,00 63,75 67,50
Euro
Alexander Groh 47
Simulated EBIT
Forecast: Ebit 2001
1.000 Trials Frequency ChartEbit 2002
Forecast: 0 Outliers
,029 29
1.000 Trials Frequency Chart
Forecast: Ebit 2003 0 Outliers
,025 25
1.000 Trials Frequency Chart 0 Outliers
,022 21,75 Forecast: EBIT 2004
,025 25
,019 18,75
,015 1.000 Trials 14,5 Frequency Chart 0 Outliers
,019 18,75
,013 ,021 12,5 21
,007 7,25
,013 12,5
,006 6,25
,000 0
,006 6,25
12,00
,000
13,25 ,016 14,50 15,75 17,00
0 15,75
Euro
12,00 13,50 15,00 16,50 18,00
,000 0
Euro
12,00 13,75 15,50 17,25 19,00
Euro
,011 10,5
,005 5,25
Mean = 16,29
,000 0
12,00 14,00 16,00 18,00 20,00
Certainty is 80,80% from 15,01 to +Infinity Euro
Alexander Groh 48
Calculating FCFs
and Entity Values
2005 2006 2007 2008 2009
Revenues 100,00 103,01 106,11 109,30 112,59 3% est. Annual Growth Rate
Cost of Goods Sold 54,00 55,15 56,81 58,52 60,28 54% est. COGS/Revenues
SGA Expenses 3,00 3,09 3,18 3,28 3,38 3% SGA/Revenues (constant)
Depreciation Expenses 29,00 29,87 30,77 31,70 32,65 29% Dep./Revenues (constant)
EBIT 14,00 14,89 15,34 15,80 16,28
Taxes on EBIT 5,60 5,96 6,14 6,32 6,51 40% assumed marginal Tax Rate
Operating Cash Flow 8,40 8,93 9,20 9,48 9,77
Net Investments 2,00 2,06 2,12 2,19 2,25 3% est. Growth Rate
Free Cash Flow 6,40 6,87 7,08 7,30 7,51
Net Present Values 5,98 5,35 4,80 32,94 15% Discount Rate
Alexander Groh 49
Possible Bidding Range
Forecast: Entity Value
1.000 Trials Frequency Chart 0 Outliers
,084 84
,063 63
,042 42
,021 21
Mean = 49,10
,000 0
35,00 41,88 48,75 55,63 62,50
Certainty is 50,40% from 44,84 to 52,48 Euro
Alexander Groh 50
Putting All Together !!!
Formulate your bid !!!
Use your Valuation-Spreadsheet
Alexander Groh 51