Advanced Valuation Lecture 1

Question 1

What are the key drivers of value?

Answer 1

1. Growth: reinvestment rate, RONIC, inflation
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2. Spread in business return (ROIC, RONIC, ROE, CFROI) versus required return (WACC, CoC, CoE)
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   If ROIC < WACC , growth destroys value
   If ROIC > WACC, growth adds value

Question 2

What are the items of the restructured balance sheet?

Answer 2

1. Operating fixed assets
2. Operating NWC
3. Operating liabilities
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4. Non-operating assets
5. Non-operating liabilities
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6. Financial liabilities
7. Equity

Question 3

Why are transaction multiples higher than trading multiples? What does it consist of? What’s a problem of transaction multiple?

Answer 3

Due to the acquisition premium paid in an M&A deal. It consists of 2 things:
1. Control
2. Synergies
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Problem with transaction multiples: Winner’s Curse > bidder might have overpaid.

Question 4

Valuation context determines the valuation method used…

Answer 4

• DCF: you implicitly assume you control the FCFs = control perspective
• For a minority stake valuation –> use Dividend Discount Model
• FCFE is what you could payout versus what you do pay out (DDM). Use FCFE to value financial institutions
• If EV < nominal value of the debt, the ordinary shares are OTM –> use option pricing technique to value the shares
• Use accounting based valuation when the company is distressed. There’s a difference between going-concern value and liquidation value. In case of liquidation, intangible assets (e.g., customer relationships) disappear.

Question 5

When cleaning the historical financials, you adjust for certain items…

Answer 5

1. Nonrecurring items
2. Pro-forma adjustments: for example the impact of an acquisition, changes in accounting policy
3. Accounting adjustments: for example expensing R&D and marketing costs, off-balance sheet items, netting of capitalised financing fees from gross debt
4. Management adjustments

Question 6

How do you account for lease adjustments?

Answer 6

• Rent expense = 500 x multiple of 8x = 4,000
• Add 4,00 to PPE and Lease liabilities

Break 500 up in:
- depr = 300
- interest = 4,000 x cost of borrowing of 5% = 200

Rent = op. expense so EBITDA goes up with 500
Depr goes up with 300
EBIT goes up with 200
Interest goes up with 200
EBT remains UNCHANGED!!

Question 7

Formula for ROIC

Answer 7

EBIT * (1 - tax rate) / avg(op. cap. previous period ; op. cap. current period)

Question 8

Dupont ROIC formula. Discuss the impact of high/low asset heaviness

Answer 8

ROIC = EBIT/revenues x (1-tax rate) x revenues/avg. op. capital

1st term = ROS
2nd term = op. taxes
3rd term = op. asset turnover ( = asset utilisation)
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asset heavy industries: high ROS, low asset turnover
asset light industries: low ROS, high asset turnover

Question 9

Explain what ROIC incl and excl goodwill measures

Answer 9

Excluding goodwill: measuring operating performance
Including goodwill: measuring operating performance + EFFECTIVENESS OF INORGANIC GROWTH

Question 10

What are the challenges with ROIC?

Answer 10

1. difficult to apply in asset light industries
2. subject to other accounting conventions, such as capitalising R&D costs
3. subject to aging of the asset base

Question 11

Propose a solution to the challenge of ROIC in assets light industries

Answer 11

ROIC in asset light industries can be challenging:
- very high ROIC as the firm has limited op. cap. but is profitable
- negative ROIC if op. cap. is negative while firm is highly profitable
- very volatile ROIC as low op. cap. can be volatile due to swings in working capital.
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Asset light industries rely on internally generated intangibles that are not capitalised on the BS under GAAP. Examples: R&D, client acquisition costs, brand building costs, training & development costs.
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Solutions:
- create pro forma financial statements by capitalising expenses
- abandon ROIC concept and express value creation not in Op. Cap., but use another scaling factor such as Sales / no. of employees
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Economic profit / Sales = (NOPAT - WACC x OC) / Sales
Economic profit / no. employees = (NOPAT - WACC x OC) / no. of employees

Question 12

What is a solution for the ROIC challenges?

Answer 12

Use CFROI:
= sustainable op. CF / gross asset base (incl. working capital)
= NOPAT + depr&amort - maintenance Capex / gross asset base (incl. working capital)
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where gross asset base is based on historical cost and adjusted for inflation

Question 13

general comment: the basis for forecasting is industry and strategic analysis. By combining industry specific factors and firm specific factors, you can build a forecast story line

Answer 13

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Question 14

What are the forecasting methodologies? And when do you use each one?

Answer 14

1. Top-down: start with demand and TAM etc. and work down to firm specific drivers
2. Bottom-up: start with firm capacities and work your way up (favourable)
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   Use 1 if the business is very scalable. Use 2 if the industry/business is very capacity driven

Question 15

How do you decide on how long the explicit forecast period should be?

Answer 15

The planning period should be long enough so that the business will have reached a steady state = constant growth, constant RONIC, constant reinvestment rates).
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10Y is recommendation

Question 16

What is a DTA?

Answer 16

If you make losses, you can compensate it with profits from previous year (only 1Y carry-back) or future profits. If the los is $100 and the tax rate is 25%, then DTA = $25. It is typically non-operating, but could also be classified as operating!!!

Question 17

Why would you include goodwill in operating capital?

Answer 17

If you do acquisitions and you pay goodwill, you want to include it in operating capital, as you will be able to calculate if it makes a return yes or no (ROIC).

Question 18

Do you include derivatives as operating or non-operating?

Answer 18

Depends. look at what exposure is being hedged. If you hedge operating risk, it is an operating asset. If you hedge financial risk, then it is non-operating.

Question 19

How does a DTL arise?

Answer 19

due to a timing mismatch in depreciation for tax purposes and reporting purposes. Typically it’s related to operating items (like PPE). The DTL is the difference in the cash tax (e.g., accelerated depr) and the tax expense from the income statement (e.g., straight-line depr).
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however, this is temporary, since cumulative you depreciate the same amount, so the net cash effect at the end of the period is the same.

Question 20

Why do you calculate taxes over EBIT?

Answer 20

Normally you would calculate taxes over EBT. But, the WACC already includes the financing effects (1-tax rate)!!!!
Therefore, the FCF you calculate are on an UNLEVERED BASIS!!!

Question 21

Why do you treat JV as non-operating?

Answer 21

if you receive dividends and you include that in the FCF, you discount it with the WACC which is not the appropriate discount rate. You should discount it with CoE.

Question 22

If you want to grow your EBITDA, how do you do that?

Answer 22

Capitalise as much as possible. If you capitalise it, you have to amortise it, which falls below EBITDA. Otherwise, it would be an operating expense which falls above EBITDA. So, there’s a tradeoff between IS and BS. This makes comparison also hard between companies that capitalise and those that don’t. As a solution, look at EBIT.
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Another way is to use provisions. In the first year, increase provisions which suppresses EBITDA. After couple of years, you release it which increases EBITDA. Solution: compute EBITDA + ∆provisions –> creates a normalised EBITDA.

Question 23

How do you break down CAPEX?

Answer 23

1. Maintenance Capex. If main.capex/depr. < 1, this means that you’re underinvesting in the business, and not replacing assets properly
2. Expansion Capex.
3. Corporate Capex = new HQ, forecast as % of sales.

Question 24

How do you calculate effective tax rate?

Answer 24

Effective tax rate = tax expense / profit before taxes
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effective < statutory = due to tax credits and incentives
effective > statutory = due to non-deductible expenses, like speeding fines. End up in IS, but doesn’t lower your taxable profit.

Question 25

Inflation and forecasting

Answer 25

For countries with low inflation, forecast everything in nominal terms. For countries with hyper inflation, convert everything to $ using historical spot rates and then do the forecasting.
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Due to the PPP, you can use the inflation of the home country even though other countries have a different inflation rate. Due to the PPP, the higher/lower inflation is offset by a change in the exchange rate, such that the growth abroad is equal to the inflation of the home country => ASSUMING PPP HOLDS
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So if a business operates in Europe, use Europe’s inflation forecast. If it solely operates in Holland, use Dutch inflation forecast.