Chapter 2 financial management

Financial accounting i (Arba Minch University)

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 CHAPTER-TWO

CORPORATE

VALUATION

2.1 Introduction

A business valuation is a general process of determining the economic value of a

whole business or company unit. Business valuation can be used to determine the fair
value of a business for a variety of reasons, including sale value, establishing partner
ownership, taxation, and even divorce proceedings. Corporation valuation is a process
and a set of procedures used to estimate the economic value of an owner's interest
in a business. Valuation is used by financial market participants to determine the price
they are willing to pay or receive to perfect the sale of a business.

What Is Corporate Valuation About?

When we discuss the valuation of a company, we may be referring to any of the
following:

Enterprise value: Valuing the company’s productive activities.

Equity: Valuing the shares of a company, whether for the purpose of buying or selling a
single share or valuing all of the equity for purposes of a corporate acquisition.

Debt: Valuing the company’s debt. When debt is risky, its value depends on the value
of the company that has issued the debt.

Other: We may want to value other securities related to the company—for example, the
firm’s warrants or options, employee stock options, etc.

2.2 Four Methods to Compute Enterprise Value (EV)

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The key concept in corporate valuation is enterprise value. The enterprise value (EV) of
the firm is the value of the firm’s core business activities and forms the basis of most
corporate valuation models. We distinguish between four approaches to computing the
enterprise value:

1. The accounting approach to EV moves items on the balance sheet so that all
operating items are on the left-hand side of the balance sheet and all financial
items are on the right-hand side. Although most academics sneer at this
approach, it is often a useful starting point for thinking about the enterprise
value.
2. The efficient markets approach to EV revalues—to the extent possible—
items on the accounting EV balance sheet at market values. An obvious
revaluation is to replace the firm’s book value of equity with the market value of
the equity. To the extent that we know the market value of other firm liabilities
— debt, pension obligations, etc.—this market value will also replace the book
values.
3. The discounted cash flow (DCF) approach values the EV as the present value
of the firm’s future anticipated free cash flows (FCFs) discounted at the
weighted average cost of capital (WACC). The FCFs can best be thought of as
the cash flows produced by the firm’s productive assets—its working capital,
fixed assets, goodwill, etc.
In this chapter we use two implementations of the DCF approach. These
approaches differ in their derivation of the firm’s free cash flows.
4. DCF with two Methods;-
4.1 DCF future anticipated FCFs on an analysis of the firm’s consolidated
statement of cash flows.
4.2 DCF future anticipated FCFs on a pro forma model for the firm’s financial
statements.

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2.3 Using Accounting Book Values to Value a Company: The Firm’s Accounting
Enterprise Value

While we would rarely use accounting numbers to value a company, the balance sheet
of a company is a useful starting framework for the valuation process. In this section
we show how accounting statements can help us define the concept of enterprise value
(EV). As a starting point, consider the balance sheet for XYZ Corp.:

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 A B C D E
1 XYZ CORP BALANCE SHEET
2 Assets Liabilities and equity
3 Short-term assets Short-term liabilities
4 Cash 1,000 Accounts payable 1,500
5 Marketable securities 1,500 Taxes payable 200
6 Inventories 1,500 Current portion of long- 1,000
term debt
7 Accounts receivable 3,000 Short-term debt 500
8
9 Fixed assets Long-term debt 1,500
10 Land 150 Pension liabilities 800
PPE at cost
11 2,500
12 Minus accumulated -700 Preferred stock 200
depreciation
13 Net fixed assets 1950 Minority interest 100
14
15 Equity
16 Goodwill 1,000 Stock at par 1,000
17 Accumulated retained 3,500
earnings
18 Stock repurchases -350
19 Total assets 9,950 Total liabilities 9,950
and
equity

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We rewrite this balance sheet:

• We separate the operational versus financial items in short-term assets and

short-term liabilities.

• We move the operational current assets to the left side of the balance sheet.

• We move all the debt (short-term debt, current portion of long-term debt, and
long-term) into one debt item.

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 XYZ BALANCE SHEET
Operational current liabilities moved to left side All financial
liabilities in one account on right side

2
Assets Liabilities and
equity
Liquid assets (cash
2,500 Financial debt
marketable
securities)
Current portion of
long- 1,000
term debt
Current assets, Short-term debt 500
operational
Inventories 1,500 Long-term debt
1,500
Accounts receivable
3,000 Total financial
3,000
debt
Minus, current liabilities,
operational
Accounts payable -1,500
10 Taxes payable 200 Pension 800
liabilities
11 Net working
2,800 <--
capital =SUM(B6:B1 0)

12 Preferred stock 200

13Fixed assets 1,950 Minority interest
100
14
15Goodwill 1,000 Equity 4,150
16
Left-hand side 8,250
of <-- Right-hand side8,250 <--
rewritten =B11+B13+B =E7+E10+SUM( E1
17 balance sheet 15+SUM of 2:E15)
(B3:B4) rewritten
balance
sheet
In the next step we subtract liquid assets (cash and marketable securities) from financial
debts, to get the firm’s net financial debt. When we finish this step, we have all of the
firm’s productive assets on the left side of the balance sheet and all of its financing on
the right side. The left-hand side of the resulting balance sheet is the firm’s enterprise

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value, defined as the value of the firm’s operational assets: These are the assets that
provide the cash flows for the firm’s actual business activities:

A B C D E F
1 XYZ ENTERPRISE VALUE BALANCE SHEET
2 Assets Liabilities and
equity
3 Net working 2,800 Total financial 3,000
capital debt
4 Minus liquid -2,500
assets
5 Fixed assets 1,950 Net debt 500
6
7 Goodwill 1,000 Pension 800
liabilities
8
9 Preferred stock 200
1 Minority 100
0 interest
1
1
1 Equity 4,150
2
1
3
1 Enterprise 5,750 <-- Enterprise 5,750 <--
4 value =B3+B5+ value =E5+E7+SUM(E
B7 9:E12)

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 Caterpillar Corporation2

To show the rewriting of the balance sheet in practice, here is the 31 December
2011 balance sheet for Caterpillar Corp. (CAT):

CATERPILLAR CORP.,
BALANCE SHEET 31 December 2011
Current assets Current liabilities
Cash and cash 3,057,000 Accounts payable 16,946,000
equivalents
Short-term investments Short-term debt 9,648,000
Net receivables 19,533,000 Other current1,967,000
liabilities
Inventory 14,544,000 Total current28,561,000
liabilities
Other current assets 994,000
Total current assets 38,128,000 Long-term debt 24,944,000
Other liabilities 14,539,000
Long-term investments 13,211,000
Property, plant, and
equipment 14,395,000 Minority interest 46,000
(net)
Goodwill 7,080,000 Total liabilities 68,090,000
Intangible assets 4,368,000
Other assets 2,107,000 Stocks, options,473,000
warrants
Deferred long-term asset 2,157,000 Common stock 4,273,000
charges
Retained earnings 25,219,000
Treasury stock -10,281,000
Other stockholder -6,328,000
equity
Total equity 13,356,000
Total assets 81,446,000 Total equity and81,446,000
liabilities
To get to the enterprise value balance sheet for Caterpillar, we move financial
items from the left side of the balance sheet to the right, and we move

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 operating current liabilities from the right side of the balance sheet to the left.
Notice that we netted out liquid assets (cash and marketable securities) from
the financial debts of the company. The assumption is that these assets are not
needed for the core business activities of Caterpillar. The book value of
Caterpillar’s enterprise value is $59,476,000:

A B C D E F
CATERPILLAR CORP., 2011 ENTERPRISE VALUE
1 BALANCE SHEET
Book values
Net working capital 16,158,000 <-- Net financial31,535, <--
debt 000
=195330 =9648000+2494400
00+1454 0-
4000+99 3057000
4000-
1694600
0-
2 1967000
3 Long-term 13,211,000 Other 14,539,
investments liabilities 000
4 Property, plant, and 14,395,000
equipment
5 Goodwill 7,080,000 Minority 46,000
interest
6 Intangible assets 4,368,000
7 Other assets 2,107,000 Equity 13,356,
000
8 Deferred long-term 2,157,000
asset charges
9 Enterprise value 59,476,000 <-- Enterprise 59,476, <-- =SUM(E2:E7)
=SUM( value 000
B2:B8)

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2.4 The Efficient Markets Approach to Corporate Valuation

The Caterpillar example above assumes that the book value is a correct valuation of the
company. But a simple calculation shows how problematic this is: At the end of 2011
Caterpillar had 624.72 million shares outstanding, and the market price per share was
$90.60. This suggests that the Caterpillar’s enterprise value is $102.720 billion—a far
cry from the book value of the enterprise value of $59.476 billion.

The efficient markets approach to the valuation of Caterpillar’s equity and financial
liabilities assumes that the market value of a company’s shares or debt is simply the
market value at the time of valuation. Moreover, it has the power of logic and much
academic research behind it.

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If markets work—in the sense that there are many participants trading the corporate
securities, that there is a lot of information about the company in question, and that the
valuator has no special information—why not accept the market price as the true value
of the company?

➢ Applying the efficient markets approach to the Caterpillar Enterprise Value

Balance sheet gives 102,719,878 for the right-hand side of the enterprise value
balance sheet. This means, of course, that we have to revalue the left-hand side
of the balance sheet. One approach to bringing this enterprise value balance
sheet into balance is to assume that the networking capital’s book value is a
reasonable approximation to its market value. We can then re compute the
market value of the firm’s long-term assets to bring the balance sheet into
balance.

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We have to be careful: Market prices change over time, often precipitously. The
efficient markets hypothesis only says that it is impossible to predict market prices
beyond the information compounded into current market information.

➢ Note that we could also apply the market valuation to other components of the
right-hand side of the balance sheet—we could try to revalue the firm’s financial
obligations, its other liabilities, and minority interest. This is usually not done,
unless there is a convincing case that the book values for these liabilities differ
materially from their market value.

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 2.5 Enterprise Value (EV) as the Present Value of the Free Cash Flows: DCF “Top
Down” Valuation

In the previous section we valued the EV by using the market value of the right-hand
side of the firm’s enterprise value balance sheet—using the market value of its equity
and perhaps the market valuation of other elements of the firm’s financing. In this
section we concentrate on the left-hand side of the enterprise value balance sheet.

✓ The discounted cash flow (DCF) method focuses on two central concepts:

1. The firm’s free cash flows (FCFs) are defined as the cash created by
the firm’s operating activities.

2. The firm’s weighted average cost of capital (WACC) is the risk-

adjusted discount rate appropriate to the risk of the FCFs

The firm’s enterprise value (EV) is the present value of the future FCFs discounted
at the WACC:

The idea is to value a company by considering the present value of the FCFs, where FCF
is defined as the cash flow to the firm from its assets (the word assets is used broadly,
and can be fixed assets, intellectual and trademark assets, and net working capital).

In these chapters we often make two additional assumptions: We assume a limited number
of predictive periods for the FCFs and we assume that cash flows occur throughout the
year. The assumption that, for valuation purposes, cash flows occur approximately in
mid-year is meant to capture the fact that most corporate cash flows

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occur throughout the year and that it is therefore a mistake to value them as if they
occur at year-end.

Defining the Free Cash Flow (FCF)

The free cash flow (FCF) is a measure of how much cash is produced by the firm’s
operations. There are two accepted definitions of the FCF (both of which, of course,
ultimately boil down to the same thing).

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 Free Cash Flow Based on the Income Statement
Profit after taxes This is the basic measure of the profitability of the business, but
it is an accounting measure that includes financing flows (such
as interest), as well as non-cash expenses such as depreciation.
Profit after taxes does not account for either changes in the
firm’s working capital or purchases of new fixed assets, both of
which can be important cash drains on the firm.
+ Depreciation and Depreciation is a non-cash expense that in the FCF calculation is
other non-cash added back to the profit after tax. To the extent that there are
expenses other non-cash expenses in the firm’s income statement, these
are also added back.
– Increase in When the firm’s sales increase, more investment is needed in
operating current inventories, accounts receivable, etc. This increase in current
assets assets is not an expense for tax purposes (and is therefore ignored
in the profit after taxes), but it is a cash drain on the company.
When adjusting the FCF for current assets, we take care to not
include financial current assets that are not directly related to
sales such as cash and marketable securities.
+ Increase in An increase in the sales often causes an increase in financing
operating current related to sales (such as accounts payable or taxes payable). This
liabilities increase in current liabilities—when related to sales— provides
cash to the firm. Since it is directly related to sales, we include
this cash in the free cash flow calculations. When adjusting the
FCF for current liabilities, we take care to not include financial
current liabilities that are not directly related to sales: changes in
short-term debt and the current portion of long-term debt being

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 the most prominent examples.
– Increase in An increase in fixed assets (the long-term productive assets of the
fixed assets company) is a use of cash, which reduces the firm’s free cash
at flow
cost (CAPEX)
+ After-tax FCF is an attempt to measure the cash produced by the business
interest activity of the firm. To neutralize the effect of interest payments
payments (net) on the firm’s profits, we:
• Add back the after-tax cost of interest on debt (after-tax since
interest payments are tax-deductible),
• Subtract out the after-tax interest payments on cash and
marketable securities.

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 An alternative, equivalent, definition is based on the firm’s earnings before
income and taxes:

Free Cash Flow Based on the EBIT (earnings before interest and
taxes)

EBI
T

+ Depreciation and other

non-cash expenses
– Increase in Operating Current Assets The sum –ΔCA + ΔCL is the change in
the

+ Increase in Operating firm’s net working capital ΔNWC

Current Liabilities
– Increase in fixed assets at
cost (CAPEX)

How Can We Predict Future FCFs?

The most critical aspect in valuing a company is to project its anticipated future free
cash flows. In this chapter we explore two ways of deriving these cash flows. Both
methods are primarily based on accounting data. Since accounting data is historical
data, we need to add some judgment about how this data will develop in the future.

1. One method is to base our estimates of future free cash flows on the
consolidated statement of cash flows (CSCF) of the firm
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 2. The second method is to estimate a set of pro forma financial statements for the
firm and to derive the free cash flows from these statements
A. Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
The consolidated statement of cash flows is part of every financial statement. It is the
accountant’s explanation of how much cash was generated by the business, and how this
cash was generated. The consolidated statement of cash flows (CSCF) is composed of
three sections: Operating cash flows, investment cash flows, and financing cash flows.

A.1 SCF, Section 1: Operating Cash Flows

The operating cash flows adjust the firm’s net income for non-cash deductions to the
income and for changes in the firm’s operating net working capital. Because modern
accounting statements include many non-cash items, translating the firm’s accounts to a
cash basis necessitates many adjustments.

A classic adjustment is to add back depreciation to the firm’s income: Since depreciation is
a non-cash charge on the firm’s income, it must be added back when making the
adjustment for cash. But depreciation is just the tip of the non-cash iceberg:

When firms issue stock options to employees, the value of these options is deducted from
the firm’s income. The logic behind this—that in giving its employees options, the firm
has given them something of value which must be accounted for in its income statement
—is impeccable. But the actual charge for options is a non-cash deduction, and in the
consolidated statement of cash flows, it is added back.

A firm’s income statements must reflect the decrease in goodwill (so-called “impairment”).
This impairment—the loss in economic value of an intangible asset that was purchased
by the firm—is an economic loss to the firm’s share- holders. But it is not a cash flow
loss, and in the consolidated statement of cash flows it is added back.

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SCF, Section 2: Investment Cash Flows

The second section of the CSCF includes all investments made by the firm. These
investments include both investments in securities and investments in operating assets
of the firm.

✓ Investment in securities can refer to the sale or the purchase of securities held by
the firm. Investment in securities is not part of the firm’s free cash flows, which
are intended to measure solely cash flows related to the firm’s core business
activities. Investments in fixed assets are usually related to the firm’s FCFs.
For purposes of computing the firm’s free cash flows, we need to distinguish between
financial investment cash flows (not part of the FCF) and investment in assets used to
produce the firm’s business income (part of the FCF).

SCF, Section 3: Financing Cash Flows

The last section of the CSCF deals with changes in the firm’s financing. For FCF
purposes, we can ignore this section.

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 2.7 ABC Corp., Consolidated Statement of Cash Flows (CSCF)
Five years of the consolidated statement of cash flows of ABC Corp. are given below:

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 To turn these CSCF into free cash flows:
✓ We keep all the items under operating activities.
✓ In the section for Investing Activities, we delete items that are not related to
operations. For example, we would delete “short-term investments, net” under
Investing Activities—these represent the purchase and sale of financial assets.
✓ We completely ignore the cash flows under Financing Activities
✓ We add back after-tax net interest to the sum of the remaining items to neutralize
the subtraction of interest from the net income.

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 2.6 Free Cash Flows Based on Pro Forma Financial Statements

Another way to project free cash flows is to build a set of predictive financial statements
based on our understanding of the company and its financial statements. A typical
model might look like the following:

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/

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Valuation

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