Company Valuation

In this papers, we describe generally the four main groups comprising the most widely used company valuation methods: balance sheets-based methods, income statements – based methods, mixed methods, and cash flow discounting – based methods. Then we present a real – life example to illustrate the valuation of a company – Biotechnology S. A in different methods. We conclude the paper with some recommendation on valuate Biotechnology. 2. Valuation methods For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite.

This is not only because of the importance of valuation in acquisitions and mergers but also because the process of valuing the company and its business units helps identify source of economic value creation and destruction within the company. The methods for valuing companies can be classified in six groups: MAIN VALUATION METHODS BALANCE INCOME MIXED CASH FLOW VALUE OPTIONS SHEET STATEMENT (GOODWILL) DISCOUNTING CREATION . Book value . Multiples Classic Equity cash flow EVA Black and . Adjusted . PER Union of Dividends Economic Scholes .

Sales Free cash flow Investment value European profit . Liquidation . P/E EBITDA Accounting Capital cash flow Cash value option value . Other Experts APV added Expand . Substantial multiples Abbreviated CFROI the project value income Delay the others investment Alternative uses 2. 1 Balance sheets – Based methods (shareholders’Equity) These methods seek to determine the company’s value by estimating the value of its assets. These are traditionally used methods that consider that a company’s value lies basically in its balance sheet.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

They determine the value from a static viewpoint, which, therefore, does not take into account the company’s possible future evolution or money’s temporary value. Neither do they take into account other factors that also affect the value such as: the industry’s current situation, human resources or organization problems, contracts, etc. that do not appear in the accounting statements. Some of these methods are the following: Book value, adjusted book value, liquidation value, and substantial value 2. Income Statement – Based methods Unlike the balance sheet- based methods, these methods are based on the company’s income statement. They seek to determine the company’s value through the size of its earnings, sales or other indicators. Thus, for example, it is a common practice to perform quick valuations of cement companies by multiplying their annual production capacity in metric tons by a ration (multiple). It is also common to value car parking companies by multiplying annual premiums Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th y a multiple. This category includes the methods based on the PER: according to this method, the share’s price is a multiple of the earnings. – Value of earnings. PER: According to this method, the equity’s value obtained by multiplying the annual net income by a ratio called PER (price earning ratio), that is: Equity value= PER x earnings – Value of the dividends: Dividends are the part of the earnings effectively paid out to the shareholder and, in most cases, are the only regular flow received by shareholders.

According to this method, a share’s value is the net present value of the dividends that we expect to obtain from it. In the perpetuity case, that is, a company form which we expect constant dividends every year, this value can be expressed as follow: Equity value=DPS/Ke Where: DPS – dividend per share distributed by the company in the last year Ke- required return to equity If, on the other hand, the dividend is expected to grow indefinitely at a constant annual rate g, the above formula become the following: Equity value =DPS/(ke-g) Where: DPS is the dividends per share for the next year. Sale multiplies: This valuation method, which is used in some industries with a certain frequency, consists of calculating a company’s value by multiplying its sales by a number. Price/sales=(price/earnings) x (earnings/sales) 2. 3 Goodwill –Based methods Generally speaking, goodwill is the value that a company has above its book value or above the adjusted book value.

Goodwill seeks to represent the value of the company’s intangible assets, which often do not appear on the balance sheet but which contribute an advantage with respect to other companies operating in the industry. 2. 4 Cash flow discounting – Based method These methods seek to determine the company’s value by estimating the cash flow it will generate in the future and discounting them at a discount rate matched to the flows’ risk.

Cash flow discounting methods are based on the detailed, careful forecast, for each period, of each of the financial items related with the generation of the cash flows corresponding to the company’s operation, such as, for example, collection of sales, personnel, raw material,… – General method for cash flow discounting The different cash flow discounting –based methods start with the following expession: V= CF1 + CF2 + CF3+…+ CFn+VRn (1+k) (1+k)2 (1+k)3 (1+k)n Where: Cfi =cash flow generated by the company in the period i Vn = residual value of the company in the year n K =appopriate discount rate for the cash flows’ risk

Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th 3. Investment decision process applied for preparing the long term financial plan of Biotechnology S. A Investment Plan Debt table (use past contract) Depreciation Plan INVESTMENT PLAN PROJECTIONS Criteria to use Potential solutions Information on biotech shares Selection of a solution Income Statement (forecast) Financial needs

Cash Flow Sale forecast Financial analysis (past data) . Liquidity/solvency . Debt capacity . Return for shareholders Valuation of biotech II. Background of Biotechnology S. A 1. Company porfile Year of establishment: 1990 Operation fields: Manufactures and sells instruments for the biotechnological industries Capital: 10 000 000EUR divided into 100 000shares with a face value 100 euro each. Owners: Mr. Vincent-current resident: 60% equivalent to 60 000 shares Other directors of the company: 10% equivalent to 10 000 shares Venture capital organization: 30% equivalent to 30 000 shares Market: France and other foreign countries (mainly in European countries) Customers: Large corporations: LAFARGE, LVMH, BSN… Small industries Research laboratories. Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th

Long term Target: Maintenance of a growth rate of 20 to 30% (for the next 10 years) Development plan: Company will undertake geographical diversification: Europe market (in particular in Germany); American and South Asian Markets. 2. Financial figures and operation results Balance sheet ASSET 1998 1999 Cash 1,700 1,100 Receivables 9,600 13,850 Inventories 8,450 11,050 Other 1,000 1,200 Total current asset 20,750 27,200 Plant&equip 31,952 42,602 Depreciation 3,452 8,852 Net fixed assets 28,500 33,750 Total asset 49,250 60,950 2000 LIABILITIES 2,900 Payables 16,250 Acrues expenses 14,500 St Bank loans 2,150 35,800 Total current liab. 0,032 LT&MT loans 14,752 Equity 45,280 Retained earnings 81080 Liabil&equity (in thousands of Euros) 1998 1999 2000 7000 9000 11500 2,400 4,850 5,250 2,850 4,600 3,330 12,250 18,450 20,080 9,000 13,500 27,500 10,000 10,000 10,000 18,000 19,000 23,500 49,250 60,950 81,080 Income Statement (in thousands of Euros) 1998 1999 2000 63,300 83,000 110,020 17,940 23,500 30,810 45,360 58,500 79,210 34,216 38,150 41,986 11,144 21,350 37,224 2,400 5,950 8,800 8,744 15,400 28,424 2,080 2,500 3,600 6,664 12,900 24,824 1,999 3,870 7,447 4,665 9,030 17,377

Sales COGS Gross margin General & admin expenses Operation income bf depreciation Depreciation Operating income Interest expenses Income bf tax Incometax NI 3. SWOT analysis Strengths: • Solid leadership; • Diversified Customer Base, including some big names (Lafarge, LVMH, BSN); • Weaknesses: Dominant shareholder, reluctance in having new shareholders; Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th • • • • •

Export accounts for 30% of the total sales in 2000 and is moving fast; Company is in high growth situation and this situation will continue for the next 10 years; Company’s ability to increase production capacity without any difficulties; Steep growth in sales, production cost controlling efforts and ability; Financial supports from Banks. Opportunities: • Preparedness of the company in capturing the market opportunities; Low inventory level; Dependent on banks for financial resources; Cash flow is not sufficient. • • • Threads: • • • • • •

High growth sector with very little competition at both local and international market; Expansion of existing exported market (European countries); New exported market (USA, some fast growing Asian Countries); Geographic diversification possibilities. • Multinational companies are considering entering into the field; Technological risks due to rapid technological changes in the field of biotechnology; To maintain technological superiority, heavy investment is required. III. Biotechnology S. A valuation 1. Financial analysis using past data From the balance sheet and income statement of Biotech S.

A, we draw out a general financial picture through the main financial figures as below: (in thousands of Euros) Year Capital Employed Fix assets Working capital Total Net Financial Debt Equity Total Operation Sale Progression Working capital in days of sale Trade Receivable in days of sale Inventory in days of sale Trade Payable in days of sale 1998 28,500 9,650 38,150 10,150 28,000 38,150 1999 33,750 12,250 46,000 17,000 29,000 46,000 31% 53 60 48 39 2000 45,280 16,150 61,430 27,930 33,500 61,430 33% 53 53 47 38 55 55 48 40 Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th

Capital Employed turnover 1. 66 1. 80 1. 79 Margins Gross margin 72% 70% 72% Operating margin 14% 19% 26% Net margin 7% 11% 16% Returns ROCE before taxes 23% 33% 46% effective taxe rate 23% 23% 23% ROCE after tax 18% 26% 36% ROE 17% 31% 52% Debt and Solvency Long + Med term debt/NI+ Dep 127% 90% 105% Gearing (debt/equity) 36% 59% 83% Interest expense/EBITDA 19% 12% 10% Long term + Med term debt/Equity 32% 47% 82% Liquidity Current ratio 1. 69 1. 47 1. 78 Quick ratio 0. 92 0. 81 0. 95 Cash ratio 0. 14 0. 06 0. 14 1. 1 General analysis The above figures shown out that the Biotech S.

A is in quite good situation on business and its financial results. Almost of financial ratios are improving by the time with high percentage, bringing a big benefit for its shareholders. Despite growing competition on the market for biotechnology products, company’s sales have significantly increased by more than 30% over the periods. However, capital employed at the end of 1999 and 2000 are respectively 20% and 30% higher than previous year because the Capital Employed Turnover has slightly decreased from 1,80 in 1999 down to 1,79 in 2000. This is mainly due to the increase in fixed assets investment (+18% in 1999 and + 34% in 2000).

Operating margin and net margin have significantly increased with the average growth rate is about 5% per year. Thanks to high growth rate of net margin, ROCE after tax and return on equity have grown impressively. This is really good performance in the context of managing return for shareholders. During three years (from 1998 to 2000) the company has successfully optimized leverage ratio (gearing). At the end of 2000 the gearing is 0,83 (instead of 0,59 a year before) so that shareholders benefit from a rather strong financial leverage with a return on equity as high as 51. 7% in 2000 and 31. 14% only in 1999. The level of debt may become a concern in the future. The liquidity ratios are acceptable, though not that strong. 1. 2 Specific analysis on the four key financial ratios • Solvency problem • Debt capacity • Return for share holders Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th • 1. 2. 1 Cost of capital in comparison to ROE Solvency problem Solvency ratio (A) = Interest expense EBITDA This ratio must be as low as possible to ensure the solvency of the company.

Two limits reflect solvency situation of a company: If A40%, there will be more than 50% of solvency problem happens in the next 3 years. In Biotechnology case, solvency ratio is always less than 20% during the past three year. It is 19% on the year 1998, 12% on the year 1999, and 10% on the year 2000. This means such ratios are improving from year to year, the company are adjusting its solvency situation follow up in a good direction. Quick Ratio (B) = Cash + Account Receivable Account payable + Accrued expense + Bank loan

This ratio represent the level of cash in & out; if this ratio is equal to 1, that means the company have sufficient cash to run its business. In Biotechnology case, quick ratio is 92% on the year 1998, 80% on the year 1999, and 95% on the year 2000. These figures are nearly equal to 100% and remarkably increased between 1999 and 2000. Though it may leads to some shorten cash issue would happen but it is very good situation if the company continuously keeps at around this level. In practice, optimal of this ratio is 103-105%. For conclusion, solvency of Biotechnology S.

A is in quite good situation. 1. 2. 2 Debt capacity In classic measure using capital structure of company: Debt Equity ratio (D/E) = Long term + Medium term debt Total Equity In theory, it is ideally for the company to have this ratio equal to 1, which they can be used up their resources and enjoy the fair interest borrowing rate. In Biotechnology case, debt equity ratio is 32% on the year 1998, 47% on the year 1999, and 82% on the year 2000. That means in 2000 the company almost used up their debt capacity, only 18% is left or equivalent to EUR6mio.

This shows that debt capacity of company is not sufficient to finance for the investment plan. By cash flow approach, we can measure if the firm can pay the debt or not: Debt capacity = Long term + Medium term debt Cash flow Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th In Biotechnology case, debt capacity in cash flow approach is 127% on the year 1998, 90% on the year 1999, and 105% on the year 2000. According to international practice, a company, which is in good debt payment ability, should reach the 4 years of cash flow in debt capacity.

This means: in 2000: Debt capacity left = (26. 117*4-27. 500)=77. 208 million euro. In short, from the two approach ways of debt capacity, company do not have any problem in cash flow of payment, only needs to modify capital structure or debt equity ratio, debt capacity therefore will be improved. In addition, company should have look on return on investment to ensure that it is higher than cost of debt. Moreover, according to their investment plan, Biotechnology needs EUR55million in year 2001, whereas total equity (equity + retained earning) = EUR33mio and the company has already indebtedness of EUR27. 5mio.

This raise the critical issue that Biotechnology need to structure their debt, base on their resources to have more flexibility in capital utility. 1. 2. 3 Return for shareholders Dividend policy: From the figures on Balance sheet and Income Statement, we have the dividend policy of the company during the past 3 years: (in thousand of euro) Years 1998 1999 2000 Net Income 4,665 9,030 17,377 Dividend 3,665 4,530 5,400 New Retain Earning 1,000 4,500 11,977 Retained earnings end of period 18,000 19,000 23,500 Total R. E in B/S 19,000 23,500 35,477 We see the dividend is increasing regularly during the past 3 years.

It is quite good signal for the shareholders. Payout Ratio: Payout ratio = Dividend Net income 1998 3,665 4,665 79% 1999 4,530 9,030 50% 2000 5,400 17,377 31% Years Dividend Net income Pay out ratio Payout ratio is depended on dividend policy of the company, it has not fully reflected if company is creating value for shareholders or not. Thus, when payout ratio is declining as the above; shareholders must refer to other indicator – that is return on equity (ROE) in comparison to that ratio of market. Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th

Return on Equity or earning for shareholders: ROE = Net income Total Equity Years 1998 1999 2000 Net Income 4,665 9,030 17,377 Total equity 28,000 29,000 33,500 ROE 17% 31% 52% Although payout ratio is declining but return on equity is increasing (from 17-52%). It is understandable and justify that company has kept a certain amount of net income each year as retained earnings (retained earnings is increasing from 28-70%) and reinvest it for operations to obtain benefits. Thus, we can conclude that the company is increasing the value for shareholders. 1. 2. Cost of capital in comparison to ROE Using CAPM to calculate the cost of capital of the company, we have: k = Rf + Beta*{E(Rm)-Rf] Rf: Risk free rate E(Rm)-Rf: market risk premium Beta: volatility Currently (2000), E(Rm)-Rf=6%, with Rf=5,3%, E(Rm)=11,3% Rf is depended on payback period and maturity for 5 years, 10years, or 3 years. This case we choose 5 years. Years 1998 1999 2000 Rf 6. 7% 6. 1% 5. 3% Beta 1. 6 1. 6 1. 6 E(Rm)-Rf 4. 6% 5. 2% 6. 0% K 14. 06% 14. 42% 14. 90% ROE 17% 31% 52% ROE is always higher than k in past 3 years; means investment return is enough to cover cost of capital.

Seemingly, k is nearly unchanged during the years (around 15%), whereas ROE is increasing from 16% up to 52%, hence, shareholders could have been convinced by the good financial performance of the company. Moreover, Biotechnology can form a view of requesting shareholders to issue new shares. In summarize, taking the look at Balance sheet and income statement, it is showing that Biotechnology’s business is in good condition; cash & solvency problem is quite good and company is creating value for the shareholders. However, taking further look on other ratio, we can find several hurdles, such as Debt/Equity ratio or problem on Debt capacity.

Since Where: Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th the company may have to keep investing to develop R& D on fast growing markets, an increase in equity would be welcome. 2. Valuation Process 2. 1 Book value methods Equity Retained Earning New Retain Earning Total book value 2. 2 Market value through accounting 10,000 23,500 11,977 45,477 Market value = book value * market to book value ratio Average market to book value ratio of Biotechnology sector is 5. 3, we suppose that this ratio of Biotechnology is around this figure: 5. 3. Therefore, market value = 45,477*5. 3 = 241,028 2. Market value through PER Market value = PER * Net earnings Average PER ratio of Biotechnology sector is 12. 5, we suppose that this ratio of Biotechnology is around this figure: 12. 5.

Therefore, market value = 12. 5*17. 377= 217,000 We may average the two market value to determine approximate value of the company as below: Market value of company= (241,028+217,000)/2=229,014 2. 4 Discounted cash flow method Estimate and calculation of company value Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th Investment Plan 2001 1 4 13 14 15 8 1 55 2001 1 4 4 0. 2 42 16. 8 25. 2 16. 8 3. 36 25. 2 8. 5. 9 17. 86 2001 1 1. 00 0. 50 0. 50 0. 50 2. 50 2002 2 4 11 16 15 4 1 51 2002 2 4 8 0. 4 42 16. 8 25. 2 33. 6 6. 72 50. 4 16. 8 3. 5 27. 42 2002 2 1. 00 0. 50 0. 50 0. 50 5. 00 7. 50 2003 3 6 5 8 2 21 2003 3 8 0. 4 19 7. 6 11. 4 41. 2 8. 24 61. 8 20. 6 2. 4 31. 64 2003 3 1. 00 0. 50 0. 50 0. 50 5. 00 7. 50 2004 4 3 6 3 12 2004 4 8 0. 4 9 3. 6 5. 4 44. 8 8. 96 42 14 1. 8 25. 16 2004 4 1. 00 0. 50 0. 50 0. 50 2. 50 2005 5 2 6 3 11 2005 5 8 0. 4 8 3. 2 4. 8 48 9. 6 21. 6 7. 2 0. 3 17. 5 2005 5 1. 00 0. 50 0. 50 0. 50 2. 50 2005 5 227. 5 0. 20 22% 50. 05 17. 5 32. 55 9. 765 22. 785 11 29. 285 154. 248 total 8 35 35 50 12 10 150

Construction Equipment for R&D center Equipment for new Prd unit Equipment for existing unit Equity participate Working capital total Depreciation plan Construction Cal Contruction Basis Depreciation (20 year) Equipment total Ordinary material & equips (40%) Shopiticate Mat (60%) Cal basis prd Depr of Ordinary Mat(20%) Cal shophiticate Mat Depr of Shop Mats(1/3) Depr Past inv Total Depr Debt table LT &MT Loan total 8 36 1. 8 120 48 72 48 36. 88 21. 6 MT Loan Total debt repay Sales plans Sales Growth Margin% Magin – Depreciation Earning Before Taxes Taxes (30%) Net Earning Dividents Retain earning + depr Net Cash Flow

Loan in 1996 Loan in 1997 Loan in 1998 Loan in 1999 Loan in 2000 Tenor Amt 10 10 10 5 10 5 10 5 3 10 Year 2001 2002 2003 2004 1 2 3 4 128. 2 141. 2 157. 95 189. 5 1. 00 0. 10 0. 12 0. 20 30% 26% 24% 22% 38. 46 36. 712 37. 908 41. 69 17. 86 27. 42 31. 64 25. 16 20. 6 9. 292 6. 268 16. 53 6. 18 2. 7876 1. 8804 4. 959 14. 42 6. 5044 4. 3876 11. 571 14 0 0 0 18. 28 33. 9244 36. 0276 36. 731 18. 28 52. 2044 88. 232 124. 963 Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th Income Statement forecast Sales Margin on sales (hypothesis 1) EBITDA –

Depreciation EBIT – Interest of LMD EBT Tax (28%) Net income – Dividends Retained earnings 2001 128. 2 0. 3 38. 46 16. 96 21. 5 2. 63 18. 87 5. 28 13. 58 2 11. 58 2002 141. 2 0. 26 36. 712 28. 92 7. 79 2. 4 5. 39 1. 51 3. 88 3 0. 88 2003 157. 95 0. 24 37. 908 34. 24 3. 67 1. 85 1. 82 0. 51 1. 31 1. 31 2004 189. 5 0. 22 41. 69 28. 36 13. 33 1. 3 12. 03 3. 37 8. 66 8 0. 66 2005 227. 5 0. 22 50. 05 22. 2 27. 85 0. 75 27. 1 7. 59 19. 51 12 7. 51 Earnings before interest and tax (EBIT) Years – Tax paid on EBIT (28%) Net income without debt + Depreciation – increase in fixed asset – increase in WC Free cash flow PV (15%) Value of operations 28% 5% 252. 48 2001 21. 5 6. 02 15. 48 16. 96 46 4. 29 -17. 85 -15. 52 2002 7. 79 2. 18 5. 61 28. 92 46 4. 72 -16. 19 -12. 24 2003 2004 3. 67 13. 33 1. 03 3. 73 2. 64 9. 6 34. 24 28. 36 19 9 5. 19 5. 71 12. 69 23. 25 8. 34 13. 2919 2005 27. 85 7. 8 20. 05 22. 2 8 6. 28 27. 97 13. 91

Free Cash Flow forecast Years OUTFLOWS (1) Debt repayment Investment INFLOWS (2) Net income Depreciation FINANCIAL NEEDS (2-1) Dividends New financial needs New cumulated fianancial needs 2001 2002 2003 2004 2005 57. 5 2. 5 55 30. 54 13. 58 16. 96 -26. 96 2 -28. 96 -28. 96 56. 83 5. 3 51 32. 8 3. 88 28. 92 -24. 03 3 -27. 03 -55. 98 26. 83 5. 83 21 35. 55 1. 31 34. 24 8. 72 0 8. 72 -47. 27 17. 83 5. 83 12 37. 02 8. 66 28. 36 19. 19 8 11. 19 -36. 08 13. 5 2. 5 11 41. 71 19. 51 22. 2 28. 21 12 16. 21 -19. 87 -55. 98 Total amount of financial needs is about 1/4 total value of the firm (V=220. 000 Assignment: Company Valuation Case Study: BioTechnology Student: Tran Ngoc Minh – MEBF 5th From the above estimation and calculation, we found that to implement the investment plan, Biotech has lack of financial needs with the amount of 55. 98 million.

In this situation, Biotech can raise funds by issuing new shares or borrow money from the bank to finance its plan. We raise out 3 cases that biotech can take a consider to maximize its profitability for shareholders. 1. Issuing equity for existing shareholders Outstanding shares 100,000 Book value of company 45,477 Market value before new issuing 240,747 New issue shares(planed) 25,000 issue 1 new share for 4 old New issue price (planed) 2. 24 discount 7% Value of company after new issuing 296,721 Book value after issuing 101,451 Total debt 28,000 Total equity 77,559 36. 10% Debt/equity

Author:

x

Hi!
I'm Eileen!

Would you like to get a custom essay? How about receiving a customized one?

Check it out