Pages: 88

No chapter abstract available.

Pages: 16

This chapter presents an overview of the fair value of a business, the skills required to be an appraiser and some of the qualities that we believe a valuation should contain. Appraiser is a fascinating profession; you need to master several disciplines like economic and financial theories, financial analysis, research, capital asset pricing models to perform good valuation supporting your assumptions with data and facts. When we value a business, we are valuing expectations. The free cash flow is an expectation, the cost of capital is an expectation, and multiples also reflect an expectation on stock prices. Our expectations must be anchorage in analysis, research and data; nevertheless, we must recognize that even we are as objective as possible, there is room for error. The market is not right all the time; that is why the profession of appraiser exists.

Pages: 30

This chapter focuses on financial statements, which are the first document we request when we are hired to perform a valuation. We will use a simplified, step by step example to explain how to calculate the historical free cash flow in a model that integrates the balance sheet, the income statement and the Shareholder’s equity statement. This allows us to analyze the historical performance, which then assists us in designing the set of assumptions that would define the projected financial statements, primarily the forecasted free cash flow. In addition, we will demonstrate how to perform a simple sensitivity analysis with a spreadsheet and how to perform a simple regression analysis to forecast sales. Despite its simplicity, and while we will add more complexity in subsequent chapters, the simplified model outlines the essence of how a professional forecast should be carried out.

Pages: 21

This chapter is devoted to the financial mathematical formulas employed in valuation. We begin with a brief review of the time value of money, followed by an explanation of how arithmetic and geometric mean are calculated, which may be required for estimating the cost of capital. However, in valuation we deal with a stream of cash flow rather than a single cash flow. Therefore, we focus on the value of a stream with different cash flow patterns, ranging from constant cash flow to variable cash flow with finite life to growing perpetuities. For example, the terminal value, which represents an important part of the company value, is often calculated using the growing perpetuity formula. Additionally, we address the present value of a three-stage growth rate, the net present value, and the internal rate of return.

Pages: 13

This chapter introduces the risk-return relationship and describes the key components of the weighted average cost of capital (WACC), which will be used to assess the Greenworth’s fair value in the following chapter. The world of the CAPM model is described including a brief explanation of the risk-free rate, the market risk premium, and the calculation of beta, for the case of public and private companies, which will be covered in further detail in Part 2.

Pages: 7

This chapter covers Greenworth’s valuation using the discounted cash flow method, which is based on the forecasted free cash flow and the cost of capital estimates from Chapter 2 and 4. All of the elements introduced in the previous chapter are combined to determine the fair value of Greenworth. Because we use the free cash flow method, we must use the weighted average cost of capital to avoid tax shield duplications. Finally, we present an introduction to the relative valuation approach and compare the values provided by the two approaches.

Pages: 80

No chapter abstract available.

Pages: 15

This chapter discusses the Modigliani-Miller propositions with and without taxes. Appraisers must possess a thorough understanding of the Modigliani-Miller theorem because it provides a foundation for understanding how the company’s leverage affects the cost of equity capital and WACC. It can be considered the first to provide a rule for calculating the cost of equity capital, informing financial executives that in a world without taxes, the leverage cannot affect the company value. Years later, they concluded that the value of a leveraged firm is the sum of unleveraged firm’s value and the present value of tax savings. More debt means tax savings but also increase the financial distress’ risk, implying an optimal capital structure defined as a trade-off between the present value of tax savings and the present value of financial distress costs.

Pages: 29

This chapter discusses three capital asset pricing models: the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory Model (APT), and the Fama-French three-factor model (FFM). The emphasis is on the CAPM since it is the model widely used in practice. We shall simply describe the development of the CAPM from portfolio theory. Then we will discuss the inclusion of risk-free assets in the portfolio and the capital market line. Finally, beta is introduced as a measure of risk and the market equilibrium represent by the security market line. Although in practice the corresponding formulas are used directly, we encourage the study of underlying mathematics to acquire a comprehensive understanding of it. The reader who is familiar with the mathematical details of the CAPM can skip this section without losing comprehension because we offer a simple example. There are also step-by-step examples of beta and implied equity risk premium calculations using a spreadsheet.

Pages: 17

This chapter discusses the equivalence of discounted cash flow methods: free cash flow, equity cash flow, capital cash flow, and adjusted present value using perpetuities, as well as a simple derivation of Hamada’s formulas for unlevering and relevering the beta coefficient. Knowing the equivalencies allows you to understand the different cash flow risks, tax effects, and the appropriate cost of capital. As we explain, there are circumstances where one approach may be better than another. Because the WACC valuation assumes the company periodically rebalances its capital structure, we couldn’t leave out an explanation of the Miles-Ezzel formula and the different approaches proposed to compute the present value of tax shields, as well as the associated formulas for calculating betas and cost of capital.

Pages: 17

This chapter discusses the optimal capital structure. First, we outline a bond rating trade-off model to estimate the optimal capital structure. Because the tradeoff between tax benefits and expected financial distress is frequently insufficient to define an optimal capital structure, we describe other tradeoffs and factors that influence capital structure decisions including agency costs, asymmetric information, size, debt rating, creditworthiness, and strategy. Then, we provide a brief overview of four real-world applications: in the first two cases, we applied the optimal capital structure model. The second case was when we have to value the Argentine company with the highest market capitalization. The third describes an issue of agency costs, and the fourth address the role of the capital structure as a strategy.

Pages: 180

No chapter abstract available.

Pages: 28

Chapter 10 addresses the issues related to the business cycle and the calculation of the terminal value. Because the terminal value represents an important portion of the company’s value, we discuss in further detail the ideal conditions that must be met in a steady-state. Along this chapter, we react to the following questions: if we use the growing perpetuity formula to calculate the terminal value, what conditions should the company follow to ensure that it is in steady-state? What should be the long-term growth rate? How sensitive is the company’s value to the long-term growth rate? Does the empirical data support the assumption that a business is unable to grow above the GDP growth rate in the long run? It is expected that the company cannot create value in a steady-state because the ROIC converges to the cost of capital; however, does the assumed ROIC-WACC convergence observed?

Pages: 20

This chapter deals with the lack of market values, specifically the valuation of private companies. The lack of market values is not exclusive to emerging countries, as the bulk of transactions involve non-public companies, both in both emerging and developed countries. The lack of market values poses two additional challenges to appraisers: they must estimate a beta coefficient and the expected capital structure. While the beta estimation is based on the bottom-up approach, we discuss the pros and cons of three approaches to circumvent the expected capital structure. When valuing in emerging markets, analysts face an additional set of questions: there is frequently no well-defined market risk premium or risk-free rate, and how to add a country risk premium. The chapter concludes with an example of a private company valuation in an emerging country that applies all the topics discussed in this chapter.

Pages: 28

This chapter discusses how the country risk is counted in a valuation. Although in the CAPM’s world beta is the only risk that commands a premium, there is a professional consensus that all risks cannot be eliminated through diversification when valuing in emerging markets. From the standpoint of a foreign investor planning to invest in an emerging country, risks are frequently associated with changes in laws, failure to enforce contracts governing an investment, regulations, currency risk, and civil disturbances in a way that reduces the return on the investment. The country risk is not fiction, even though the way the country risk premium is counted into valuation is debatable. In this chapter, we discuss the pros and cons of the two typical approaches to introduce the country risk into valuation: the most common, which consists in adding a country risk premium in the cost of capital, and the weighted probability scenarios. Finally, we present the key findings of a study that examined how country risk affects market values in three emerging markets.

Pages: 19

This chapter discusses currency valuation issues when valuing in emerging markets or international equities. Companies located in other countries generate sales, expenses, and cash flows in domestic currency, and these currencies have gone through periods of depreciation/appreciation. Acquiring a company when the local currency and the business value are overvalued, is not a good deal. A devaluation will eventually be imposed by the government, decreasing the expected cash flow and the business value expressed in dollars. Purchasing a business after a devaluation has the opposite effect because the asset’s dollar value. Acquiring a business after a devaluation could be profitable since probably the assets are undervalued. Therefore, the obvious question when considering an investment is if the local currency is overvalued or undervalued. We present a model that shows the equivalence of valuing a business in domestic and foreign currency. Although the equivalence is not important per se, it provides a framework for analyzing an acquisition in another country. For example, managers should be interested in analyzing the effect of a sudden devaluation or appreciation of the domestic currency, exploring different economic scenarios and combinations of devaluation and pass-through rates.

Pages: 16

This chapter addresses the factors that determine the value of the control premium and the discount for lack of marketability and includes some empirical data as well as some methods to calculate the marketability discount. Acquiring a controlling number of shares in a public company entails paying a premium over the current market price per share to induce existing shareholders to sell. The control confers privileges in favor of the majority party that reduces the influence and the return on minority stockholder´s investments. On the other hand, selling an interest in a private company implies a risk for potential investors since is more costly and time-consuming process than selling a position in a public company. Therefore, potential buyers request a percentage reduction in an asset value to compensate for this risk.

Pages: 30

This chapter discusses the economic profit, which has been proposed as both a valuation method as well as a metric of business’ performance. It strictly focuses on computing the “true” capital that produces the “true” operating income, and considered as a metric performance, has the merit to emphasize that not only earnings matter but the capital invested to generate them. More importantly, earnings can create a mirror effect when the increase in market capitalization is less than the new capital invested. To compute the economic profit, frequently we have to make some adjustments to financial information in order to correctly determine capital and the net operating profit after taxes, which we describe in depth, as well as how traditional financial metrics can lead to wrong financial decisions. The literature has offered the equivalence of FCF and Economic Profit as a valuation approach, which appears unusual given that EP is an earnings measure rather than cash flow. We compare the equivalence for various scenarios, ranging from perpetuities to unequal cash flows, with and without ROIC-WACC convergence.

Pages: 37

Another common valuation method frequently applied in M&A deals is relative valuation. This chapter begins by describing the most typical multiples and their variants through some examples. Then we describe how we select the peer group and the right multiple, as well as how we adjusted the financial information to make useful comparisons. There is a section dedicated to analyzing the relationships between multiples and company fundamentals such as ROE, dividends per share, ROIC, which traders can use to make quick decisions. Finally, and most importantly, we examine the limitations of relative valuation, particularly in terms of the business cycle, using real-world examples.

Pages: 84

No chapter abstract available.

Pages: 22

This chapter describes the valuation of Sofora Telecomunicaciones SA, the controller company of Telecom, one of Argentina’s two telecommunications providers. The case is rich in analysis and uses every method/technique we outline in the preceding chapters. We describe in detail the process to obtain the fair value of Sofora that we carried out in May 2008, presented as documentary proof by W de Argentina in its lawsuit with Telecom Italia. We first determined the DCF value of Telecom, then added a control premium, and finally deducted the preferred shareholders’ fair value, which was obtained by discounting the forecasted dividends. Then, we perform a relative valuation using EBITDA multiples to establish a comparison with our DCF value. The case includes an unusual double-check of fair value, which was inspired by an inquiry from W de Argentina’s senior management and solved utilizing Modigliani-Miller theorem as a guideline. Many skeptics believe that it belongs to the realm of “blackboard economics”, where there is little correspondence between the theory and the real world. However, MM theorem is also useful in practice. This is not surprising, since there is nothing more practical than a good theory.

Pages: 21

This chapter examines the valuation of “Automotive Financial” (AUF), the financial branch company of “Latin American Automotive” (LAA), a subsidiary company of a well-known European multinational automotive manufacturer that operates in some South American emerging countries. AUF finance the purchase of automobiles sold by LAA in Argentina through its dealer network and consumer loans. Argentina went through a severe economic crisis in January 2002, which resulted in a sharp devaluation of the local currency and a decrease in the GDP of 10.6%. The government created restrictions and regulations that negatively impacted the financial system and resulted in defaulted on its obligations. AUF was compelled to reduce its operations by the European controller, stopping to receive deposits and give loans. A year later, as the economy improved, the controller manifested its desire to run the firm; however, LAA, which would have started the business from scratch, required compensation from the controller based on the fair value of the new business after the controller expressed a wish to run the company. Because the financial business is so distinct from a non-financial company, a different DCF model is built for this case, taking into account the nature of the business and industry regulations. As AUF continued to receive loan payments, many non-operating assets like as buildings, land, cash, and untraded sovereign bonds, accumulated; therefore, we must also value non-operational assets.

Pages: 21

This chapter describes the valuation of “Automotive Recovery” (AR), a company that provides stolen vehicle recovery services (SVRS). In 2008, we were hired by “JJ Corp.”, an American public company at the time, to estimate the fair value of its subsidiary AR, which operates in Argentina. JJ Corp. is the parent company, which had a 25% of the AR at the time. The performance of the business was strongly related to automotive’s sales, which were in time related to the GDP growth rate. Following the severe recession in 2002, the GDP grew by an average of 8% per year. Sales in the industry experienced a re-emergence in 2003 and 2004, maintaining high growth rates in 2005, 2006, and 2007. AR has been tremendously successful, with revenues growing at a 45% annual rate over the last five years, which is comparable to the industry growth rate. Although the primary concern of JJ Corp.’s senior management appeared to be the cost of capital, we met for three hours and had an interesting discussion in which we only spent 15 minutes explaining the cost of capital calculations and 2.45 hours discussing how the government could affect the business return.

Pages: 19

This chapter describes the valuation of “American Packages”, a listed Argentinean company primarily involved in the production of plastic packages for the dairy products industry, with a particular focus on the yogurt segment. It controls approximately 55% of the local market, being the major packaging manufacturer in the region, and exports to many countries across Latin America. The majority interest of American Packages is owned by “Dix”, a Brazilian company which poses 62% of the shareholding, and RR poses the remaining 38%. A long-standing positive relationship between Dix and RR ended when Dix made a first bid and stated its intention to buy the RR shareholder. RR declined to sell and swiftly rejected the offer. A few days later, Dix raised his offer by an additional 10%. After rejecting the offer again, RR hired us to undertake the valuation. The case illustrates how we explained and defended our valuation to DIX’s senior management, which ultimately led to the purchase.