Valuation by parts
Recall that the idea behind relative valuation (i.e., multiples analysis) is that we can arrive at a valuation for the firm by looking at how similar firms are priced. This becomes a bit of a challenge for firms that are engaged in multiple businesses and operate in many countries, since usually there is no other company exactly like that firm (e.g. GE, Siemens, etc.). What we can do, instead, is to value each individual business segment as if it were a standalone company and then aggregate the value over all of the segments. This is called sum-of-the-parts valuation*. 1. Identify the business segments for your company. You already have this from previous assignments. 2. Find the competitors for each business segment. The competitors can be what is specified in the 10-K (note that this has to be broken down by business segment), or the competitors that you got from Bloomberg. Or, from other sources. 3. Decide on the multiple that you will use. While the P/E ratio is the most widely recognized and commonly used multiple, it has its drawbacks. It is not appropriate for companies with zero or negative earnings. Also, because the denominator is usually some variant of net income per share, it is heavily influenced by capital structure choice. That is, two firms that are identical save for their choice of the levels of debt and equity will have different P/Es. It is, however, the typical measure used to value financial companies. It might be better to use general enterprise value multiples such as EV/EBITDA, EV/EBIT, or EV/Sales. Of these, EV/EBITDA is preferred since it is independent of capital structure and capital spending decisions (i.e., firms that have recently purchased PP&E will have a higher depreciation expense; operating leases will also have an impact on depreciation and amortization). However, EV/EBITDA may not always be available for business segments, so you might want to use EV/EBIT instead. You may use EV/Sales, but this is less preferred since Sales, while a good indicator of size, does not tell us how a profitable a firm is, or how good it is at generating cash flows. Note that you can value some segments using the EV multiples and some segments using the P/E multiple. Just remember that what you get from the EV multiples is a value of the enterprise (i.e., value for both debt and equity), while what you get from the P/E ratio is a value of the equity in a firm. So, when you use both, you need to make an adjustment when you aggregate the values later on. 4. The next step is to decide how you will use the multiples from comparable companies. It is tempting to simply apply either the mean or median value. However, a better way is to find the two or three closest competitors, and use their multiples to “bracket” the value. You may choose the close *
References: Damodaran, “The Dark Side of Valuation”, 2nd ed.; Rosenbaum and Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions”.
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competitors based on closeness of operations, size (either revenues or market cap), and other characteristics. 5. Finally, you need to consider centralized costs for the company. These are costs that are shared by all segments and cannot be allocated by segment. You can search for centralized costs using “corporate expenses” or some other variant. Your best bet would be to find the section in the 10-K where segment revenues and expenses are reported --- there is usually a line there that reports companywide revenues and/or expenses (be sure to read the footnote to make sure). Failure to account for these costs will result in overvaluation of the firm. There are three ways you can calculate a value for centralized expenses:
Divide the total enterprise value that you get from your sum-of-the-parts valuation and divide it by consolidated EBIT. Multiply this number with the centralized costs.
Get the ratio of centralized costs to after-tax EBIT (both from the financial statements) and apply this discount to the EV from your multiples. For example, if this ratio is 3%, then you would get 97% of EV and then subtract the value of debt etc.
Treat it as a perpetuity and calculate a terminal value: 𝐶𝑜𝑟𝑝𝐶𝑜𝑠𝑡𝑠𝑇𝑉 =
𝐶𝑜𝑟𝑝𝐶𝑜𝑠𝑡𝑠(1 − 𝑡)(1 + 𝑔𝑠𝑡𝑎𝑏𝑙𝑒 ) 𝑊𝐴𝐶𝐶 − 𝑔𝑠𝑡𝑎𝑏𝑙𝑒
6. Let’s look at two examples. Assume that there are only two business segments in each case. Example 1: Using EV multiples for both segments.
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Business Segment 1 EV/EBITDA 4.71 5.43 8.33 3.21 4.23 6.47
Competitor 1 Competitor 2 Competitor 3 Competitor 4 Competitor 5 Competitor 6
Suppose the closest competitors are Competitor2, 3, and 6. Then for Business Segment 1, EBITDA 10,000
Multiples Range 5.43 8.33
Enterprise Value 54,300 83,300
Business Segment 2 EV/EBITDA 16.32 9.25 11.28 15.91 8.15 8.08 7.58
Competitor 1 Competitor 2 Competitor 3 Competitor 4 Competitor 5 Competitor 6 Competitor 7
Suppose the closest competitors are Competitor2, 4, and 7. Then for Business Segment 2, EBITDA 7,500
Multiples Range 7.58 15.91
Enterprise Value 56,850 119,325
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The total Enterprise Value is then Enterprise Value Business Segment 1 54,300 83,300 Business Segment 2 56,850 119,325 Total 111,150 202,625 Value of debt Value of options
75000 8000
Corporate costs 15 Consolidated EBIT 1115.8333 TV of corp costs (low) TV of corp costs (high)
1,494.17 = (1115.83/15)*111,150 2,723.86 = (1115.83/15)*202,625
Value of equity = EV - Value of debt - Value of options - TV of corp costs = 111,150 - 75,000 - 8,000 - 1,494.17 = 26,656 = 202,625 - 75,000 - 8,000 - 2,723.86 = 116,901 shares outstanding price per share
10,000 2.67
11.69
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Example 2: Using EV/EBITDA for one segment and using P/E for the other segment
Business Segment 1 EV/EBITDA 4.71 5.43 8.33 3.21 4.23 6.47
Competitor 1 Competitor 2 Competitor 3 Competitor 4 Competitor 5 Competitor 6
Assume that the Debt/Asset ratio of the whole company is 0.6 and that this ratio is constant across segments. Also, suppose that total assets for Business Segment 1 = 60,000. Then the total debt for Business Segment 1 = 36,000 Suppose the closest competitors are Competitor2, 3, and 6. Then for Business Segment 1, EBITDA
Multiples Range 5.43 8.33
10,000
Enterprise Value Debt 54,300 83,300 36,000
Equity Value 18,300 47,300
Business Segment 2 P/E Competitor 1 Competitor 2 Competitor 3 Competitor 4 Competitor 5 Competitor 6 Competitor 7
31.12 12.18 17.81 10.55 11.51 9.93 13.37
Suppose the closest competitors are Competitor2, 4, and 7. Then for Business Segment 2, Segment Income 2,500
Multiples Range 10.55 13.37
Equity Value 26,375 33,425
The total Enterprise Value is then Equity Value Business Segment 1 18,300 47,300 Business Segment 2 26,375 33,425 Total 44,675 80,725 Value of options
8000
Corporate costs 15 Consolidated EBIT 1115.833 TV of corp costs (low) 600.56 = (1115.83/15)*44,675 TV of corp costs (high) 1,085.18 = (1115.83/15)*80,725
shares outstanding price per share
10,000 3.61
7.16
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