Principles of Company Valuation

Authors: Clayton Nesslein & Sam Crider

In this article we will discuss the principles of company valuation by evaluating a mock acquisition opportunity. TechGiant is a publicly traded firm, and is considering the acquisition of a private company, TechPrism. TechPrism is an Object-Based Upward-Trending Collaboration Platform that is seen as a complementary product to TechGiant’s current stack. The investment will be evaluated based on NPV of future cash flows, otherwise known as the DCF method. Qualitative factors such as intellectual property rights and competition in the marketplace will also be considered.

Here are the facts of the case:

The following data has been gathered on TechPrism. 5 year forecast data is shown here:

TechPrism has $1,475,000 (market value) of long-term debt. COGS are 20% of revenue in year 1. SG&A is 75% of revenue in 2019, and is expected to reduce to 63% by 2023. The corporate tax rate is 40%, its cost of borrowing is 6.2%, and it has a target debt to value ratio of 15%. The company has impressive revenue growth figures, showing 50% in year 1.

Current relevant market data includes YTM on 3 month Treasury Bills of 2% (risk free rate), and a forecasted 30 year S&P return of 8%.

TechPrism is a private firm. We will need to compare it to a similar firm that is publicly traded. PublicTech has a long term debt to equity ratio of .75, and an equity beta of 2.1.

The recommended firm valuation is written below in memo format, and references spreadsheet Exhibits.

Memo: Valuation of Acquisition Target - TechPrism

As a result of the board's decision to pursue growth through acquisitions, we must analyse TechPrism as a potential acquisition opportunity. To do so we want to understand our cost of capital and decipher the relevant cash flows in order to arrive at an evaluation of TechPrism. We will use the NPV analysis method in deciding whether the acquisition should occur as well as provide context to the decision depending on the boards strategic objectives.

In order to properly evaluate the investment we need to establish our weighted-average cost of capital (WACC). With this we can properly discount future cash flows to understand their present value and pay a reasonable amount for TechPrism.

The discount rate was calculated using the after-tax weighted-average cost of capital (WACC) method:

WACC is utilized to consider capital budgeting decisions when debt and equity interactions cannot be separated. For example, the value of tax shields must be considered against the cost of debt in order to make a fair comparison to equity. In order to calculate WACC, we are interested in current values and expectations of future cash flows, while ignoring returns on past projects. Determining WACC will show us the opportunity cost of investing in TechPrism. Therefore it is logical to use PublicTech (a publicly traded company) and other market data as a fair proxy for equity value and market returns. In order for TechPrism to be used as a proxy, we assume it has a similar risk profile, and it will remain that way. Debt to Value must also remain the same for the life of the project. We must unlever the equity beta of the comparable firm PublicTech and then re-lever it with consideration to the capital structure of TechPrism.

PublicTech has a debt to equity ratio of 0.75 which is 57% equity and 43% debt while TechPrism has a debt equity ratio of 15% debt and 85% equity. Thus, we must remove the impact (unlevered) of PublicTech’s debt to equity structure from the equity beta and then add the impact (levered) of TechPrism debt to equity. To perform this calculation we take the beta (2.1) of PublicTech and unlever it by dividing by the impact of the capital structure of PublicTech. Next we calculate the new levered beta by multiplying the unlevered beta by the capital structure of TechPrism. The market return is 9% as listed and we will use the risk-free rate of 2% represented by the 3-month Treasury Bill. By applying the newly calculated levered Beta of 1.6, the risk free rate, and market rate we can calculate the cost of equity as being 13.2%. The cost of debt is 3.72% calculated as 6.2% return on debt times (1 - tax rate). Considering TechPrism’s target debt to value ratio of 15%, the weight of debt is 15% and the weight of equity is 85%. From this we can arrive at a WACC of 11.8%. Calculations can be seen in Exhibit 1 (click here).

Next, we must apply the WACC to the relevant forecasted future free cash flows of TechPrism, to understand the present value of the cashflow. We must consider the operating cash flow, the impact of capital investment, the impact from tax shields as a result of interest expense, and the value of 3% growth in years 6 and thereafter.

The annual capital investment must be subtracted from overall cash flows in the appropriate year as the capital outlay will impact the cash position of the firm and must be covered by operating cash flow or debt. The operating cash flows can be obtained by subtracting the COGS and SG&A cost from forecasted revenues. Next we subtract depreciation and apply the tax rate to get profit after tax. Depreciation is added back to arrive at operating cash flow. The result of this can be seen in Exhibit 2. The 3% projected growth rate was applied to year 2024 to calculate the Terminal Value using and exit multiple. Exit multiples vary widely by industry, but the EBITDA multiple on software companies in 2018 averaged 19.89x. Given the forecasted terminal EBITDA times the exit multiple, and discounted by WACC in year 6, we get Present Value of Horizon Value (PVHV) of $8.5m. This is also known as Unlevered Free Cash Flow.

We also must factor in the impact of the tax shield benefit from interest expense. To do so we can multiply the interest expense by the tax rate to get the tax shield that will benefit cash flows. As a result, our cash flows are reduced by $233k.

By adding together the impact of cash flows from capital investment, operations, and financing activities, we can calculate the present value by discounting the net cash flows based on the WACC calculated earlier. Each year’s relevant cash flows can be seen in Exhibit 2.

The goal of calculating the net present value of the relevant cash flows of TechPrism is to understand what we should pay for the acquisition. We know that the value of a firm is NPV of all future cash flows. By summing the NPV of future cash flows (including the tax shield from the interest expenses) we arrive at the Base NPV of $8.2m from free cash flows from operations and capital investment. Adding those two figures together brings us to an Adjusted Present Value (APV) of $8.2m. However, this would be overpaying for the firm as they currently carry a market value of debt to the tune of $1.5m. As a result we will not want to pay to take on that debt and instead subtract it from the APV. In doing so we arrive at the equity value of the firm: $6.8m.

Despite this valuation, there are scenarios where it would make sense to pay more for TechPrism. Equity value of the firm, in the amount of $6.8m, is based on current considerations of cash flows in the first 5 years, plus an EBITDA exit multiple. Accuracy of those projections along with the current computation for WACC could all effect the estimated firm value. More importantly, assumptions for perpetual growth in year 6 and beyond greatly impact the value that equity shareholders would pay for the firm. Only 5% of value comes from cash flows in the first 5 years, while the rest is derived from horizon value. Therefore, 95% of the current valuation is based on a growth assumption along with projected EBITDA. More aggressive projections of growth would persuade investors to pay more for the firm.

Additionally, if we see inverted yield curves in the market then it indicates that interest rates are projected to go down in the future. This would reduce TechGiant’s cost of debt and as they would be able to consolidate through refinancing at a lower interest rate and thus increase cash flow. Similarly, if the expected market rate of return dropped then the cost of equity would also decline. This would alter the discount factor and increase the net present value of future cash flows and the firm's valuation. Essentially if the WACC (and thus opportunity cost) is reduced then the value of this investment will increase.

The acquirer may end up paying an acquisition premium if the synergy created from the merger is believed to be greater than the total cost of acquisition. Several factors contribute to the size of the premium, such as presence of other bidders, competitors, and motivations of the buyer and seller. The acquirer records the acquisition premium as goodwill on their balance sheet, which can include good employee relations, loyal customer base and reputable customer service, value of brand name, and any proprietary technology from the target company. An impairment of goodwill can occur when the intangible benefits are valued below its acquisition cost, as is the case with increased competition, declining cash flows, or economic depression. These adverse events will decrease the goodwill which is reflected in the diminished value on the acquirer’s balance sheet and subsequent loss of income.

Therefore, the fair market equity value of the firm is $6.8m.