Week 10: Valuation Section B Focus

โ† Back

Master DCF valuation, multiples method, and M&A analysis for Section B (70 marks, ~95 minutes).

๐ŸŽฏ Exam Relevance: Valuation ties together FCF, cost of capital, and capital budgeting. The critical step most students miss: converting Enterprise Value to Equity Value (EV โˆ’ Debt + Cash). Interpretation is worth 40-50% of marks!

๐Ÿ“Š The Valuation Pipeline

FCF Calculation
โ†’
Terminal Value
โ†’
Enterprise Value
โ†’
Equity Value
โ†’
Share Price

1. Free Cash Flow (FCF)

Core FCF Formula
FCF = EBIT ร— (1 โˆ’ t) + Depreciation โˆ’ CAPEX โˆ’ ฮ”NWC

Where:

  • EBIT ร— (1 โˆ’ t) = Unlevered Net Income (tax on operating income)
  • Depreciation = Add back (non-cash expense)
  • CAPEX = Net Fixed Assetsend โˆ’ Net Fixed Assetsbegin + Depreciation
  • ฮ”NWC = NWCend โˆ’ NWCbegin where NWC = Current Assets โˆ’ Current Liabilities
โš ๏ธ Exam Trap: CAPEX is NOT just the change in fixed assets. You must add back depreciation: CAPEX = ฮ”Net Fixed Assets + Depreciation

2. Terminal Value

Gordon Growth Model (at steady state)
TV = FCFsteady / (r โˆ’ g)
๐Ÿ’ก Two Approaches:
Method A: TV at year before steady state = FCFsteady / (r โˆ’ g), discount back
Method B: TV at steady state = FCFsteady ร— (1 + g) / (r โˆ’ g), discount one more year

3. Enterprise Value to Equity Value

The Critical Conversion
EV = Equity Value + Debt โˆ’ Cash โˆด Equity Value = EV โˆ’ Debt + Cash
Share Price
Share Price = Equity Value / Shares Outstanding
โš ๏ธ Common Exam Mistake: Students forget to subtract debt (and add cash) when converting EV โ†’ Equity Value. This is where "many marks sit" according to your exam instructions!

4. Multiple Valuation Method

EV/EBITDA Multiple
EV = EBITDA ร— Average(EV/EBITDA multiples from comps) Equity Value = EV โˆ’ Debt + Cash

Remember: EBITDA = EBIT + Depreciation = Sales โˆ’ Costs (before depreciation)

5. Comparable Transaction Method

Merger Premium Approach
Equity Value per Share = Stock Price ร— (1 + Mean Merger Premium)

6. Private Company Discount

When valuing private companies using public comps, apply a liquidity discount (typically 15-30%):

Discounted Multiple
Adjusted Multiple = Public Multiple ร— (1 โˆ’ Discount%)

Why? Private companies lack marketability, are smaller, and have less diversified operations than public peers.

๐Ÿงฎ FCF Calculator

Practice calculating Free Cash Flow step-by-step:

๐ŸŽฏ Terminal Value & Enterprise Value

๐Ÿ’ฐ EV โ†’ Equity Value โ†’ Share Price

๐Ÿ“ˆ EV/EBITDA Multiple Calculator

Enter comparable company multiples (comma-separated):

๐Ÿค Merger Premium Calculator

Enter merger premiums from comparable transactions (%):

๐Ÿ’ก Choosing Comparables: Select companies with similar:
  • Industry and business model
  • Size and growth profile
  • Geographic exposure
  • Risk characteristics
Avoid using broad market indices (like DAX) as comparables โ€” they contain unrelated sectors.

Practice Problems (Exam Style)

Problem 1: Complete DCF Valuation

Given the following data for Year 2014:

  • EBIT = $500M, Tax rate = 40%
  • Depreciation = $100M
  • Net Fixed Assets: Beginning = $1,400M, Ending = $1,500M
  • NWC: Beginning = $100M, Ending = $140M

Calculate the FCF for 2014.

Show Solution

Step 1: Unlevered Net Income

EBIT ร— (1 โˆ’ t) = 500 ร— (1 โˆ’ 0.40) = 500 ร— 0.60 = $300M

Step 2: CAPEX

CAPEX = NFAend โˆ’ NFAbegin + Depreciation

= 1,500 โˆ’ 1,400 + 100 = $200M

Step 3: Change in NWC

ฮ”NWC = 140 โˆ’ 100 = $40M

Step 4: FCF

FCF = Unlevered NI + Depreciation โˆ’ CAPEX โˆ’ ฮ”NWC

= 300 + 100 โˆ’ 200 โˆ’ 40 = $160M

Problem 2: Terminal Value & Enterprise Value

Using FCFs: 2014 = $160M, 2015 = $256M, 2016 (steady) = $314M

WACC = 8%, Growth rate = 3%, Debt = $600M, Cash = $0

Calculate the share price (40M shares outstanding).

Show Solution

Step 1: Terminal Value (at end of 2015)

TV = FCF2016 / (r โˆ’ g) = 314 / (0.08 โˆ’ 0.03) = 314 / 0.05 = $6,280M

Step 2: Enterprise Value

EV = FCF2014/(1.08) + (FCF2015 + TV)/(1.08)ยฒ

= 160/1.08 + (256 + 6,280)/1.1664

= 148.15 + 5,603.57 = $5,751.72M

Step 3: Equity Value

Equity Value = EV โˆ’ Debt + Cash = 5,751.72 โˆ’ 600 + 0 = $5,151.72M

Step 4: Share Price

Share Price = 5,151.72 / 40 = $128.79 per share

Problem 3: Multiple Valuation with Private Discount

WIRK company (private) has EBITDA = โ‚ฌ102M, Debt = โ‚ฌ323M

Comparable public multiples: 7.1, 8.2, 7.6, 5.9, 5.0

Apply a 25% private company discount.

Calculate the equity value.

Show Solution

Step 1: Average Multiple

Avg = (7.1 + 8.2 + 7.6 + 5.9 + 5.0) / 5 = 33.8 / 5 = 6.76

Step 2: Apply Discount

Discounted Multiple = 6.76 ร— (1 โˆ’ 0.25) = 6.76 ร— 0.75 = 5.07

Step 3: Enterprise Value

EV = EBITDA ร— Multiple = 102 ร— 5.07 = โ‚ฌ517.14M

Step 4: Equity Value

Equity Value = EV โˆ’ Debt = 517.14 โˆ’ 323 = โ‚ฌ194.14M

Note: Seller wants โ‚ฌ300M, so this looks like a good deal for the PE buyer!

Problem 4: Assess an Acquisition Offer

CVT offers $128/share for TXA (40M shares). Your analysis shows:

  • DCF method: $128.79/share
  • Multiple method: $129/share
  • Transaction method: $127/share

Is the offer reasonable? What should you conclude?

Show Solution

Analysis:

The offer of $128/share falls within the valuation range of $127โ€“$129 from all three methods.

Conclusion:

CVT's offer is reasonable from CVT's perspective. The offer:

  • Is slightly below the DCF and multiple valuations (good for acquirer)
  • Aligns with the comparable transaction approach
  • Provides fair value to TXA shareholders while not overpaying

Key exam point: When assessing M&A offers, compare against multiple valuation methods and consider if the offer falls within a reasonable range.

โš ๏ธ Exam Reminder: For Section B, always:
  1. Write the formula first
  2. Substitute numbers clearly
  3. Show calculation steps
  4. Provide interpretation (this is where 40-50% of marks sit!)

Self-Check Quiz

Test your understanding of key valuation concepts.