Introduction to Company Valuation

1. Introduction to Company Valuation: Hello, and welcome to this course on Company valuation. It's a great pleasure to welcome you to the course. My name is John Cole. Now, I started my investment banking career at Security Pacific Horgbt in 1988, and I don't even want to count the years that have gone past since then, so please don't do the maths. That's over 30 years, in fact, of investment banking experience to managing director level, and I also co founded two investment banking boutique. So I've been pretty busy over the years. Now, if you're looking for a career in any of these business areas, investment banking, equity research, private equity, venture capital, asset management, consulting or advisory or indeed anything to do with entrepreneurship, then this is a course that you should be taking. Because if the answer to this is, yes, if you want to have a career in these areas, then you have to be completely in control and understand what company valuation is all about. It is absolutely a core topic that you have to master. But Don't worry. This class is for everyone, whatever their level. If this is all completely new to you, then you'll enjoy my easy to follow delivery, and if you have some knowledge, there will undoubtedly be some additional jewels of information for you to take away. Of course, I cannot give you a master class in such a short course, but I can share with you many of the key principles that you really need to know. Now, we're going to cover the main valuation methodologies, cost valuation, ratio analysis, comparable company valuation, precedent transaction analysis, discounted cash flow, DCF valuation. We're also going to look at the capital asset pricing model and the weighted average cost of capital. That's quite a lot to cover in a relatively short amount of time. I'm also going to share with you some of the challenges involved in valuing start up companies and private companies because these can be particularly challenging. The class project is simple, but I hope instructive. I want you to complete a DCF valuation model that I will provide you with. All you have to do is complete the input cells, and then you can experiment with the valuation parameters to see how they affect the outcome. There's a little bit more on this class project in the next lecture. This company valuation course is a great starting point from understanding that company valuation is a very complex process, but one that can be mastered. You will leave this course with familiarity with the main valuation methodologies. This, of course, can be a great starting point for your knowledge collection, your knowledge building, and indeed, any career development that you want to undertake, because from here, you will understand the broad parameters of company valuation. So good luck with your career, and I really hope you enjoy the course. So this is an introduction to company valuation, and I really hope you enjoy what I've got in store for you. 2. What is the Class Project: I thought I'd just give you a heads up on the class project to enable you to anticipate with relish and delight what is about to come. The class project in this class is focused on discounted cash flow modeling. Now, while we expect you to create a complex model, I have prepared a simple one which you will have to complete. Now, I've provided all the input cells. You can see them in green here and in a separate file, I provide you with the data you need to type into them. And you'll be able to see what happens in your discounted cash flow model when you put in the cash flows and when you put in the discount rate metrics. This model will enable you to use different cash flows and different discount criteria to understand what happens when these change. You will be able to grasp the sensitivity of the valuation outcome to relatively minor changes in discount rates. You'll also be able to use this model as a template for your own projects going forward. Now, don't worry if DCF models are new to you. By the time you've completed this course, it will make sense. So well, one, I hope you enjoy the course, and secondly, let's crack on with it, shall we? So that's a quick heads up on what the class project is all about so that as you go through this course, you'll understand what we're going to be looking at right at the end. 3. How do you value a company?: This sounds like a simple question, but I think you're about to find out it's not. How do you value a company? The starting point for answering this question is to ask very simply, well, what's a company worth, and you'd think that would have a relatively straightforward answer. The real problem is that actually there is no answer to this question, or rather there is no single answer to this question. Depending on who you ask, you will get a different answer. Depending on what method you use, you will get a different answer. So valuing a company is a process of trying to narrow down a range of different answers. Our first problem is that markets are not efficient. Whatever the efficient market hypothesis says, it is clear that the information available to the market is imperfect. Some people have more information than others. Some people have more appetite for risk than others. So people frankly are just buyers and some people are sellers, and there are two different prices right there. You may think that all you have to do is look up the share price of a company and you can find out what it's worth. But market price is not the same as value. In imperfect markets, some companies are undervalued and some are overvalued, whatever the market price happens to be. Value investors, such as Warren Buffett recognize that markets are imperfect. That's how he's made his money. They compare the financial information in the company's financial statements to the price in the market, and they look to identify companies with certain characteristics, which in their view are undervalued by the market. So where do we start trying to understand how to value a company? Well, we need to understand that company valuation is a process through which we attempt to estimate the range of economic value a business may have to its owners. Asking why we want to value a business will tell us a lot about its value to us. Fair market value is sought by buyers and sellers to arrive at a price for a transaction. Investment value is what a particular investor is prepared to pay, and he'll have his own strategies and agenda and reasons and his view about risk. Intrinsic value is the in depth measure of potential economic value in the business, which is derived from a detailed study of the financial records and the future forecasts of the business itself. If we believe that a company has long term potential, we're going to value it on an ongoing concern basis. We expect it to make profits in the future, and therefore, to have a future value. We may be more pessimistic and feel that the company's assets should be sold in an orderly way to unlock its value, an orderly disposition. In that case, clearly the assets are going to have to be priced to sell. Or perhaps we're only interested in liquidating the assets as quickly as possible, which would place a much lower value on those assets. The starting point for valuation then are the financial statements of the company. Now, we can turn to ratio analysis to understand these numbers in a way that makes comparative valuation with other companies possible. Ratios also tell us about historic trends. The price and earnings ratio enable us to compare the relative market value of the company to other companies. As soon as you reduce it to a ratio, you can make it comparable with the ratios of other companies. It's important though, to understand the purpose of the three financial statements, the income statement, the balance sheet, and the cash flow. They aim to show a true and fair position of the company, but that has nothing to do with valuation. Accounting principles adjust the numbers. As a result, profits do not equal cash. So we need to make sure that we focus on cash flow and not profit when we're trying to understand valuation because at the end of the day, that's what investors are going to get. We have already seen that the market can give us an indication of a company's value if that company is publicly traded. We can also look at the financial statements of the firm and consider the value of its assets ranging from going concern to liquidation. And we can study the cash flow of the business to appraise the value from the historic and future income of the firm. So we can either look at the market value, we can look at the asset value, or we can look at the intrinsic value based on the income. Let's look at these three approaches to valuation in more detail, and we'll start with the income approach. The income approach forecasts the future stream of cash flow or earnings from the business and using a discount rate, converts the future value to a present value. This is commonly referred to as discounted cash flow or DCF. The discount rate is derived from the capital asset pricing model or CPM. The discount rate is a measure of the risk that the investor is prepared to pay for the investment today in order to benefit from the future cash flows tomorrow. The higher the discount rate, the higher the expectation of risk and the lower the value. The components of the discount rate are set out in the capital asset pricing model, the risk free rate, which is equivalent effectively to buying a government bond, the risk premium, in addition to the risk free rate, which effectively accounts for the market risk, and then the beta or often referred to as the company specific or asset beta, which reflects the company or asset specific risk. When valuing the whole firm, the discount rate needs to be adjusted for the balance between debt and equity as these have different costs of capital and therefore, different discount rates, and this is where we turn to the weighted average cost of capital or WACC. Debt interest, of course, is also tax deductible, which reduces the cost of debt by one minus the corporate tax rate. The weighted average cost of capital must be applied to the company net cash flow from total invested capital, and we end up with a evaluation of the firm. The asset based valuation approach starts with the presumption that the value of the firm is the sum of its parts. Asset value in the balance sheet adjusted for depreciation and revalued to fair market value where applicable. But there are fixed assets and there are intangible assets. The intangible asset valuation, of course, is highly subjective. It's more likely to be taken as the difference between fixed assets and market capitalization. So it's derived subsequently. And of course, you have to bear in mind that it's the net asset position you're looking at after taking off the liabilities. Net book values, therefore, may be adjusted if the company is in financial distress. More useful in asset rich companies such as property investment companies, not so much in technology companies. The market approach assumes that in a free market, the balance of supply and demand will correctly price an asset. This also assumes that information in the market is efficiently distributed and investors act in a logical rather than emotional way. So you can see there are some flaws in the assumption straightaway. Comparable companies valuation is a method where a peer group of comparable companies is used to value either a private or a public company. The average of the peer group valuation ratio, such as the EBITDA multiple or the price earnings multiple is used to derive a range of values for the company being valued. In the case of a public company, this may help to identify whether the market is undervaluing or overvaluing the company. The precedent transaction approach takes a group of historic M&A transactions and uses them as the valuation benchmark. The deal values are used to derive ratios which are then applied to the company being valued. This approach, of course, is fundamentally historic and backward looking. It does not take account of any acquisition premiums paid in the deal for the control of the target company. And I can tell you from experience, identifying a suitable peer group and its underlying financial information can be problematic. So, these market based valuation approaches are often used widely used, in fact, by investment bankers for a number of purposes, initial public offerings, M&A advisory work, fairness opinions, restructuring, share buybacks. Multiples and ratios also have a role when driving the terminal value in a discounted cash flow. So we're going back now to intrinsic valuation. The assumption is that a sale of the business at the end of the cash flow periods, five or ten years, normally, and a profit multiple of EBITDA or PE is used to assume that the business has been sold and therefore it puts a value on the business. The alternative approach is to assume the perpetual growth of the firm into the future, which, as you can imagine, is problematic as well. Neither approach is particularly satisfactory, but they are easy to apply. One final word is that you have to be aware that terminal value can often be a significant portion of evaluation in a discounted cash flow, so you do need to be very careful how you derive it, whether you're using multiples or the perpetual growth method. So this is a process and not a destination. Company valuation is clearly a complex topic. You will never arrive at a finite number, and there is always the possibility of further analysis, updates, and, of course, argument. Sorry, negotiation. It's a process, not a journey to a terminal destination. Well, I hope you found this discussion of company valuation helpful. Obviously, it's a very complex topic. It's difficult for me to go into very much detail in a relatively short video. But to learn more, definitely look out for my company valuation course, which offers you over 8 hours of detailed company valuation tuition based on my over 30 years of investment banking experience. So how do you value a company? Well, you can see after this, it's just as easy as asking how long is a piece of string. 4. The Six Key Valuation Principles: Take a look now at six key valuation principles that will impact any valuation exercise or modeling exercise that you do. For any entrepreneur, these six principles will affect the value of their businesses in a practical sense. So as analysts or modelers in our search to understand valuation, it is important to understand some of the underlying issues that can impact the result. The first of these is that valuation is time dependent and can change if the underlying assumptions behind the valuation change. And these may include things like cash and cash flow, working capital and indeed, market conditions. And you only have to think about the.com boom and bust, where in 1999, a company might have been valued at 100 million, and only 18 months later, it was probably valued next to nothing. And I know from my own experience working in investment banking at that time, that I spoke to a lot of entrepreneurs after the.com bubble had burst, and they couldn't really understand where all the value had disappeared because they had been told repeatedly how valuable their businesses were, and then after the bubble burst, they were told they were worth next to nothing, and particularly if they had no profits. The second principle is that whatever method you use for valuation, future cash flow is an essential component in determining value. Now note, we refer to future cash flow, not historic as we base our valuations, particularly when we're modeling on the future value of the company on the future forecast of the cash flow. So, cash flow takes into account profits, capital expenditure, and working capital, but it doesn't take into account things like financing costs and dividends, which are separate issues completely. One is a function of capital structure and the other one is an election on behalf of shareholders whether to take money out of the business. So in preparing evaluation, financial modeling enables you to construct a forecast of these cash flows, and you use the historic numbers only to underpin the assumptions for the future forecasts. The third principle is that market forces determine the rate of return and vary over time. Now, other variables feeding into rates of return include things like market conditions, the industry or sector that business is operating in, the costs of financing in and overall economic conditions. But you can reflect these in the input assumptions in your model. In a practical sense, timing is a critical issue when planning any sort of business event, whether it's an investment, and acquisition, a company sale, or an exit. The fourth point is that net tangible assets may impact e valuation. Now, it's easy to understand why physical assets underpin valuations and accompany with higher levels of net tangible assets may benefit may benefit from a higher valuation. In practice, this is more relevant in a downside scenario, such as a liquidation or a bankruptcy when those assets can be sold off and have value. It is just a matter of fact that some business models are just not capital intensive, things like technology or services businesses, for example. So you shouldn't expect companies with low levels of tangible assets to be necessarily less valuable, but you should be aware of the potential value, particularly on the downside that tangible assets may have in a business. The fifth principle is that cash flow should be independent of ownership. Now, the point here is that any business which is unduly dependent on its founder for its cash flow will have a lower value. And it's important when communicating to clients or entrepreneurs that if the business is entirely wrapped up in them, then it's very difficult for them to hand that over, and therefore, the expectation will be that when they do hand the business over, the cash flow will be negatively impacted because they're so tied up in things like service delivery, customer relationships, or sales growth. The way to solve this is to have a balanced management team to disconnect cash flow and ownership. The final point is that value is a function of supply and demand. We've already seen how subjective value can be. So if there are more buyers, the value will increase through competition. If there are more sellers, the value will decrease through lack of demand. It all comes down to the perceived value of the asset at a specific point in time. So when you're preparing valuations, as an analyst, you need to factor in these principles to the underlying assumptions of your model. Variables are so called because they change, they vary, and these changes can impact the valuation process and the results of the valuation process and the outputs of your model, and it's not surprising that the valuation may change over time if the underlying assumptions, if the principles we've discussed in this lecture vary over time as well. So that's an introduction to the six key principles of valuation. The point here is to get you to understand that there are underlying issues which need to be reflected in the assumptions of your model and that they can be explained and they can be structured, and you need to have that detailed underlying understanding of these principles so that you can explain them if you're building a model for a client. 5. How does Cost Valuation Work: So how does cost valuation work? Well, I should really have called this lecture cost valuation and other asset based methodologies because it does open up the whole question of valuing businesses based on the assets in them and what they can realize. And the starting point for that is cost based valuation. Now, these are seldom used in corporate finance and M&A, but you do need to be aware of them and understand the approach. The cost based approach looks at what it would cost to rebuild the business to its current levels and profitability. So what do you have to spend to go out to reassemble these assets? Of course, this is quite difficult and complicated because you're not just talking about the physical assets in the business, but you're also talking about the brand, the goodwill, the people, the connections with suppliers, the whole ecosystem of the business. Just think about Michael Porter's life cycle and his whole chain of connections that businesses have. It's much more than just buying the assets on the balance sheet. The approach as well is purely historic and takes no account of the future growth of the company, which is a major limitation because what you're really interested in evaluation is what you will earn from the business going forward or the investment going forward at the point from which you make the investment. And what has happened in the past is really only a guide, but it's not that relevant to what you will achieve. You can think of cost valuation as an asset based valuation, and it's basically you start with the balance sheet values and then you try to work out what these assets would cost today, and then you have to put on all the other non tangible elements that I've already alluded to. Note two that balance sheet valuations, of course, are represented at the lower of cost or fair value. So you're starting straightaway with a discounted asset. And of course, on top of that, you can layer the depreciation that has been applied to these assets, and if there are intangible assets, you'll have amortization as well. Another asset based approach is to estimate the liquidation value should the company's assets be sold off. Again, this is often at a discount to their fair value because such sales take place in distressed circumstances and assets are often sold at discounts to their fair value. Now, we will touch on asset valuation methods in this course, but they are of limited use to determining valuations of businesses and assets, and you need to be aware of these shortcomings in this methodology in this approach. So that's a quick look at at cost based valuation and other asset value approaches. And you can see that all of them fundamentally have a number of flaws which make them a very limited use to us in the corporate finance environment. 6. Types of Ratio Analysis and their Role in Valuation: I want to open this discussion about ratios by looking at the different types of ratio analysis and their role and the overlap with valuation. Ratio analysis itself is a technique for evaluating company performance by analyzing its financial statements over a period of time. You need to be clear in your mind about the distinction between ratio analysis and using ratios in valuation. Ratio analysis enables the performance of the company to be evaluated over time and compared to its peers. It also allows us to adapt the methodology to create some tools which we can use in valuation. So there are basically five different types of ratio analysis, profitability ratios, which look at the profitability of the company as it stands and over time, solvency ratios, liquidity ratios, turnover ratios, and earnings ratios. Now, many of these ratios are simply measures of performance not evaluation. You can, of course, compare companies side by side. But it does it is clear and you need to be clear that ratio analysis in this respect is a completely separate discipline to evaluation. However, we can adapt the ratio approach for use in valuation. When we combine financial information with price data with market data, we're able to create ratios, which we can then apply to target companies to value them on a comparative on a relative basis. We can also use these ratios to evaluate compatibility of peer group companies with a target company. So does it have the same level of gearing? Does it have the same level of profitability? Does it have the same rate of growth? These sorts of criteria. Earnings ratios can be used to generate comparative values. So earnings per share, the price earnings ratio and the pay ratio, the price earnings to growth ratio. We can generate valuation ratios by comparing income statement data to market capitalization or enterprise values. Things like enterprise value to sales to EBITDA to EBIT and to profit after tax or net income. The balance sheet data can be used as well. Enterprise value to capital employed or price market price to book ratio. The cash flow statement enables us to create valuation to create valuation ratios to. Is a tongue twister, enterprise value to free cash flow and price to cash flow. So you have to look at ratio analysis as a very useful discipline, but the technique of using ratios, we can adapt to use effectively in order to use them to create values in our comparative approach to valuation, and we're going to discuss these in this section. 7. Introduction to Comparable Company Valuation: Section, I want to take a look at comparable company valuation, and this lecture is going to introduce this to you before we go on to look at it in more detail. Comparable company valuation is a method which uses the trading metrics and ratios of other obviously similar companies to derive a value for a target business. Comparable company valuation or comps, as it's frequently referred to, is widely used in corporate finance valuation, in things like setting the price for IPOs, in mergers and acquisitions transactions on both sides of the table when you're trying to justify a price or negotiate for a higher one. In fairness opinions, when a firm is asked to present a fairness opinion about the value of a company, such as in a private equity portfolio situation where they want an updated value on a privately held company which is held by the private e quity company, something that I've done in the past, and in corporate restructuring and in share buyback situations. Now, comps can also be used as a reality check, for other valuation methods, such as discounted cash flow and dividend discount model. Note, of course, that the comps fall into the relative valuation group of evaluation techniques because we are comparing companies to each other and looking at their relative position and relative valuation in comparison to one another. You, of course, when doing this, need to be aware of the current trading and market conditions because when the market is overvalued, when it's really at high levels and is very hot, you can see distortions to the value of the company using this method. Now, an obvious example of this is in the.com boom when valuations went astronomical. And if you look even today in 2021 at some of the tech companies, whose valuations are phenomenally high. You know, by making comparable valuations to those companies today, you might arguably be getting an overvaluation if your company isn't very similar to the companies you're comparing it with. You, of course, therefore, need to be aware of the similarities and the differences between the company and the peer group you've selected for the comparatives. Okay. Comparable company's analysis is not, however, without its issues. It is a simplistic approach. You are basically taking a few ratios and multiplying some of the financial information from the target company to come up with the value. Pretty straightforward. Of course, it's static in time. You're taking the share price as it is today, and you're also taking either historic or immediately forecast financial information, very, very limited, unlike discounted cash flows which extend out over a period of time. It is difficult, unbelievably, but it is difficult to identify perfect comparison companies. There are many reasons for multiples to differ. One of the reasons you take a basket of companies and look at averages and look at means and medians. But nonetheless, you have to be very careful in your peer group selection. We're going to look at this. You have to understand the level of dependence on these peer groups because they will set the multipliers you're going to use in your valuation, and you should be looking at the outliers, the highs and the lows to see if there's anything distorting those valuations, and if there are, you need to understand what's causing that. And of course, it's quite short term. You're looking at historic data or short term forecast data, which can be difficult for cyclical businesses and industries. Now, despite these drawbacks, there are some advantages to the method. It's easy to generate a range of values to consider. So the simplicity, which is seen as a drawback is at the same time an advantage. It's simple to use and apply. You don't have to create a major complicated, integrated three spreadsheet model. You can just take as we're going to see some very straightforward data, which is readily available particularly for public companies. And of course, it's relevant because this is one of the core methods used both by professionals and investors to look at values of companies in the market. Now, an important distinction needs to be made between equity values and enterprise values. Equity multiples are most commonly used, but they do not take into account the capital structure of the company, and for this, you need to use enterprise value, and we're specifically going to look at this issue later in the section because it's important that you understand the difference. So that's an introduction to comparable company valuation. This is a really useful something you can use very easily, but you do need to understand its pluses and its minuses, and I'm going to show you exactly how to use it, how to create a spreadsheet, and I'll provide you with a model as well so that you can actually do this and execute this valuation methodology yourself very straightforwardly. 8. What is Precedent Transaction Analysis: Let's start by asking the obvious question, which is what is precedent transaction analysis? Precedent transaction analysis is one of the three main valuation methods used in investment banking. The other two are obviously comparable companies analysis and discounted cash flow. This method, precedent transaction analysis. Let's call it PTA. It's much easier. This method relies on previous transactions in the M&A field to provide valuations of similar companies. After all, these values were realized in a real deal. They were worth what someone was prepared to pay for them. As with Cops, this method is a relative form of valuation. Unlike Cops which rely on current prices, precedent transaction analysis relies on historical deal data. The similarities between the two methods are that they're both relative methods. They use multiples to create the valuation. The peer group is always difficult to establish and the pricing is market based. However, there are some significant differences. Takeover premium is included, and we're going to look at that in this section. It's particularly significant obviously with transactions in M&A where you get that extra piece of value created and paid by the buyer in order to take over the target company. The historical nature of the data is potentially an issue because it might get out of date, and information, of course, may not have been disclosed about the deal, which sometimes makes it difficult to use the transaction as a precedent. So let's look at the PTA process step by step to understand how it works. The first step is to identify the relevant transaction. This is putting the peer group together as you do in the comps process. You need to find transactions which are right and relevant for your target company. The criteria include some of the criteria shown here, the SIC code, whether it's a public or private company. The key financial metrics of the deal, revenues, EB DA, profit after tax. The location of the business is critical. The geography is very important. Where's the HQ and where are all the operations? The products and services offered, obviously. The type of buyer can be important because that'll say something about particularly the premium paid, whether it's a private equity firm, a strategic buyer, a public company, or a private company. And of course, the deal size has to be in the same ballpark as your target company in terms of its valuation. And then, of course, you need to be able to calculate the various valuation ratios, things like enterprise value to sales and enterprise value to EBITDA. The next step is to screen the peer group. You should be able to identify a long list of transactions, but you have to filter out those that don't fit or those for which you don't actually get all the key financial data that you need. Further research, of course, in press releases and analyst reports may help you to fill in missing information. The next step is to assess the valuation multiples. These need to be screened and the outliers removed. Now, we've talked about takeover premium and we will look at it as a separate lecture. But if there's a particularly high premium, this can distort the valuation of that deal, and it can distort the valuation of your calculation. So you need to be very aware of this. And then you need to calculate the mean, the median, the high, and the low as you do in Cs, and you calculate the high and the low so you can identify the outliers. The next step is to apply the multiples. So you apply the multiples from your analysis to your target company to establish the range of value. And then you can present the results either in a table, from your spreadsheet graphically, or in a footballs field style presentation, along with results from other methods. This is where you have them all on a graph and you show the different methods alongside each other. So you can understand visually what the range of values are for the particular company from the different methods that you've used. Now, PTA precedent transaction analysis has a major caveat in my view. The transaction multiples tell you nothing about the deal. Each transaction, as I know from my own experience, is always unique, and the strategic reasons for the deal are unique and they can result in very unusual premium being paid. I can remember one deal where we paid almost twice what the company had sold for only 18 months before, because it was so strategically important to my client. I was worth him to pay that premium to make the acquisition that he wanted to make. And yet, if you looked at it on paper and you didn't know anything about the deal, I'd be very hard for you to understand why that premium was paid. So you have to choose your peer group with great care and then do your due diligence on the deals to understand their background. At the very least, read the deal press release. So that's an introduction to president transaction analysis. I hope you find helpful as an outline. We're going to look at it in a lot more deal, and I am going to show you how to put this all together. 9. What is a DCF Valuation: Let's start by asking ourselves, what is a DCF or discounted cash flow valuation? Discounted cash flow is a method of valuation, which is used to arrive at the value of an investment or an asset or indeed a company based on its expected future cash flows. Hence, its name discounted cash flow. In simple terms, we aim to arrive at the value today based on the cash flows of tomorrow. The model can be applied to a range of cash flows. It can be applied to dividends. You get the dividend discount model. It can be applied to earnings, operating cash flow or free cash flow. You can end up with the discounted asset model, the discounted residual income model, or indeed the discounted free cash flow model. Whichever cash flow you apply it to, you need to be aware of the limitations of that cash flow, what it means. And also, you need to ensure that you calculate the right discount rate for that particular cash flow. Now, we're going to come onto all the detail of this later in this section, but just be aware that discounted cash flow isn't automatically going to be applied just to free cash flows. In all cases, the model requires a rate of return or a discount rate with which to discount the future cash flows back to the present day values. This takes into account the time value of money, essentially, very simple. The basis is that $1 or a pound in your pocket today is more valuable to you than $1 or a pound in your pocket in 12 months time. Why? Because you can spend that dollar or make an investment with that dollar to earn you a return now, you don't have to wait 12 months. So that dollar or pound can be earning money for you over the next 12 months as opposed to you having to wait a year in order to get it and then start investing. So time value of money is a critical part of any DCF valuation. The following steps are required to arrive at a DCF valuation. To start with, you need to create a model from which you can project, calculate the future unlevered, means they have no debt in future cash flows, free cash flows of the business you're looking at. You then need to calculate the terminal value, which is basically the value at the end of the period of the model. Normally, five years, seldom you would be make it as short as three years and sometimes you might go out to ten, but clearly the further you go out, the more hypothetical your assumptions are about what the cash flows are going to be because it's so much more difficult to see that far out. You then establish the discount rate or the rate of return that you require, and then you calculate the enterprise value, by discounting the projected unlevered free cash flows and terminal value to the present day to the present value. And then you calculate the equity value by subtracting the net debt from the enterprise value. So those are the essential steps, but don't worry about them now. We are going to go into them in a lot more detail. If you're calculating the value of a company, the DCF will give you an absolute value based on your initial assumption. So it will give you a number. If you're using the method to evaluate an investment, the investment will be profitable if the DCF value exceeds the initial cost of the investment. If you're evaluating a listed company, the DCF valuation can be compared to the company's current stock price to understand whether the company is undervalued or overvalued in the market. A DCF valuation should, however, seldom, in my opinion, be used on a standalone basis. It's advisable to balance this approach with market based methods such as comparable companies and comparable transactions to get a balanced view, a range of different values to ensure that you're at least in the ballpark. Now, here's an example. This enables you, by having these different values, you come up to a range of values for your asset. So here we can see what is called a football field, which is basically a graph on which you show the different methodologies laid out. And here we can see that the comparable companies give a range of 30 to 45 million. The comparable transactions give a range of 40,836 million. The DCF base case gives a range of 42 to 39 million, and the DCF scenario, one, whatever it happens to be, it looks like it's more of an upside scenario than a downside scenario, gives a range of 54 to 40. So you can see that you have a range of values, and then you can adjust your modeling your DCF assumptions to test your different scenario outcomes, to evaluate their impact on the valuation. You can see what your assumptions are effectively doing to the valuation. This is one of the real benefits of having a DCF model is that you can test different scenarios and sensitivities. Now, a DCF valuation is not without its challenges, and we will examine this as we go through the method in detail and we gain a better understanding of its advantages and its disadvantages, as well as the implications of the assumptions and decisions made in its preparation. So that is a quick introduction to what we're talking about when we talk about a DCF valuation, but we're now going to look at this in a lot more detail. 10. What do you mean by Cash Flow?: So in the light of what we've just looked at in terms of the price to cash flow, let's ask the key question. What do you mean when you talk about cash flow? This is probably a good point in the course to review the differences between earnings and different cash flow metrics because they are critical to all aspects of valuation. Starting with EBT dA, which represents earnings after all operating expenses, but before depreciation, amortization, interest and tax. EBIT includes depreciation and amortization. I'm sure you can see that. Net income or profit after tax is profit after interest and tax. Net income divided by the weighted number of shares in issue equals earnings per share. Those are the income statement metrics which we need for our valuation. Note that EBITDA is often used as a proxy for cash flow. In practice, the two are seldom the same. And when you conduct your own valuations, you should check, have a look at the different levels of cash flow and have a look at the EBITDA and see where the differences are and see how significant the differences are because they will always be different. However, cash flow can be a little more confusing, which is why I'm going to walk through it here in some detail. There are basically four different ways of talking about cash flow. And very often, people will just talk shorthandedly about cash flow. When they could actually mean any of these, and indeed, it's most likely what they really mean is free cash flow to the firm, unlevered cash flow, which is actually the most complicated of them all, but they'll very often just refer to it as cash flow. So you mustn't get taken in by that or side swiped by. You must understand exactly what's being spoken about. Starting with cash flow or cash flow from operations. This is a measure of cash flow from normal operations. You take the net income and you add back the depreciation and the amortization. You then also add back all other non cash items such as stock based compensation. It also includes the changes in net working capital between the two balance sheet dates. However, operating cash flow does not include capital expenditure. Free cash flow, FCF basically is the next step, and it basically is cash flow from operations, but then after deducting capital expenditure. This is the cash flow that management can now use for discretionary spending from anything from acquisitions to further C to paying dividends. The third one is free cash flow to equity, FCF E, also called levered cash flow. This takes the operating cash flow and deducts CAPEX, but it also then adds the net debt issued and deducts the net debt repayment and includes any interest paid on debt. This then represents the cash flow available to equity investors, taking into account the leverage in the company. Hence, it's referred to as either free cash flow to equity to the equity investors or it's called levered cash flow because it's taking into account the leverage in the business. Now we come to the f one. Free cash flow to the firm, FC FF or unlevered cash flow. And the critical thing about this is even though it's the most complicated, this is the cash flow used in discounted cash flow calculations, so you absolutely have to understand it. And I make no excuse for explaining it here long before we get to discounted cash flow. It'll really help you to have this bedded down. Let me take you through the calculation. You start with EBIT earnings before interest and tax off the income statement. You then calculate the hypothetical tax based on EBIT as if there's no tax sheeld in the business, because if interest would give you a tax shed. So you calculate the hypothetical tax on EBIT. You then add back the depreciation and amortization. You then deduct any increases in non cash working capital and you deduct CP x. That brings you to the FC ff, the free cash flow to the firm, and that's the critical line of cash flow you need to calculate your discounted cash flow from, and that is what is often referred to when people talk about cash flow. The main lesson from all this is that you need to understand the metrics you are working with when preparing your ratios. EBITDA is easy but the least accurate. Free cash flow to the firm, unlevered cash flow is the most complicated, but it's the most accurate and it's the one you have to use in discounted cash flow calculations. On balance, these ratio metrics provide us with easy to calculate ratios which we can apply to comparable companies valuations. In the end, are they really a replacement for DCF? I'm not sure. I think comparable companies valuations certainly complement DCF, but I would rather have a DCF instead of a comparable companies valuation. So I hope that helps you to understand when we asked the question, what do you mean by cash flow? It's not a simple answer, and you really have to get your mind around these different types of cash flow and understand exactly which one is being used, how to calculate it, and definitely use the right free cash flow to the firm when you're doing discounted cash flow valuations. 11. Drivers of Business Valuation: When creating your discounted cash flow model, you need to be very aware, very sensitive to the assumptions you're going to make, to the inputs that will affect business valuation. So in this lecture, we're going to take a look at the drivers of business valuation in a discounted cash flow model. So in a discounted cash flow model, we need to be aware of the inputs that directly affect cash flow. And this is not necessarily a straightforward linear exercise. You do need to give some considerable thought to this. So we're going to discuss in the next lecture, some of the strategies a business can adopt to generate more cash. But here, I just want to focus on the drivers themselves. The area of the model, which impacts this is your input sheet where you make your assumptions forecasting the future performance of the business. The main drivers behind all this are things like market size, the mix of sales, volume and price, cost of raw materials, staffing levels and business costs, wage rates, tax structures. So all the sort of major inputs, if you like to the income statement, to the profit and loss account. We can also look, however, at issues on the balance sheet, affecting particularly working capital and the plant and equipment. So, accounts receivable, the inventory, accounts payable, and then the maintenance, investment and duration, the life of, if you like the plant and equipment used in the business itself. The financing structure of the business will also affect the discount rate through the weighted average cost of capital. Now, it will impact the cash flow directly, obviously, because interest costs will leave less money available for dividends. But you'd be aware, of course, in a DCF valuation, the cash flow line is taken before the financing on an unleveraged basis. These drivers can be diagrammatically represented in six seven straightforward boxes, and we're going to discuss each of these in turn. So let's think now about the thinking behind the assumptions to help you to understand how to approach your inputs. Starting with revenues or sales, if you like, and these should be based on an objective assessment of sales projections as well as historical rates of sales growth. So you don't want to see any hockey six. Thank you very much. Gross profit or operating margins should be calculated bottom up from the constituent costs and reflect and reflect historical rates of profit margin in the business. A sudden improvement in these would significantly improve cash flow, but would raise a red flag in most DCF model. EBIT or EBT DA margins again should reflect historic rates. You have considerable opportunities for operational efficiencies here, but also be aware that the proportion of many of these will increase with sales. That is to say, you need to be aware of which costs are fixed and which are variable. Depreciation and amortization are non cash items which reduce profit but have no direct impact on cash flow. You should always take the depreciation number from the cash flow statement rather than the income statement, as you know it will not be distorted by accounting policies or accrual accounting. Historical tax rates can be a good guide here, but it's better to be conservative rather than rely on tax saving structures. Be aware, of course, that interest in most jurisdictions is deducted before tax which can have cash flow advantages in levered companies. Working capital should be assumed to operate on the same basis as it has historically. So you can't have great improvements in your accounts receivable days or your accounts payable days. As the business grows, so will the cash requirements for expanding levels of working capital, which should be proportionate to revenues and costs of goods sold. Capital expenditure is not something you can cut corners on in a DCF valuation model and retain credibility. So in your model, assume historic rates, and in practice, this should be decided by management after an appropriate budgeting process. The capital structure of the firm is critical to its ability to continue to fund its business. Obviously, the amount of bank debt, bond issuance, preference or common stock is again a management matter. For your model, assume an unchanged capital structure and work out the weighted average cost of capital carefully. A final word on timing. The timing of future investments which have the ability to accelerate growth and increase profits in cash flow should be carefully considered. One advantage of a DCF model is you can run scenarios based on different timing assumptions to see the impact such investments make on the value, and therefore, on the value of the investment decision itself. So that's an overview, if you like an insight into the drivers of business valuation and the approach you should take in your modeling to ensure that your model is an accurate representation of the historic performance of the business. 12. The Weighted Average Cost of Capital Formula: Let's take a look now at the weighted average cost of capital formula. The weighted average cost of capital or WACC is the cost of capital for a company which combines the cost of capital across all types of financing and weights for the proportion of the different types of capital that are in the capital structure. And this is the discount rate we use for our discounted cash flow model. And this can be seen in the following diagram. Here you see the weighted average cost of capital split between the cost of equity and the cost of debt. The cost of equity is the risk free rate beta and the equity risk premium, which we've just been looking at, which is the capital asset pricing model. And the cost of debt is the average yield on the debt multiplied by the tax shield. I'll explain that in a minute. And then you get the cost of equity plus the cost of debt balanced out for the relative proportions of debt and equity, and you get the weighted average of the two, and that gives you the cost of capital. So the WACC formula is as follows. And it looks a bit daunting. But basically, you can read the top is the formula, and the bottom, if you like, is the English explanation of what the top tells you, and I'm not going to read it out to you because you can read as well as I can. So the elements of the formula, and this explains the components, E is the market value of equity, IE, the market cap of the company. D is the market value of debt. V is the total value of capital equity plus debt. E divided by v is the percentage of equity, and D divided by v is the percentage of debt, which you need to get the weighted average. R e is the cost of equity, which we get from the capital asset pricing model, and RD is the cost of debt, which is the long term yield, the yield to maturity of the interest cost of the debt, and t is the tax rate. Now, if there are other types of capital in the capital structure, such as convertibles or preferred stock, their weighted costs should be included in the calculation as well. The cost of equity, as we've seen, is calculated using the capital asset pricing model, and we did this in the previous lecture. The cost of debt, which is usually cheaper than equity, and so enhancing to returns is calculated using the interest rate of the debt or the yield to maturity of the debt. However, because our DCF uses cash flows after tax and interest costs are tax deductible, we can reduce the cost of debt by the tax rate. So we have to multiply the cost of debt by one minus the tax rate. This is one of the major reasons, debt is used in leverage transaction. Firstly, it reduces the cost of capital. Debt is cheaper than equity, but it can also the cost of debt can be the interest costs can be deducted from taxable income, so you get a tax shield from the costs of the interest costs, and this means that you can further reduce the cost of debt. Be aware, of course, that excess debt, too much leverage increases business risk. Note also that different debt instruments will have different interest costs, different yields to maturity, and each will need to be calculated separately to arrive at the blended cost of debt. To arrive at the weighted average cost of capital, we simply add the weighted cost to the debt and equity together, the weighted cost of the debt and equity together. Now, we have the discount rate to use in our discounted cash flow model, and this is also the hurdle rate with which the company should evaluate investment opportunities. One detail to be aware of is the difference between nominal and real WACC. Nominal free cash flows include inflation and should be discounted by a nominal WACC. This is the most common way to construct your DCF model. If you use real free cash flows and exclude inflation, you need to adjust your WACC to reflect this. So that's the weighted average cost of capital formula, which I hope you find now relatively straightforward because we're really only building on the capital asset pricing model. I'm going to look at a specific example to show you how this is calculated in the next lecture. 13. Understanding the Discounted Cash Flow Formula: Let's take a look now at the discounted cash flow formula, and I want to explain it to you in very straightforward terms so you understand exactly what it means, because if you just look at the algebra, it can look really quite daunting. Now, on the face of it, the DCF formula looks formidable. But I'm going to break it down for you into its components and explain exactly how it's made up and that I hope will make it easier to understand. So the DCF formula basically tells you that it is calculating the sum of the future cash flow in each period divided by one plus the discount rate, normally, the weighted average cost of capital. Don't worry about that. We'll come onto it later, raise to the power of the number of the period plus the terminal value similarly discounted to the present by the power of the number of the period. Now, the cash flow is CF. The interest rate is represented by little r. The number of periods is represented by n and the terminal value is TV. The formula then looks like CFN over one plus r to the n. But don't worry about that. All you have to do is understand the basics of how you put it together and you don't have to become a wizard at understanding all these formulas. So essentially, the cash flow is the cash generated by the asset, the company, whatever it happens to be in each period. And when conducting a DCF valuation on a company, we use the unlevered cash flow. This is the free cash flow that assumes the company has no debt. It's also known as the FCF, the unlevered cash flow, and also the free cash flow to the firm, the FCF f. These little acronyms get quite confusing, but just understand you're using the unlevered free cash flow. When you're doing a company valuation. Discount rate R is the rate by which we discount the cash flows to the present day value. When valuing a company, we use the company's weighted average cost of capital, as we've already said. The period number n is the time period of the cash flow. This is typically a year, but it can be months. It just depends on the asset you're valuing. But not if you're using months, you need to adjust the discount rate to reflect the shorter time period. The terminal value, TV is the value of cash flows beyond the five year period projection of your model. So if you're doing a three year cash flow projection, the terminal value starts at the end of year three. If you're doing a ten year, it starts at the end of year ten. It basically represents the future cash flows after the end of the model so that you have a complete value. Now, you do this because after the end of the model period, normally five years, the future value has become increasingly difficult to estimate based on the assumptions of the model. Another point to be careful of here is in very short periods. Let's say it's a three year model. The terminal value becomes a very significant portion of the value. In a ten year, it's normally about half. But even in a five year model, it's a significant portion and it has its sensitivities, which we're going to go into. But bear in mind the terminal value is an important element of the calculation, and it can make a significant proportion, albeit, of course, it's discounted to the present day. Now, there are two ways to arrive at a terminal value. Either you could use an exit multiple, say an EBT DA multiple, where you're making the assumption that the business is sold for its value at that time, using that multiple, and that's a very simple way of doing it, but of course, there are sensitivities to what multiple you use there. And then you have the perpetual growth model, which is a formula which assumes that the company continues to grow in perpetuity. The two do arrive at slightly different values, but they're not significantly different. And if you're not sure, then look at both of them and then choose probably the most conservative. So we end up with a little spreadsheet laid out. This is not a spreadsheet. This is just a slide, but you can see that you have the cash flows of $200 or $200 million in each period. Periods are years, in this case, one, two, three, four, and five, and then the terminal value at the end of year five, which we're assuming is 600. And then you have the formula. You can see it's 1/1 plus r to the n, and you can see the calculations going forward there. So it means that the present value of a cash flow reduces over time as the discount rate applies. The further out the cash flow is the less money it's worth to you. And you can see this now when we put the numbers into this calculation, you can see that the $200.01 year out is worth $182, but at five years, it's only worth 124. So when we total the discounted cash flow, we arrive at a DCF enterprise value in this case of 1.130 million dollar, and that's how the basics of the cash flow are calculated. Now, the DCF value is also referred to as the net present value. It is the sum of all negative and positive net cash flows discounted net present value to the present take. In Excel, you can use the MPV function, and all you do is you input the discount rate and the series of cash flows, as you can see on the right, and this gives you an enterprise value in the calculation. It does all the calculating for you. Bear in mind that you must make sure your discount rate reflects the periodic the periodic. I can't say the word, the number of periods and that it's years or months. So you have to have a discount rate reflecting years or discount rate reflecting months in the formula. And you must make sure that you also have the terminal value in there as well. And then you can adjust for the cash and the debt in the business to arrive at an equity value. But we're going to look at that again in more detail later on. The net present value then tells you how much to pay in order to make a rate of return equal to the discount rate. If you pay more, your return will be less than the discount rate, and if you pay less, you will exceed the rate of return. In the context of a company valuation, the value is based on the cost of the company's capital, the weighted average cost of capital, WACC, as we've already seen. This takes into account the blended cost of capital for each type of capital in the company's capital structure. It's also used or should be used by the company as a hurdle rate when evaluating investment or acquisition opportunities. So I hope that helps you to understand the discounted cash flow formula. It helps you to get past the formula itself and understand really what is going on. And if you understand that, you don't have to worry about exactly what the letters and the formulas mean. Just concentrate on understanding how it's put together, and this will enable you to move forward. 14. Three Ways to Value a Private Company: Let's take a look at the three basic ways we might value a private company. As we've already seen, valuation can be defined in a whole range of different ways, fair market value, market value, fair value for financial reporting, fair value for litigation, investment value, intrinsic value, and so it goes on. But the lack of transparency in the private company market can add another dimension to this and make private company valuation very problematic. So let's take a look at it at the most basic level. The three separate approaches to private company valuation, assets, earnings and cash flow. The asset approach is simple but not foolproof. If we simply look at the book values and take the value of all the company's assets less its viabilities, we arrive at ness asset value. Now, as we've already seen, this doesn't take into account any future earnings the business might have. We've also seen that depreciation and amortization policies can significantly affect values. So this approach works well for stable asset rich businesses such as property or investment companies. The earnings approach to private company valuation can utilize the earnings per share of the company and apply a suitable price earnings ratio based on a group of peer companies. But as ever, this is not straightforward. We've already identified the difficulties in finding appropriate peer group companies in a public company context. With private companies, the process is no less challenging. We may not know enough about the private company to match it to the public companies. And obviously, we're looking for public company comparators, and that can be very difficult. The first step with your private company earnings is to make sure that the financial statements are prepared to the appropriate local accounting standards, IFRS or GAP. If this isn't the case, the income statement and therefore, the earnings could be materially misleading. For examples of where the income statement may require modification are the misstatement of gross and net sales. It may not be that the cost of goods sold is correctly defined. Owner compensation is often taken as dividends. It means they have less personal tax to pay, but of course, this will flatter the profits. And personal and business expenses need to be separated. Very often, they're intermingled. And of course, taxation, the rate of taxation has to reflect an appropriate corporate tax rate because the earnings per share is taken after tax. The earnings figure, therefore, should not be taken for granted. If there are any extraordinary or exceptional items that need to be excluded from the proffer figure, this must be done. Careful review of the directors and owners remuneration should be carried out, and of course, the accounting standards may not be as rigorous as those used by public companies. Hence the need to go back to IFRS or to US GAP. The number of shares in issue needs to be averaged out for any share issues during the year, and of course, any options or warrants or other convertible instruments need to be factored into the calculation as usual. Earnings is by no means straightforward, and this brings us to cash flow, which should be much easier, but of course, it's not. We need to start off by preparing our discounted cash flow model. Now, we've already identified in our DCF modeling discussion, sensitivities around input assumptions, capital structure, cost of capital and of course terminal value. With private companies, one of the most problematic errors is identifying the correct company specific beta. While these are calculated in many online sources for public companies, this will not be the case for private companies. The assumption has to be that the private company has more company specific risk than a public company. But how much more? The range of small company liquidity discount can be anything from 10% to 30% for a small owner managed business. For a start up, the discount may only be three to 5%. The discount may also vary depending on the party on the other side of the table. They may have good reasons to want a lower rather than a higher valuation, an investor or acquirer, perhaps, and will use the discount as a means to achieve this. So it's going to be very difficult to have a di meaningful discussion or argument about the discount rate. Furthermore, if the counterparty is a large public company, they may apply a smaller discount because there's less risk in the deal for this type of business. But if the counterparty themselves are private investor or a buyer, the discount they may apply is higher. The terminal value calculation is not without its problems. If the business is a small owner managed business, then is it realistic to assume a perpetual growth? Would a heavily discounted terminal value be more appropriate or a very low exit multiple one or two times? You might even consider a liquidation value at the end of the period or in extreme cases, not include a terminal value at all. So the ways of using our standard methodologies to calculate private company value private company valuations, as you can see, is difficult. It's not straightforward because of the lack of transparency you have in a private company, and we're going to have a look further at some of the challenges involved in trying to value a private company in the next lecture. 15. How do you value a Startup?: So how do you value a startup? If you're asked to value a start up company with no revenues and no profits, where do you start? All the valuation work we have done in this course requires there to be a business to value, an actual business up and running that you can put some numbers on, which of course makes this topic extremely interesting. And we're going to focus on valuation and not capital raising in this discussion, although to a certain extent, you'll see there is a degree of overlap. Entrepreneurs need valuations for their start up companies when they want to raise money because it requires them to answer three key questions. How much money should they raise? What percentage of the company should they sell and what valuation should you use? Now, it doesn't take a mass genius to realize that these three questions are interconnected. They're mathematically interrelated. You move one, the other moves two. You can either start by deciding how much to raise or you can decide how much of the company you want to sell. The question on how much to raise is determined by the 12 to 18 months cash requirements of your business. You should have a financial model, which tracks this very carefully, certainly on a month by month basis, and that should give you some idea of how much cash the business is going to require plus some sort of contingency. The question of how much the company to sell is largely determined by the return expectations of early stage investors. For a seed round, ten to 15% is probably the norm. But for an angel round and certainly for a VC round, this can go up to 30% and indeed beyond. The stage of the business as well makes a big impact on the valuation. So the company might only have an idea. It may even not be a company at this point. It might have a product but only in a mock up form. There might then be an MVP, which is a minimal viable product, which is the absolute basic product, no bells or whistles. Then you manage to go to an unpaid pilot, so you agree to work with a potential customer really to try out the idea and get it running, and they get the benefit of the product or the service or whatever it happens to be, the software without paying for it, understanding that you're developing it as you go. The paid pilot obviously extends that a step further where you get money back for it, which, of course, is nice. And then eventually you get to a point where you get a customer and you're into revenue. Now, this stage also impacts the type of investors who are going to be interested. So if it's only an idea, it's probably friends and family and probably at the mock up stage, that's true, too. The minimal viable product, angel investors get involved, and certainly, they'll be interested at the unpaid pilot stage. The paid pilot stage, you're getting into seed funds, and once you get into revenue, then potentially into venture funds. The starting point for valuation then is no better than a rule of thumb, and I want to take you through this idea of stage of development and show you how it can impact the amount of money you need to raise and the valuation on the business. So at the idea stage, you might try to argue for a 300 to a $500,000 valuation to raise 50-100 k. You can see how those numbers relate to one another. And this will get your idea off the ground. You may indeed be able to bootstrap this and not raise any money at this stage. The prototype stage, valuation creeps up a little bit, 300 750 k, and you're looking to raise 100-250. Your prototype is ready, possibly after six months, hard unpaid work. This will, of course, increase your valuation. But remember, the later you raise money, the less dilution founders will suffer. At the launch stage, you've nudged your valuation up again 500 to 1 million. You're looking to raise maybe 150 to 350,000. Your product is ready to launch, but you probably haven't yourself been paid a cent since you started this whole exercise. At the traction stage, you've nudged your valuation up again one to $2 million. This looks to raise maybe two 50 to seven 50, possibly even a bit more. Your launch was successful and you're seeing good signs of traction. Revenues are coming in, but you're still burning cash. At the revenue stage, your valuation is now one to $3 million. You're looking to raise one half 1 million to $1 million. Now the revenue is looking steady, but you're still some way from profitability. But it is time now to think about how you're going to scale up your business. At the scaling stage, your valuation is $3 million plus, and you're looking to raise $1 million plus. By now, you need to have a good product market fit, repeatable business, significant market demand. You've developed your scale plan and your new customer acquisition strategy. So far, then, the startup valuation all seems to be guesswork. You get to this stage, you get about that sort of valuation. So it's very arbitrary, but it's a good rule of thumb, and I certainly wouldn't dismiss it out of out of hand. These rules of thumb are useful, but I do believe if you're raising runny, you do need to be a little more scientific, and we're going to discuss this and develop the idea in the subsequent lectures. So that's a sort of introduction to how you value a startup, really focusing on the stage of the start, the types of investors, the amount of money being raised and how that is reflected in the valuation. In the subsequent lectures to this one, we're going to look a little more deeply into some more scientific, more numeric, quantitative methodologies to see how they can tighten up the whole discussion about start up valuation. 16. What is a DCF Model: Let's now ask the question, what is a DCF, a discounted cash flow model. Well, DCF, as we've seen, stands for discounted cash flow, and a discounted cash flow model is a financial model for valuing a business. And what it does is it forecasts future cash flows and then discounts them back to the present to calculate today's valuation. Now, we've discussed elements of the DCF valuation process and the model in previous lectures. I want to try now to bring these together in this section to understand how we use them in DCF modeling. A DCF model has a number of key components. It has its input assumptions, Three financial statements, which are the income statement, the balance sheet, the cash flow statement, all of which are integrated, and then a discounted cash flow calculation page. We need several components from our model to calculate our discounted cash flow. We need the unlevered cash flow forecast, which is then discounted to the present. We need to know what discount rate we're going to use, and we get that from the weighted average cost of capital and incidentally use the capital asset pricing model as well, and of course, we need a terminal value. The unlevered free cash flow, which we discussed earlier in the course, the free cash flow to the firm, FCFF is the cash which is available to both debt and equity investors. Cash is important because it has real economic value. Other than profits which are a measure of accounting, cash has tangible value and it's there and you can hold it and it's real. Now, we need our model to calculate the free cash flow to the firm, the unlevered cash flow for probably five years. Sometimes you can do three, five is the norm, ten is going a bit far. The time value of money tells us that cash today is worth more than cash tomorrow. It follows that cash tomorrow has a value today, but we have to discount it. We have to reduce it to today's value to take account of the time delay in receiving it. So the discounted cash flow of the model takes this timing difference into account. And for this, we use the discount rate. Now, the weighted average cost of capital, the WACC represents the investor's required rate of return, and we've seen how to use the capital asset pricing model to calculate the weighted average cost of capital. As our model only goes out for five years, we have to account for the company's value beyond that period. So we need to calculate a terminal value. And this is done using either the perpetual growth method or the transaction multiple method. So what does this look like in its most basic form? Well, here are the building blocks. You basically have the input assumptions. You have the three statement financial model, and then you have the sheet which does the DCF calculation, which basically creates the forecast of the free cash flow to the firm, the cash flows we need to actually discount. It then discounts them to the present using the discount rate and calculates a terminal value. So if we look at a very simple model, and I've made this available for you in hard copy with this lecture, but I've not built any formulas into it. I've just taken a model that I've used in the past, and I've hard coded it. And then I just want you to see the layout in full of a very simple DCF model. So you can see that the cash flow is calculated, which comes in from the financial statements, and then we make the various adjustments in order to arrive at the unleveard cash flow number, which is at the bottom. The discount rate is then applied to the free cash flow to the firm, and you can see we're using two different discount rates in this model so we can get a high value and a low value for the firm. The terminal value or residual value also is calculated on a high and low basis. And in this case, we're using a transaction multiple to capitalize the fifth year cash flow, and you can see the values on the screen, and these are then discounted to the present and then added to the discounted cash flow to arrive at the total discounted cash flow, which is at the bottom. You can see it's 13.34 for the low value and 16.9 for the high value. The discount factor is calculated at the bottom of the page using the capital asset pricing model, and the equity risk premium is based on the size of the company. And that's pretty well it. So that is a quick introduction as to what a DCF model is all about, what it looks like, and it gives you some idea about how you're going to be able to put it together. 17. Some Top Modelling Tips Before You Start: I'd like to walk you through some top modeling tips before you start creating your model to just give you a little bit of guidance and help you avoid any unnecessary mistakes. Now, you may be an experienced modeler, and I have to admit I've done quite a lot of modeling over the last 20 or 30 years, but there's always room for improvement. You may be self taught rather than trained. You may be completely new to modeling. No matter, here are some simple tips to help you to create a better model. When you're creating your model, I'd like to use color coding to differentiate between input cells and formula cells. And particularly, I'd like to highlight my input cells in green. It makes it very easy for somebody using your model to know where they have to put data in. And if you've formulated your formula cells in a particular way, they know not to touch those, and that's also quite useful. Maybe you can put them in gray or something like that. Or, of course, you can simply change the font color and make maybe the input cells green or blue and vice versa or leave the other ones black. But it does help to color code so that people can see where the input cells are and where the formula cells are. When creating a simple three statement financial model, it is easier to have all three statements on one sheet. When you're building your model, there will be many interconnections between these statements, and it's easier to program them and order them if they are on one sheet. Make sure that your input assumptions are clearly separate from the financial statements. Now, you could have a separate sheet from these. That's actually what I do. But if you wish, you could also put them at the top of the financial statements page, but make sure they're separate and in a clearly defined completely standalone area so that you can then focus on your input assumptions and you're not getting uddled up with the financial statements. Clearly differentiate sections of your model with formatting and shading, make them easier to understand. So as you go through the income statement, the different parts of the income statement, you use shading, use lines to make it clearer, so it's easy to see what the sections are. It makes your model much more visually appealing, and it, of course, makes it easier to navigate. You can use the cell comments feature, which is Shift F two to explain formulas or assumptions if they need further explanation. Regard this as a sort of discussion with the person working through your model to help them understand your intentions, your thought process, and if they're making inputs to the model, precisely what you expect them to input where. Where appropriate, build in error checks, which are easy to see. Now, the obvious one here is the balance sheet. Make sure your balance sheet always balances, and you want to have a little line that cells that basically checks that the balance sheet balances and throws up a warning if it doesn't. You can do that with a simple lip statement. If the reader sees the check throwing up an error, they're much more likely to correct it. So that's a really good top tip. It's perfectly acceptable to bring forward lines of your model to other parts to help the flow more logically. So, for instance, the opening, use the opening EBT DA line from your income statement to start your cash flow statement of so that it makes it more transparent. Avoid, and this is a big one. Avoid linking to other Excel spreadsheets, if at all possible, as this can create updating and recalculation issues. Nothing I hate more than opening a spreadsheet, and it says, update. And then you know if you haven't got the right spreadsheet there or the right links, then the whole thing is going to crash and it's not going to work. So really avoid that. And if it's absolutely essential, maybe format the cells to make them absolutely clear where this is going on. Another big one is avoiding circularity at all costs. Now, you can use iterative calculations or even breaks where you sort of cut and paste values is necessary. The latter is very crude modeling, but the biggest weakness in a three statement financial model is when it becomes circular. The biggest cause of this is normally the interest line as it basically affects both the cash balances in the balance sheet and the cash flow statement. So be very careful how you handle that. Use tables and charts to present your results clearly. And if you wish, have an output sheet which presents your results in a smartly formatted way, which is also easy to follow and understand, and of course, it's easy to print out or take screenshots of if you want to use it in reports and presentations. So that's some tips on modeling. Again, everybody has their own way of modeling. The key thing is to have things as standard and as simple and as straightforward as possible. But if you follow some of that advice, then it's definitely going to make your models, better and easier to follow and probably have less faults and less errors in them as well. 18. How To Create Your Forecast: I want to briefly talk to you about how you actually go about creating your forecast because if you're new to modeling, there may be some insights you can gain from this lecture. Now, the input assumptions page is where you will create your forecast assumptions. These assumptions are critical to the outcome of your valuation. So you need to give them some thought. It's the old adage, garbage in, garbage out, and you really need to give these some thought and get them right. There are four basic approaches you can take to building the assumptions and building your forecast. You can either go top down, bottom up Use regression analysis, or you can rely on year on year growth rates. And we're going to take a look at each one of these in turn briefly, so you understand what I'm talking about. Top down approach starts with the total addressable market and works down from there. So you talk about factors such as market share, customers geographies. Now, the problem with this is you're basically saying the global market for XYZ is $1 billion, and I'm going to have a 2% market share, and therefore, I'm going to have $20 million worth of sales. That is probably cloud cuckoo land pie in the sky. And I know from experience talking to venture capitalists and private equity, they absolutely hate this approach because it is like throwing darts at a dartboard. So I don't recommend it for your modeling, but that's my opinion. Bottom up is a lot more scientific, if you like. It uses the business drivers to build the forecast from the basic elements of the business. You start with products, unit prices, unit sales, and this builds up the levels of the revenue line like the layers in a cake line by line. Now, this is much easier to do if you have access to the management accounts, which, of course, you won't always have. It is, in my opinion, impractical for larger businesses. Can you imagine trying to put together something like this for something for a company like Apple? It's not really feasible. So there's got to be a degree of reason applied to this approach. Now, I'm not a great mathematician, and I'm certainly not a great modeling mathematician on spreadsheets. But regression analysis is a fairly simple concept to understand. You have a dependent variable and you have other variables which cause it to change. So basically, you're looking at the changes in the variables to forecast the value of the dependent variable. So revenues might be a function of the number of products, the price, the number of employees, and marketing spend. And you can use the forecast function in Excel to use regression analysis to calculate this. I will put my hand up and say this is not something I have done, but it is certainly an approach to creating your forecast. And if it's something you want to look at seriously, then you probably need to do a little bit more homework yourself. The simplest approach. And actually, in my opinion, the one that makes the most sense is to make assumptions about year on year growth rates for revenues and make the other dependent variables such as cost of sales a function of the gross of revenues, but keeping the same gross margin. You can look at the growth the historic growth over the past say three years, and you can extrapolate that out. Now, of course, you can change these assumptions in the input sheet to test the different scenarios for future growth. And if you know there's a step change because there's a new product coming, you can build that in But by building the future on the past, you at least have some logic and connection to what the business has done in the past. So this is the approach I would take although other modelers may have different opinions. So that's a little bit of insight into how you go about creating your forecasts. If you haven't done modeling before, it may not be obvious. But once you get the hang of it, it's actually pretty straightforward. 19. The Key Steps in creating your DCF Model: Now I want to walk you through the key steps in creating your discounted cash flow model. Building a DCF model can seem daunting if you've never done it before, allow me to walk you through the key steps one by one to make the process easier to understand. Okay. We start with our revenue forecasts. And the first step is to forecast the revenues either using the growth rate approach or using the bottom up approach, using the business drivers. We discussed this in the previous lecture. If you're very clever, I'm not so clever, you can use the regression analysis. I recommend that you stay away from the top down approach, as I explained. It's not really very scientific and it's a bit like throwing darts at a dartboard, in my opinion. Once you've got your revenue forecasts into your model, then you can look at your expenses. If you're working with a management team, you can ask for them to submit detailed budgets. But more realistically, if you're building the model on your own, then you need to rely on the level of expenses from previous years and extrapolate these based on the level of growth in revenues and assume no change in margins. Now, if your model gets more sophisticated, you can build in margin changes, economies of scale and the like, changes in pricing. These can impact profitability, and therefore, cash flow positively. And as long as they're based on reasonable assumptions, it's a perfectly sensible thing to do. These two items in combination, the revenues and the expenses should enable you to complete your basic income statement, which then enables you to turn your attention to the balance sheet. Tangible assets and working capital changes are what you need to look at next. Tangible assets such as property plant equipment will be subject to depreciation and will increase as a result of capital expenditure. This will lead to changes in working capital between the balance sheet dates. These can be recorded and calculated in a separate schedule, if you wish, and then brought back into the balance sheet. That's often the cleaner and easier way to manage it. But each capital asset will need a schedule that records its opening balance, any capital expenditure, the depreciation on the asset over the period, any asset sales, don't forget that'll impact cash and then a closing balance. Working capital, which is separate from the property plant and equipment, includes accounts receivable, accounts payable, and inventory, IE stock, and these need to be calculated and adjusted and their impact on cash recorded. Working capital is a critical function of cash flow, and this needs to be fairly represented in the growth of the business. Don't forget as your business and revenues grows, it absorbs cash. As your revenues shrink, it actually throws off cash. That's slightly counter intuitive, but you need to watch and manage the working capital very carefully because it is critical to cash flow. The capital structure is something you need to think about because obviously, financing the business is very important. Debt maturity and other non equity instruments need to be taken into account. These normally have their own schedules, and in venture capital and private equity models, they can be very complicated. In essence, as the business grows and you need to spend money, if the business is not generating sufficient cash to do this, you need to think about where that additional capital is going to come from, and it's either going to come from equity or it's going to come from debt, and you need to build that in. Remember, however, in a discounted cash flow, we're normally dealing with enterprise value and unlevered cash flow. Now, at the end of that, you can deduct current net debt to arrive at the equity value from the enterprise value. But to this end, if we're doing just the DCF valuation, we're not concerned about changes in the capital structure, and our starting assumption is that there is no change other than for known debt service and maturity. The discount rate will need to be calculated based on the weighted average cost of capital of the business. You'll need to derive the equity discount rate from the capital asset pricing model and then take a weighted average of the cost of debt and cost of equity. In the capital asset pricing model, of course, there are three variables, the risk free rate, the equity risk premium, and the beta, which is the company specific risk. These need to be given careful consideration because even small changes to these can have a very significant impact on your valuation outcome. Then we come to terminal value. Now, this, as we've already seen can comprise a significant portion of the valuation, often more than 50%, so it requires careful calculation. There are two approaches, the perpetual growth model or the transaction or exit multiple approach, whichever you choose to take, you need to do it carefully. You need to put in realistic assumptions. Of course, you can also model a high and low valuation assumption which will give you a valuation range. Cash flow timing is critical. Now, the period of the cash flow are not always annual, and indeed the model may begin in the middle of a year. The good news is you can overcome this by specifying the periods in a line, and you can say, date, that date, the following date, and then use the x NPV and the x IRR functions in Excel, which allow you to precisely specify the time periods and let Excel do the hard work on the discount calculation. Enterprise value is what we're looking to calculate. So when you've calculated your cash flows and you've discounted them back to the present, you've then added the terminal value and that should leave you with the enterprise value. This, of course, does not take into account the capital structure, but it does allow direct comparisons with other companies. Most M&A deals focus on enterprise value. Equity value, if you want to calculate it can be derived simply by adjusting the net present value of the unlevered cash flow, the equity value, adjust it for today's level of cash and cash equivalents, deduct debt and minority interests, and you get the equity value. And this is a more common approach for stock market investors. So they'll take that extra step to understand what the equity value is, and then they have the number of shares in issue and they start dividing earnings per share in those sorts of multiples. So those are the key steps in creating your DCF model. There is more detail to it, obviously, more granularity to it as you go deeper and deeper. But if you have that as your working plan, you won't go far wrong. 20. The best way to link your Three Financial Statements: I want to talk you now through the best way to link your three financial statements in your financial model. And hopefully, you'll find this step by step explanation will be a guide in your financial model preparation. The purpose of a three statement financial model is to ensure that the assumptions flow through the model and the model makes the correct financial adjustments and continues to provide a financial model of the business. So your assumptions have to actually work and your model must reflect the changes on the income statement, the balance sheet, and the cash flow. The statements in the financial model have to be correctly connected so that changes in the income statement then flow through correctly to the balance sheet and into the cash flow. And critically, and this is the real acid test of a model, your balance sheet must always balance. And if it doesn't, there's something wrong with your model. You will be familiar, I'm sure, with accounting standards and the principles and the use of accrual accounting to enable a true and fair picture of the business to being built up in the financial statements. And this is why we have the three financial statements to show how the accruals work. The income statement gives you an accounting standard based income statement. The cash flow shows you what's actually happening to the cash, and the balance sheet effectively records the changes and the accruals and the timing differences from the income statement. So this means that revenue recognition, timing, matching, and the accruals, make the income statement very different from the cash flow. It also means that you have to use the balance sheet correctly to reflect these accounting entries, and then the balance sheet can subsequently be used to flow into and create the cash flow statement. So here we have this is a very basic set of financial statements, but we have an income statement. In the middle, we have a balance sheet and on the right, we have the cash flow statement. And we start by creating our revenues and expenses in the income statement, and we've discussed how you do this. Okay. We then take the retained earnings from the income statement and feed them into the retained earnings on the balance sheet. Depreciation on the balance sheet is then deducted in the income statement. Those two are connected. And then they're added back in the cash flow statement through the working capital changes before arriving from the cash from operations. And this is calculated in the fixed asset schedule, which is probably a good thing to create to manage all your PP&E calculations. Okay. The cap X, which is in your PPE schedule feeds back into the PP&E on the balance sheet. So effectively, depreciation reduces the PP&E and cap x increases it. That's reflected in your schedule, and then it flows from the balance sheet into the cash flow and then from the cash flow into the balance sheet. Okay. Working capital changes relate to the current assets and current liabilities on the balance sheet, and they are connected to revenues and expenses in the income statement, but adjusted in the cash flow statement to reflect the actual cash paid or received. So we can see that revenues and operating costs affect the receivables and the payables on the balance sheet. Changes in working capital from one period to the next are reflected in the cash flow statement. Now, you have to think about this in terms of sources and uses of cash, and this is a really critical point, which I want you to get on board. Starting with accounts payable, this is money you owe to your suppliers. If your accounts payable go down, you have paid your suppliers. It is a use of cash. If they go up, they have extended you credit. It is a source of cash. If you look at accounts receivable, money that you are owed by your customers. If accounts receivable go down, you have been paid by your customers. It's a source of cash money coming into your business. If they go up, effectively, you've extended credit to your customers, it's a use of cash. Now, understanding sources and uses of cash when looking at changes between the balance sheet and the cash flow statement are critical to make sure that your cash flow statement actually reflects what's going on. Is cash increasing or decreasing? And the working capital changes are one area where this can be particularly confusing, and this is one area. If your balance sheet doesn't balances, it's worth checking to make sure you've got your pluses and minuses sources and uses of cash operating the right way. Financing is next. You may need a debt schedule to record all the interest payments and maturities, and interest payments are frequently a source of circularity and have to be handled carefully. So interest expenses start on the income statement, and the debt is on the balance sheet. Changes in debt principal amounts and interests are reflected in the cash flow statement. The final step is to link up the cash. You have your cash from operations, you have your cash from investing, you have your cash from financing, and then you end up with a closing cash balance on the balance sheet. Okay. Okay. And if the model is correctly set up, the balance sheet will balance. So you flow it through, and then you end up with the cash in C equivalent, and it's the change between the previous period and the period that's just ended ends up showing that movement that you see in the cash flow statement. So let's try and summarize this in a very simple way. Net income from the income statement connects to the balance sheet and the cash flow. Depreciation is then added back. Cx is deducted from the cash flow and is reflected in the fixed asset schedule, the PP and E property plant and equipment on the balance sheet. Financing affects the balance sheet debt and equity and are reflected in the financing section of the cash flow. Interest from the cash flow connects to the interest in the income statement, and then the sum of the closing cash balance is derived from the close at the end of the last period. So that's the closing at the end of the last period. Plus the cash from operations in this period, plus the cash from investing and financing, and that gives you a total for the period just gone. That then connects to the balance sheet. And if the model is set up correctly, the balance sheet balances. So I hope you find that explanation, and it is a fairly brief explanation of what can be quite a complex process and particularly if you have a complex model. But I hope you find that explanation of how the connections are made, particularly if this is new to you, helpful and takes you some way to understanding how this modeling process works. 21. DCF Model Exercise: In this DCF model exercise, I'm going to show you very simply how to put some key inputs into a DCF model so that you can see the DCF model working in live as it were. So I have provided with this lecture a simple DCF model, which you can see here on the right. I've also provided an image file of it if you want to have that as well. The model is called the basic discounted cash flow model exercise CLS, and you can see what it has here. Now, the cells highlighted in green are the input cells for the model and the input cells for this exercise. And I've provided the values for these cells in a second spreadsheet, which is called the DCF model exercise inputs Excels, which looks like this. So you can see that the corresponding cells apply to the green cells in the model. So to complete the exercise stroke project, simply use these values to update the DCF model and complete your DCF valuation. Now, to check your work, I have provided as well a completed version of the DCF model, so you can see that and make sure you've got the numbers right. Please do not open this until you have done the exercise. Then use it to check your results. Once you have completed the exercise, you can try changing some of the key valuation metrics, the risk free rate, the equity risk premium, the beta, and the capitalization model. Have a look and see once you do that, what impact that has on the valuation. So that's the DCF model exercise. It gives you a chance to complete a very simple DCF model, but you can then see how it's working and you'll hopefully be able to understand the flow of the numbers through the model without any difficulty. 22. Course Summary and Wrap Up: Well, this brings us to the end of the course, and it just leaves me to summarize and wrap things up with you. First of all, congratulations on completing this company valuation course. I really hope you enjoyed it, and I hope you've got a lot out of it. If you have any questions, you can message me here, and I will do my best to get back to you. In this course, we covered the main valuation methodologies, cost valuation, ratio analysis, comparable company valuation, precedent transaction analysis, discounted cash flow valuation, the capital asset pricing model, and the weighted average cost of capital. We also took a look at the challenges involved in valuing start up companies and private companies, and now you can understand that these situations particularly require a different approach. Now, don't forget to post your completed project to the gallery if you wish. Be very nice to see some of you doing that to see that we're getting some interaction going in the course. It only leads me to say, thank you very much for taking this course. Again, I hope you've got a lot from it and that you've enjoyed it. Do definitely check out my other courses, which you can find here and take a few of those. I will be posting more courses regularly. I love doing it, and I hope you love taking them as well. And of course, I look forward to seeing you again in another course very soon. So that's the course summary and wrap up. It brings things to a close for this course. And I look forward to seeing you in another course, as I said in the very near future.