Corporate Finance: 3rd Edition

I’ve started writing the 3rd Edition of Corporate Finance, for publication in January 2016.  This means a few things:

  • My writing efforts will shift from the blog to the book over the coming months.
  • I’ll be giving updates on the chapters as I write them.
  • I will continue to write blog posts on current events when I see something worth writing about or I get a request.

If you have any comments  or recommendations to improve the book, please get in touch and I’ll try my best to incorporate your views.

David

A Four Step Guide to Improving Personal Financial Decisions

Personal FinancesYou’ll be surprised at just how few individuals approach their personal finances in a robust and objective manner.  It is definitely the case that many people review their spending on a regular basis.  However, very few analyse their spending behaviour and/or periodically monitor it.

In this article, I draw from standard corporate governance principles, which are embedded in all successful businesses and apply them to the personal finance space.

The key principles of Corporate Governance are as follows:

  • There should be an effective framework for business decision-making;
  • Resources are employed to maximize the wealth of all shareholders;
  • Stakeholder interests should be reflected in all decisions;
  • All decisions are completely transparent;
  • Managers are held accountable for their decisions.

Can the principles of good corporate governance help individuals with their own personal finances? You’ll be interested to know how easy it is to adapt these to the personal level.

In the following 4 steps, I propose a structure for personal decision-making that replicates the business decision framework seen in modern corporations.  I am sure that if the steps are followed each month, readers will soon see identifiable improvements in their own financial situation.

Step 1: Create an Effective Framework for Decision-Making

No matter what your personal circumstances (single, married, divorced, single parent, etc), you should have explicit constraints on what you can spend your money on and how much. Having these boundaries in place will reduce the likelihood of impulse spending.

An effective personal finance framework (that draws on the principles of good corporate governance) requires the following:

  1. All financial transactions (buying goods, borrowing, opening a credit card, etc.) should enhance your utility (i.e. quality of life);
  2. You must only spend within your means;
  3. Your financial decisions are legal;
  4. If you share your finances with someone else, (i.e. a partner), there is a clear articulation of how spending decisions are made.

Recommendations:

  1. Ensure you keep records of your monthly income and all your spending.
  2. Sit down once a month (with your partner if you have one) and objectively analyse the major financial decisions of the previous thirty days and any issues that are likely to come up over the coming four weeks.  This is called your monthly spending review.

Checklist for monthly review:

  1. Did you spend money on goods/services you didn’t really require?
  2. Did you throw out food? What did you buy too much of? What is your monthly/weekly/daily food bill?
  3. Is your mortgage/rent too high? Can you get a better rate elsewhere?
  4. Are you paying too much for electricity and gas? Can you get a better deal elsewhere?
  5. What is the total cost of your car (monthly car payment + monthly fuel cost + monthly road tax cost + monthly car insurance + monthly maintenance/servicing)? For some of these, find the annual spend and divide by twelve to get the monthly amount. Is it substantially cheaper to take public transport/hire taxis?
  6. Is your spending balanced across all areas of your life?

Step 2: Create a savings plan and spending targets for the next month

In personal finance, strict budgets don’t work.  Unanticipated events regularly destroy the best plans and it is impossible to fully keep to strict spending limits.  In the corporate world, businesses keep a cash float to deal with any one-off unexpected spending, but in the personal finance world these unanticipated spending demands are much more common.

Recommendations:

  1. At your monthly spending review, choose how much you want to save over the coming month and transfer that amount into a separate account.
  2. Of the remaining money left, subtract your fixed recurring expenditure (such as mortgage, rent, car loan, etc).
  3. Of the remaining amount, this is what is left for the unexpected and discretionary spending.  Aim to spend only 80% of this amount over the coming month.
  4. At the end of the month, you should have 20% of your discretionary funds minus any unanticipated spend during the period.  This should be diverted to a different emergency savings fund to deal with any one-off spending shocks (replacement central heating, car repairs, etc.).

Step 3: Identify one of your repeating expenditures and attempt to shave 5% off the spend

Companies continually seek efficiencies and the same should be done with personal finances.  In any one month, choose one of your spending accounts and look to cut a permanent 5% from the recurring monthly spend. This may entail renegotiating terms, switching suppliers, or cutting down on usage.

Recommended accounts to target are:

  1. Mortgage
  2. Car Loan
  3. Insurance (home, car, buildings, life, mobile phone, travel, or dental)
  4. Utility Bills (electricity, gas, water)
  5. Phone (home, mobile)
  6. Credit Card Interest
  7. Car Fuel
  8. Satellite or Cable Subscriptions
  9. Groceries
  10. Home (Furnishing, maintenance, garden)
  11. Internet spending
  12. Clothing
  13. Dining
  14. Entertainment
  15. Music
  16. Carry Outs

Step 4: The Monthly Spending Review

At your monthly spending review meeting, objectively assess your spending performance over the previous month. Identify spending requirements (including one off expenditures) and set targets for your spending in the coming period.

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Would Scotland need a Central Bank if it voted for Independence?

LOLR

One of my readers asked this week if I could write something on what is involved in setting up a central bank. I am sure it was related to the leaders’ debate on TV a few days ago when Alex Salmond was put under sustained pressure to explain what would happen if monetary union is not possible with the rest of the UK.

The reality is that whether an independent Scotland had a currency union with the UK or had its own currency, it would still need a central bank.

The responsibilities of a central bank are:

  1. To control monetary policy (set interest rates, manage currency, and the supply of money);
  2. Supervision of the financial sector (financial services and banks);
  3. Supervision of the financial markets;
  4. Ensure the payment and settlements system is fully functional;
  5. Oversight of the country’s cash savings, debt and investments;
  6. Act as lender of last resort.

Given that the UK government has stated it would not enter into a currency union with an independent Scotland, there have naturally been no discussions over what responsibilities the Bank of England would bear (in the event of a currency union) with respect to Scotland.

If there was monetary union, I do not think it is politically likely that the Bank of England would take over all six central bank responsibilities for an independent Scotland.  The most likely would be (1) monetary policy and (6) lender of last resort.

This means that a Scottish central bank would still need to be created to carry out the other responsibilities listed above.

In answer to the original query, given the degree of existing regulation in the EU and the UK, I do not think it would be that difficult to set up an institution (Central Bank of Scotland) to undertake oversight activities.

However, the big (but not insurmountable) challenge is if a Central Bank of Scotland had to deal with monetary policy and become a lender of last resort. This would happen if the UK government continues its refusal to enter into a monetary union.

I now discuss each in turn.

  1. Monetary policy.

The Scottish Government’s plan A is for full monetary union and they have completely avoided discussion of any other option.  If Scotland had to take control of its own currency, it would need to manage its interest rates and decide on money supply to ensure that prices (inflation) remained stable.

Without a doubt, this would be a challenge but given that the objective of the Scottish government is to enter the EU, many monetary policy decisions are constrained by the union.

Verdict: Challenging, but there would be a lot of support from the Bank of England and the EU.

  1. Lender of Last Resort

This is the elephant in the room when discussing Scottish independence and monetary union.  As soon as the SNP says it would consider other currency options, the next question would automatically be, ‘How could Scotland afford to be a lender of last resort?’

It is this that is the really difficult question to answer as the only options I can see are:

  1. Divert oil revenues to create reserves
  2. Raise taxes
  3. Change regulation so that Scottish banks cannot grow to such an extent that they are too big to fail.

Verdict: No option is particularly palatable and it would be the biggest challenge facing a new Scottish government. Each solution is achievable but there would be drawbacks for each option that would be politically upopular.

Conclusions

In the event of independence, I fully expect Scotland to create a central bank whether it is able to enter into a monetary union or not.

How much power it has will be dependent upon whether monetary union is agreed and the outcome of negotiations in other areas, notably the share of oil and UK debt.

If you are interested in following my blog, you can subscribe (see button at the side of the page) and receive an e-mail when I put up a new post.

 

Corporate Finance Course: Riskless Borrowing and Lending

I have just uploaded a new video (16 minutes) to Youtube as part of my Corporate Finance course.  In this video, I extend the material of previous lectures on creating investment portfolios, and now include the risk-free asset (Government T-Bill) and the Risky Portfolio.

Key points introduced in this video:

  1. Introduction to the optimal risky portfolio.
  2. Introduction to the concept of a risk-free rate.
  3. Fisher Separation Theorem

Using Corporate Finance to Make Better Personal Financial Decisions

Personal FinancesI realize there is an almost infinite amount of personal finance websites on the internet and anything that could be said about this topic has probably been written many times over.

However, as a Finance academic, I’ve always wondered whether it is possible to apply corporate finance theory to the personal finance domain.

I think it can be done and many valuable insights could be gained in approaching individual spending decisions in such a way.  I also think Corporate Finance can provide a framework for responsible personal financial decision-making in a different mode to what has been discussed before.

Being honest up front, it is important to state that I am not a personal finance specialist.  I’ve never even read a personal finance book. In fact, I’m shamefully careless with my own spending.  As a husband and father of teenagers, it is one of the areas where I am least happy with how I go about things.

With more order and control, I believe that I can cut my expenditure by a significant amount and make better spending decisions without lowering my quality of life.

So it is in this spirit I will meander through a number of topics in corporate finance and ask whether they can be applied to optimising my own personal financial decisions.

As I’ve said, this is a new topic for me and the concept may or may not work (if it doesn’t, I’ll just drop it). However, I’m excited by the idea of applying what I know in one sphere to another similar but subtly different one.

I hope also to learn new things about my own spending and decision-making and through my journey, maybe others will find out things about their spending as well.

Setting the Scene

At the beginning of any general Finance course I state that the topic consists of three distinct areas:

  1. How to make the best investments (The Investment Decision).
  2. How to finance those investments (The Financing Decision).
  3. How to ensure you have enough liquidity (Short-Term Capital Management).

In personal finance, we face the same decisions but in a different context. So over the coming weeks, I’ll be discussing the following:

  1. How to efficiently monitor your finances and introduce accountability and transparency to your spending behaviour (Corporate Governance).
  2. How to objectively measure your spending decisions and behavior over time (Financial Statement Analysis).
  3. A Framework for optimal financial decision-making (Time Value of Money).
  4. How to assess the value of your personal goods (Valuation).
  5. An overview of different personal finance decision techniques (Investment Appraisal).
  6. Dealing with future uncertainty and options in personal finance (Risk and Sensitivity).
  7. Investing in the Stock Market (Risk and Return)
  8. How to build an optimal investment portfolio (Investments and Portfolio Theory).
  9. How behavioural biases affect your personal financial decisions (Behavioural Finance and Efficient Markets).
  10. The characteristics of debt and other types of financing (Long-Term Financing).
  11. When to borrow money (Capital Structure).
  12. The hidden costs of borrowing money (Capital Structure Theories).
  13. How to deal with Family Financial Demands (Dividend Policy, Options, Financial Engineering)
  14. What is leasing and hire purchase and how to decide between buying and leasing (Leasing).
  15. How to incentivize good behavior in children via pocket money (Executive Compensation!).
  16. Credit cards and bank overdrafts (Short-Term Capital Management)
  17. How to recognize financial difficulty and techniques to get out of it (Financial Distress)

These are my initial ideas and I admit that some seem a bit stupid. However, I’m willing to explore these areas and see where my thoughts take me. If you have any other ideas on how to apply finance concepts to personal finance then please get in touch and I’ll add them to the list.

 

A Primer in Corporate Valuation – Part 4

Value headerIn this final article on Corporate Valuation, I discuss the Valuation Multiple approach. The method is probably one of the most common approaches to valuation because it requires little detailed analysis of a company’s annual accounts and can be carried out relatively quickly.

It is also one of the best approaches when a company is private and there is no share price available.

Interested readers are invited to read Chapters 12 and 13 of my book, Financial Markets and Corporate Strategy, where I explore the method in considerably greater depth.

Which Multiple to Use?

The best multiple for a particular company will depend on its industry and growth opportunities. Multiples that are regularly used are given below:

Screen Shot 2014-08-02 at 14.09.09

Enterprise Value = Market value of equity + Debt – Cash and Cash Equivalents 

Steps:

  1. Identify peers/benchmarks for the company.
  2. Find the valuation multiples for the comparator firms.
  3. Calculate the median or mean multiples of the peer group.
  4. Calculate the expected multiple for your chosen firm and use to value equity.

I will use Carillion plc as a case study to maintain consistency with earlier articles.

Step 1: Identify peers/benchmarks for the company

You will recall from previous articles in this series that Carillion has four different business lines: Support Services, Public Private Partnerships, Middle East Construction Services, and Construction Services (Excluding Middle East).

If I was carrying out a full valuation of Carillion, I would do a peer analysis by business line and calculate a weighted average ratios for the firm. However, to keep the article short and less than 1,000 words, I will only do the valuation analysis at the company level. The full approach is covered in my textbook, Financial Markets and Corporate Strategy.

You can easily find the peers of a company by going to Google Finance and searching for the firm. On the page you will get a list of peers.

For Carillion, I got the following:

fig1

I clicked on the ‘Related Companies’ link, then ‘Add or Remove Columns’ and chose the following:

fig2

The valuation multiples we will use are the Price Earnings Ratio, Price/Book Ratio, and Price/Sales ratio.

Step 3: Calculate the median or mean multiples of the peers.

Simply calculate the average of all the firms on the list. These are:

Screen Shot 2014-08-02 at 14.12.12

Step 4: Calculate the expected multiple for your chosen firm and use to value equity.

With a price of £3.30, it is a simple matter to calculate the denominator for each of Carillion’s ratios. For example, with a P/E ratio of 14.22, the denominator (Earnings) of the P/E ratio is £3.30/14.22 = £0.23. This is also the Earnings per share, which is shown in the Google Finance output above.

On the basis of the comparator figures, one would expect the following prices for Carillion.

Price/Earnings: £0.23 x 22.48 = £5.17

Price/Book: £2.24 x 2.53 = £6.17

Price/Sales: £7.67 x 1.08 = £8.29

All of these valuation estimates are substantially higher than the actual price.

With such a large discrepancy, the choice of comparator firms should come under greater scrutiny.

As a check, I carried out the same analysis using Morningstar data. Morningstar gave the following companies as Carillion’s peers:

fig3

Notice that the firms are completely different!

On the basis of these figures, Carillion would have the following valuations:

Screen Shot 2014-08-02 at 14.13.55

The total value of Carillion plc equity is the share price x number of shares (430.25 million). The expected Equity market capitalisation using the Morningstar data are thus:

Screen Shot 2014-08-02 at 14.14.35 We then add the total liabilities (£2.6563 billion) to arrive at a valuation estimate for each ratio:

Screen Shot 2014-08-02 at 14.15.08

These compare to the other values of £4.089 billion, £4.113 billion, and £3.984 billion from the other methods.

Strengths and Weaknesses:

The strengths of the Valuation Multiples method are:

  1. There is a massive number of different multiples one could look at and so you have different ways to arrive at valuations.
  2. Ratios are very simple to calculate and they are easy to interpret.
  3. You are valuing a firm based on other companies in the same sector. Differences between the actual share price and estimated values can provide much insight into where the company could improve its operations.

The weaknesses of the method are:

  1. It can be difficult to identify appropriate peers for the company. Choose the wrong ones and your value estimates will be wrong.
  2. It is easy to focus on the wrong multiples given that there are so many to choose from.
  3. The method does not actually look at the company’s figures but uses other company data to arrive at a value.

Wrap-Up

In this series of articles I have tried to provide a simple approach to firm valuation. There are many factors I didn’t consider as my objective was to show you the general approach to value firms, rather than to look at the specific valuation of any one firm.

It is important in this regard to remember that these methods must be adapted to the specific sector the firm is operating in. They also need to be modified when firms have negative earnings.

A Primer in Corporate Valuation – Part 3

Value header

 

A Primer in Corporate Valuation Part 3

In the previous two articles on Corporate Valuation, we used balance sheet/stock market data (for market capitalization valuation) and the Cash Flow/Income Statement (for FCFF valuation).

In this article, we analyse the actual operations of a firm.

Consider the basic accounting equation:

ASSETS = LIABILITIES + EQUITY

The method used in Part 1 of this primer separately estimated the liabilities and equity of a company to arrive at an overall firm value. We did this by using a combination of market values (from the stock market) and book values (from the annual report).

Our focus now shifts to the left hand side of the accounting equation – the assets of the firm. Theoretically, asset value should be equal to the sum of the liabilities and equity values.

Steps:

  1. The best approach to valuing the firm’s assets is to work with the company’s management to identify all future cash flows that are likely to come from the assets (including human capital, brands and other intangibles).   Split the company into different divisions/activities and analyse each of these separately.
  2. Carry out a discounted cash flow analysis on each of the firm’s operational lines and then sum the individual present values to arrive at a total value for the assets (and the firm).

Valuation in Practice:

I return again to the Carillion plc case study to illustrate this method. From its website, the company is involved in 4 distinct operations: Support Services, Public Private Partnerships, Middle East Construction Services and Construction Services (Excluding Middle East).

Cash Flows:

The Carillion 2013 Annual Report provides the following information on the firm’s operations:

Screen Shot 2014-07-31 at 11.09.09

It is clear from this information that whereas Support Services is the largest market by far for Carillion, it is fairly stagnant compared to their Construction business (on a side note, this is probably why they tried to merge with Balfour Beatty in July 2014).

Pipeline orders for Construction (Middle East and elsewhere) are massive compared to existing revenue streams. In addition, the efficiency of these business lines is much better than for Support Services.

The Discount Rate:

Page 93 of Carillion’s 2013 Annual Report states:

Discount rates have been estimated based on pre-tax rates that reflect current market assessments of the time value of money and the risks specific to the Cash-Generating Units (CGUs). Whilst the Group has four CGUs, the risks and rewards associated with Construction services (excluding the Middle East) are consistent, and therefore one discount rate has been applied to each CGU. Similarly the risks and rewards encountered in the Support services CGUs are consistent and therefore one discount rate has been applied to each CGU. Management has derived a Weighted Average Cost of Capital (WACC) using the capital asset pricing model to determine the cost of equity and then weighting the overall cost of capital for the Group by equity and debt. The WACC was then used to determine the pre-tax discount rates for each CGU. The rate used to discount the forecast cash flows for the CGUs in the Construction services (excluding the Middle East) was 10.0 per cent (2012: 11.7 per cent) and for the CGUs in the Support services segment was 8.8 per cent (2012: 9.9 per cent).

So, from this text we have a discount rate of 10.0% for Middle East Construction and Construction (Exc. Middle East) and 8.8% for Support Services and Public Private Partnerships.

Valuation:

From this point on, it is up to the analyst to decide on the assumptions with respect to cash flow growth and future cash flows. This is covered in much more detail in my textbooks, so for now I am just going to state a number of very broad (and probably unrealistic!) assumptions.

Assumptions:

  1. For the next five years, cash flows will grow at a rate in proportion to the Pipeline/Order Book ratios for each business line.
  2. From the 5th year onwards, cash flows will remain constant.
  3. The maximum year on year growth in cash flows in any unit will be 20%.

I admit these can be criticised as being “finger in the air” assumptions. However, I feel that (without further in-depth analysis) we cannot forecast any further than five years from now. Also, from year five onwards assuming no growth is as good an estimate as any!

With the exception of Support Services, the pipeline of orders are significantly higher than the existing order book. Consequently, I am assuming 20% growth year on year for each of the other units.

Support Services, on the other hand looks as if future performance will be flat. Given that the pipeline of orders in this division is 23.5% less than the existing order book, I have chosen a negative growth rate of 23.5/10 = -2.35% for the next five years. This reflects a potential tightening of this market over the coming period.

With these assumptions, we have the following cash flow streams for each business unit:Screen Shot 2014-07-31 at 11.13.01We now need to estimate the terminal value for each of the Business Lines. To do this, I simply treat the cash flows from Year 6 onwards as perpetuities and discount them at the respective discount rate for each unit (=Cash Flow@Yr 6/Discount Rate).

Screen Shot 2014-07-31 at 11.13.47 
We now have cash flows and a Terminal Value for each business unit. These will be discounted to present values using the respective business unit discount rates. The present values for each cash flow are given below:

Screen Shot 2014-07-31 at 11.14.32

Summing the present values gives us an estimate of the value of Carillion plc. The value from the Asset Valuation method is thus £4.089 billion.

Compare this estimate with the Market Valuation estimate of £4.113 billion and the (closest) FCFF estimate of £3.984 billion.

Strengths and Weaknesses:

The strengths of the Asset Valuation approach are:

  1. If full sight is given of the firm’s operations, it is possible to come to a completely independent estimate of firm value that does not rely on financial reports.
  2. The method (when valuing the future cash flows of operations) avoids accounting assumptions like intangibles valuation, which can be difficult to understand.

The weaknesses of the Asset Valuation approach are:

  1. It is often exceptionally difficult to get information on the firm’s operations and sales pipeline, making this method almost impossible to use.
  2. The method suffers from the need to make assumptions about future cash flows just like all other methods.

In the next instalment of this Primer on Corporate Valuation, I will look at the final valuation technique, Valuation Multiples and Peer Comparisons.

Interested readers can subscribe to my posts by hitting the subscribe button on the left side of the webpage and you will receive an e-mail whenever I put up a new article.

A Primer in Corporate Valuation – Part 2

Value header

In the first part of this article series I showed how to value a firm using the market valuation method, where stock prices are used to estimate equity market capitalization.

In this post, I will explain the Free Cash Flow to the Firm (FCFF) method of corporate valuation. The approach is covered in a lot more detail in my textbook, especially Corporate Finance: 2nd Edition, and you can find out much more about the fundamentals of the approach there.

The basis of the FCFF method is Discounted Cash Flow and Time Value of Money. I won’t spend any time discussing this concept here but the interested reader is invited to read any of my textbooks, where I go into this method in depth.

To value a company using the FCFF method, one must first estimate the cash flows that are earned in each year and discount these values to today’s terms.

Step 1: Estimation of Free Cash Flows.

The best way to estimate free cash flows is to work with a company’s management and derive estimates of future cash flows (up to about five years).

However, this isn’t practical in many cases where only the most recent financial accounts are available. In this situation, the easiest way to estimate the cash flows that come into the firm is to use the following formula together with the company’s most recent cash flow statement:

Free Cash Flow to the Firm = Cash Flow from Operations + Cash Flow from Investing Activities

To illustrate, we will continue with our case study of Carillion plc. The cash flow statement of Carillion (taken from the 2013 Annual Accounts) is as follows:

280714Fig1280714Fig2

The Free Cash Flow to the Firm in 2013 was thus £107.2 million – £78.4 million = £28.8 million.

At this point, I’d like to state that the massive change in cash flow components between 2013 and 2012 gives me significant concern on the viability of this method in valuing Carillion plc.

This is because we have no way of knowing what is a sustainable cash flow or whether cash flows will settle down in the future.

Keep a look out for cases were the cash flows change significantly from one year to the next. In Carillion’s case, there was a significant disposal of assets (£143.7 million) in 2013 that would unlikely be repeated. However, we don’t know if the cash that was released because of this sale was used to acquire assets in the same year!

Since this post is only to show how to use the FCFF method, we will keep this concern in mind but do nothing to investigate further.

Lets move on to the next steps…

Step 2: Estimate the growth rate in cash flows

A simplifying assumption that I am going to make here is that the FCFF grows at a steady rate forever. Clearly, this is unrealistic. However, it is a good starting point and a Launchpad for more complex analysis later on.

Unfortunately, growth rates are notoriously difficult to estimate as they are based completely on subjective forecasts. My favoured approach is to simply use analyst forecasts as an initial estimate, and iterate further once initial firm values have been calculated.

Looking at the Carillion page on FT.Com (search for the name in the FT.Com website and click on forecasts tab):

280714Fig3Source: FT.Com, July 2014.

Two forecasts are provided for the growth rate: 1.71% and 1.45%.

Looking at earnings figures for the company can also provide some more insight on growth rates (assuming that dividends are paid out as a constant percentage of earnings):

280714Fig4

Source: FT.Com, July 2014.

Thus, a third growth rate estimate is 6.53%.

Finally, we can also check Carillion’s annual report to see if they have an estimated growth rate of cash flows. From page 93 of their 2013 annual report:

“The cash flows used to determine the value-in-use calculations are based upon the latest three year forecasts approved by management which are based upon secured and probable orders and the Group’s overall strategic direction. The cash flows are extrapolated from year four, with a terminal value using a growth rate of 2.5 per cent. This growth rate does not exceed the long-term industry average and reflects the synergies from recent acquisitions.”

Step 3: Estimate the discount rate (Weighted Average Cost of Capital or WACC).

The fastest way to find out the Weighted Average Cost of Capital of Carillion is to search Google to see if an analyst has already estimated the figure (sometimes, the company itself will provide the WACC).

From a quick search of the internet, I found this December 2013 report from Saxo Bank (via www.tradingfloor.com) :

280714Fig5

The full document can be downloaded here.

The WACC we will go with for Carillion plc is 7.3%

Step 4: Estimate Value of Firm

There are many ways to work with cash flows in discounted cash flow analysis and much of what is calculated comes down to simplifying assumptions. In my analysis here, I am assuming that cash flows will grow at a constant rate forever.

The formula I am using is:

Value of Firm = FCFF(1+g)/(WACC-g) = 28.8(1+g)/(.073-g)

where FCFF = £28.8 million; WACC = 7.3%. We have several growth rates (1.45%, 1.71% 6.53%, 2.5%).

Our estimates of firm value are therefore:

Screen Shot 2014-07-28 at 14.15.23

As you can see, they are less than the market valuation method estimate (from Part 1) of £4.1163 billion, with the third model (Average Earnings Growth) closest.

Strengths and Weaknesses:

The Strengths of the Free Cash Flow Method are:

  1. The method is applicable for all firms (public and private firms) and is useful when the company to be valued has no stock price data.
  2. The method is tied to the financial accounts of the company and is thus based on audited financial figures.
  3. It is good for companies with stable cash flows and constant capital structures.

The weaknesses of the method are:

  1. It doesn’t use stock price information, which is the most timely information.
  2. It is very sensitive to inputs such as Free Cash Flow Estimates, Growth Rates, and Discount Rate.

Admittedly, the method hasn’t been particularly effective in valuing Carillion plc.

To explore this further, I would definitely attempt to come up with a more refined set of cash flow forecasts. I would also look again at the growth rates we used in this example and identify the most appropriate.

Interested readers can find out how to do this in much more detail in any of my textbooks.

In the next instalment of this article series, I will discuss the Asset Valuation method of corporate valuation.

Interested readers can subscribe to my posts by hitting the subscribe button on the left side of the webpage and will receive an e-mail whenever I put up a new article.

 

A Primer in Corporate Valuation – Part 1

Value header

The last 12 months has seen a resurgence in merger and acquisition activity and a lot of newsprint has related to bid prices that may or may not be at the correct level.

In this multi-part series of posts on corporate valuation, I will describe  general approaches to valuing a firm. It is important to emphasise that the valuation techniques I present pay no attention to industry differences. Each specific industry has its own unique factors to consider and these will be covered in future articles.

Interested readers are invited to check out my textbooks for far more detailed information on corporate valuation.

My advice on corporate valuation is to start off with the methods given in this post, adapt them to the specific industry and corporate conditions, and then come to a consensus view based on all four approaches. Sense checking with other companies is also advisable.

The four methods are:

  1. Market Valuation, where actual market information is gathered on the debt and equity of a firm.
  2. Free Cash Flow to the Firm, where the present value of future cash flows to the firm are calculated.
  3. Asset Approach, where the company’s assets are valued.
  4. Valuation Multiples, where information is used on peer firms in the same industry to arrive at a valuation of the firm.

In this post, I will use the British construction firm, Carillion plc, as an example (the only reason being that it is in the news today for a possible merger with another construction firm, Balfour Beatty plc).

Market Valuation  

The Market Valuation method takes data from the stock market to value a firm.

Steps:

  1. Equity Value: Visit any financial webpage (such as FT.Com, Yahoo! Finance, etc.) and find the market capitalization of equity. I went to FT.Com and got the information below:

 

Fig 1Figure 1: Summary data on Carillion plc, July 25 2014 (source: FT.Com)

The Market Capitalisation of equity is £1.46 billion.

  1. Debt Value: In most countries outside of the US, corporate debt is traded irregularly. This means that the prices one gets from financial pages can be out of date by a long way. The fastest way to find the value of a company’s debt is to get the total value of its liabilities from the most recent set of accounts.

Don’t worry about any bond issues or loans taken out since the most recent report because the cash raised would be reflected in the equity market capitalization.

Screen Shot 2014-07-30 at 15.40.22Screen Shot 2014-07-30 at 15.40.35

Figure 2: Carillion plc 2013 Balance Sheet (Source: Carillion plc 2013 Annual Report)

From Figure 2, the value of the Debt is the total value of short-term and long-term creditors = £1,661.6 million + £994.7 million = £2.6563 billion.

The total value of Carillion plc according to the market valuation method is thus:

Value of Equity + Value of Debt = £1.46 billion + £2.6563 = £4.1163 billion.

Strengths and Weaknesses:

The strengths of the market valuation method are as follows:

  1. Share prices contain all available information in the stock market including future growth prospects, intangible assets and the quality of a firm’s management, among other factors.
  2. The information you are using is the most up to date out of all the valuation approaches. Other methods use figures that can be many months old.
  3. The method makes no theoretical assumptions and is based entirely on observed market valuations.

Weaknesses are:

  1. Market prices may not reflect value fundamentals. This can occur if a firm is the target of a takeover and the price changed in response to the potential bid.
  2. The company is not publicly traded and so there are no market prices. Most valuations are carried out for private companies with no share price, which makes it impossible to use this method.
  3. The company may be small and traded infrequently leading to stale market prices. Out of date information can cause as many issues as poorly estimated information.

If a company is large and traded on the stock market, the market valuation method can be used quickly and easily to arrive at a firm value.

In my next post, I will explain the Free Cash Flow to the Firm method, which is also known as the income approach to corporate valuation.

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The Best Finance Textbooks 2014-2015

There is a plethora of Finance textbooks available for those wishing to gain a rigorous understanding of the concepts and principles of Finance.

However, many of these books are either too complex, boring, or simplistic to be a good basis for development of in-depth understanding and application.

When I started my Finance career way back in the very early 1990s, I came at the topic from a Mathematics perspective because that was the basis of my undergraduate degree.  It’s probable, then, that my selection of books will be influenced by this preference.  Apologies if that is the case.

It’s also important to state that I haven’t purposely gone out to review books for this post and so I may have missed a few that should be here.  If that is the case, please get in touch with recommendations and I’ll update the list accordingly.

General Finance:

There are three textbooks that I think are worthwhile for the  Finance specialist. All cover the same topics, with some variation at the edges. The ones below are the best starting point for anyone wishing to start a finance career.

Warning: As you will see, the first book is my own.  I feel like apologising for this, but I really do think it covers the topics very well for an international reader. I hope this doesn’t put you off reading this article as I’ve been unbiased in all of my reviews.

  1. Corporate Finance (Hillier, Ross, Westerfield, Jaffe, Jordan)

The focus is very strongly on European and International Corporate Finance and based on the most up to date academic research. It also covers Corporate Governance (in detail) and Islamic Finance (in passing), which is in demand in many parts of the world.  I use it for most of my Corporate Finance teaching (unless I am using my other books).

2. Principles of Corporate Finance (Brealey and Myers)

A wonderful book and one of those from which I learned Corporate Finance.  It is exceptionally well-written with strengths in capital structure theories and application. The big issue is that this edition is too focussed on the US corporate environment, which isn’t great when trying to understand corporate environments elsewhere.

3.  Corporate Finance (Berk and De Marzo)

The best thing about this book is its central theme of the Law of One Price that permeates the full text.  It’s an excellent way to bring the theory together and the authors do this very well.  My biggest gripe is that the international edition does very little to vary the US text and so I find it of less use in teaching students in the international context.

Specialist Areas:

Once the reader has understood the main theories of finance from the list above, they will be ready to study specialist areas in more detail.  In the list below, I present what I feel is the best in class for each of the areas.

Warning: I haven’t read every book on Finance and so I may have missed a fantastic text.  If you feel that this is the case, please get in touch and I’ll check out any that you feel should be on this list.

Corporate Governance:

1. International Corporate Governance (Goergen)

Corporate Governance is one of my favourite research areas and I feel out of all the books out there, International Corporate Governance has the best breadth of research, theory and practice.  The book isn’t as long as other textbooks in the area but it is the most solid and rigorous.

Investments:

1. Investments and Portfolio Management (Bodie, Kane and Marcus)


Without doubt, the best in class.  I use this to teach Investments and Portfolio Theory at university and it is by far the most accessible and insightful text in this area.  It is also good for those wanting to study for the Chartered Financial Analyst (CFA) course.

Advanced Finance Books:

These books are for those planning to study at PhD level or above.  I use them not only for doctoral training but also as a basis  for my own academic research.  I do not recommend these for those who have no prior Finance knowledge.

  1. Financial Markets and Corporate Strategy (Hillier, Grinblatt and Titman)

Another of my books.  The main strength of this book is that it combines strategy with finance, which is a major gap in the literature.  It is fairly mathematical but not overly so.  I would also say , though, that the book is getting a bit long in the tooth as it was published in 2011 and so some of the earlier chapters on the financial markets are slightly out of date. The theory hasn’t changed though!

2. Financial Theory and Corporate Policy (Copeland, Weston and Shastri)

I love this book and it was the core of the higher level of textbooks that I read when I was studying Finance as a PhD student.   It explains the main Finance concepts exceptional well and goes into the theory in an accessible way.  My mathematical and theoretical understanding of Finance was helped in so many ways by this book.  The good thing is that it a new edition came out last year, so the material is up to date.

3. The Theory of Corporate Finance (Tirole)

This is a very solid theoretical text on Corporate Finance.  Although it was published in 2010, it hasn’t lost anything of its currency and definitely should be read if you want to understand the mathematical theory of corporate finance.  I promise it isn’t an easy read but well worth it.

4. The Theory of Financial Decision-Making (Ingersoll)

This book nearly killed my career in Finance and it is probably one of the toughest finance books that I have read. During my PhD at Strathclyde, we had to read this cover to cover and I just barely kept up.  However, I did get through the book and I’m so glad I did so.  It’s a shame that it is now out of print but if you can get a copy anywhere, I’d definitely recommend you do so (even if it is just to show off to other finance aficionados!).

4. Foundations for Financial Economics (Huang and Litzenberger)

The second book of my PhD reading and only slightly less difficult than Ingersoll.  It’s a shame that these books are now out of print as they are so important for PhD students to understand how finance really works.