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.
- 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.
- 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).
The Carillion 2013 Annual Report provides the following information on the firm’s operations:
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.
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.
- For the next five years, cash flows will grow at a rate in proportion to the Pipeline/Order Book ratios for each business line.
- From the 5th year onwards, cash flows will remain constant.
- 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:We 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).
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:
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:
- 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.
- 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:
- It is often exceptionally difficult to get information on the firm’s operations and sales pipeline, making this method almost impossible to use.
- 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.
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