Capitalization of Maintainable Earnings (UNLEVERED) Flashcards
Steps in Capitalization of Maintainable Earnings Approach (Unlevered / Enterprise Value approach)
1) Determine approach to be used
- going concern (history of profitability, strong rep, etc)
- not capital intensive, depreciation roughly equals capital investment)
- ALWAYS STATE AT START OF QUESTIONS
2) Find EBIT
- Taxes will be reapplied to Normalized Earnings.
- In unlevered scenario, interest is removed because the cost of debt of the optimum capital structure is reflected in the calculation of WACC. (in levered example, interest adjustment would be made to reflect the optimal debt level in a company).
3) Find Normalized Earnings from Operations (a full business cycle or 3 - 5 years of historical data)
- remove non-recurring revenue and expenses (one-time contract, repair expense for fire, etc.)
- remove non-relevant expenses (wife’s car, kids cellphones, etc.)
4) Determine Representative Range of Maintainable Earnings
- if significant growth, most recent year or weighted average with weight on most recent year may be most representative
- if fluctuating, a simple of weighted average may be most representative.
- if declining, most recent year or weighted average with weight on most recent year may be most representative
- ALWAYS explain why you chose the range you did (earnings growth suggests that most recent year is most representative of maintainable earnings)
5) Select an Appropriate Tax Rate
- should be selected based on what the likely tax rate in the future will be, not what has been paid historically. If the purchaser is much larger and does not receive tax deductions like the target has paid in the past, the large tax rate should be applied.
6) Select and Appropriate Capitalization Rate
- See other Cue Card :P
7) Add Redundant Assets
- all redundant assets are assumed to be converted to cash at their net realizable value (proceeds from sale at market rate less disposal costs (commissions, taxes, etc).
8) Reduce Interest-baring Debt
9) Complete Verifying Valuation Conclusions
- rule of thumb approach, other valuation, etc.
Common adjustments to earnings in Capitalization of Maintainable Earnings and Cashflows
1) Compensation adjustments
- Owner being paid about market rate
- Owner being paid below market rate and topped up through dividends
- Family members drawing salary above market rate or for non-active role in the business.
- Drawing money through the business and increasing Shareholders Loans.
2) Non-recurring Revenue and Expenses
- start-up costs, moving costs, lawsuit expenses, one-time projects, discontinued product lines, etc
3) Market Rate Rent expense
- Unless the Building cannot be rented vs owned, add market rate rent expense if company owns building / facility. This eliminates the need to apply discount rates on real estate and consideration of asset values.
4) Redundant Asset Adjustments
- any income or costs associated with redundant assets
- dividends or interest income from marketable securities, interest on loans to officers.
- any costs associated with maintaining or operating on property/facilities that would be reasonably handled by the landlord had the company been renting.
5) Arms-length Revenues and Expenses
- payments made above or below market rates to subsidiaries, management, consultants, etc that are to arms-length vendors should be adjusted to market rates or removed.
6) Leverage Adjustments
- If doing levered approach, adjustment to determine the optimal level of debt.
7) Potential Synergies (typically only considered if multiple Special Interest Purchasers are identified)
- Adjustments for identifiable and quantifiable synergies
- access to larger markets (revenue increase), reduction of management / redundant staff, reduction of redundant operating costs, increased rebates on volume discounts, changes to processes resulting in efficiencies.
What are Redundant Assets and how are they treated
RA are assets that re not necessary to the core or ongoing operations of the business. They should be segregated because they do not contribute to the core earnings of the Company or they likely have a significantly different risk level than the earnings from business operations and should be valued separately to ensure they are not over/under valued. Any cash inflows or outflows from RAs should be removed from the earnings stream.
The value of the redundant assets added is the “net realizable value”, that is, market value less costs of disposition, including corporate taxes and selling costs.
Real Estate can be considered redundant if it is not necessary for the business operations. If this is the case, rent should be added as a pre-tax expense to the operating income and the market value of the building should be treated as a RA.
Capitalization Rate
Capitalization Rate (also known as Cost of Capital): the rate of return used to convert a point estimate of cash flow into value. Put another way, a divisor used to convert a uniform (or constant) stream of cash flow to a capital amount or value.
Capitalization Rate is typically expressed as a Multiple, which is simply the reciprocal of the cap rate (1/cap rate).
Example, if the Cap Rate is 25%, the multiple would be 4 (1/.25).
In Unlevered Approach the Capitalization rate is the Weighted Average Cost of Capital: the weighted average of the after-tax costs of different sources of capital (debt and equity), which is based on the capital structure it represents.
WACC = (Kd x Wd) + (Ke x We) Kd = after-tax cost of debt Wd = weight of debt Ke = the levered cost of equity We = the weight of equity
1) Kd
is the weighted average interest rate the company pays or expects to pay on its debt (bank loans and current/long-term credit facilities).
Because interest expense is tax deductible, Kd rate is reduced by tax rate:
Kd = pre-tax cost of debt x (1-tax rate)
2a) Ke - Build Up Approach
Determined based on the return on a particular asset of group of assets relative to the returns achieved for alternative investments.
Ke = RFR \+ ERP \+(-) IRA \+ SP \+ CSA
Risk Free rate = typically the interest rate on long-term government bonds
Equity Risk Premium = represents the fact that owning a general equity portfolio is generally riskier than owning a risk-free investment (typically between 4% - 7%).
Industry Risk Adjustment = Represents the fact that owning an equity portfolio in a specific industry may be more or less risk than owning a general equity portfolio (regulatory environment, susceptibility to economic conditions, competitive environment, effect of technological changes, etc).
Size Premium = Reflects that the subject company may have more or less risk than others in the industry due to their sheer size (market influence, customer bases, economies of scale, difficult obtaining capital, etc).
Company-specific Risk Adjustment = additional risk factors not considered above. (competitive advantages/disadvantages, reliance on management, product demand, labour force, etc.). These factors must be made in comparison and must ensure no double counting with the other adjustments.
For example, say Company A only has 2 or 3 large customers, but in the industry that is common so that risk would be baked into “Industry Risk Adjustment”. therefore, no adjustment should be made to Company Specific risks.
***WACC - Growth Rate = CAP RATE
2b) CAPM Approach
An alternative to the Build-up approach to finding the Cost of Equity is Capital Asset Pricing Model (CAPM). **FIGURE THIS OUT A DIFFERENT DAY
Enterprise Value
The total value of a business, including both its interest-baring debt and equity components. AKA, what would it cost to purchase this business in its entirety?
Enterprise Value =
Common share value
+ preferred share value
+ short-term debt (credit facilities, lines of credit, commercial paper)
+ long-term debt (term debt, mortgages, bonds, debentures, capital leases, off-balance sheet financing)
+ debt equivalents (shareholder loans, accrued dividends, accrued bonuses to management)
- redundant assets
When to use Capitalization of Maintainable Earnings
1) Business has unreliable or unavailable forecasts
2) mature business with relatively consistent earnings that is expected to be relatively stable into the future.
3) a business that does not require significant investment in fixed assets each year, or where depreciation and actual capital spending are approximately equal.
4) a business that is expected to continue for the foreseeable future and where average earnings can be reasonably estimated.
