Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

Remember, because the companies have no debt or preferred shares, the enterprise value and the

share value are one and the same.

V

V

$1,000,000, 000 /(0.10–0.05) $20,000,000, 000

$2,000,000, 000 /(0.10–0.05) $40, 000,000, 000

Twilight

Potter

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Potter is twice as valuable because it generates twice as much cash flow as does Twilight. However,

these two companies have one more thing in common. Divide the company value by next year’s cash flow

to get a value-to-cash flow multiple:

Twilightmultiple $20,000, 000 /$1, 000, 000 20

Pottermultiple$40,000, 000 /$2, 000, 000 20

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==

The companies have the same multiple because their risks and growth prospects are identical. Another

way of saying this is that in a discounted cash flow valuation of these companies, the denominator, r-g,

is the same for Twilight and Potter (10% – 5% = 5%). For these two companies, each dollar of additional

free cash flow adds $20 to company value ($20 = $1 ÷ (10% – 5%)). Therefore, if we apply a multiple of

20 to a similar company’s cash flow, we are really just taking a shortcut to get the same answer that we

would get if we did a discounted cash flow valuation for that company. Given these results, an analyst

might value a third book publishing company by forecasting its cash flows one year ahead and simply

multiplying that number by 20, the multiple for comparable companies.

In practice, things do not work out as precisely as in the preceding example. The next illustration

shows a more realistic application of valuation using multiples.

example

You work for a large technology company that is considering making an offer to buy Smart Phonz Apps,

a young, privately held start-up company. By doing careful due diligence work, you have estimated that

this company’s revenues next year will be $195 million and its earnings before interest, taxes, depreciation

and amortisation (EBITDA) $100 million. Smart Phonz has $100 million of outstanding debt. Performing a

discounted cash flow valuation of this company would require you to estimate both the company’s WACC and

its growth rate. Before doing that, you decide to conduct a public company multiples analysis on three similar

companies. Companies A, B and C are all companies that went public via an initial public offering (IPO) of

ordinary shares in the last few years, and each of these companies has a staff of software engineers who write

programs for apps for smartphones and tablet devices. Table 5.1 below summarises some key information for

each of these companies.

tABLE 5.1

Companies

comparable to

Smart Phonz

Outstanding

shares (millions)

Share price Debt outstanding

($ millions)

Revenues ($

millions)

EBITDA ($ millions)

Company A 100 $5 $100 $100 $68

Company B 200 $2 $150 $95 $65

Company C 50 $7.50 $200 $150 $63

From this information, you calculate two multiples for each company: (1) the ratio of total company value

to revenues; and (2) the ratio of total company value to EBITDA. To illustrate for Company A, company value

equals the market value of outstanding equity plus the value of outstanding debt: