Valuation Insights

Again, stemming from the private equity class readings here are some of the notes regarding valuation (by Steven Kaplan, a famous GSB finance professor). Only the things that startled me. First of all both the APV and WACC valuation methods lead to the value of the firm with debt, i.e. enterprise value. So if after applying the APV method to valuing the acquisition target you get the value of 100, but the company has the debt of 20, your equity value or the price that you will be willing to pay is only 80. Surprisingly this wasnt obvious to me. I think the same mistake (forgetting in take into account the debt) was made by our partners in the McCaw – AT&T merger case. Our partners came up with the valuation of their subscriber base and figured out the market value of one subscriber. After multiplying this number by the # of their subscribers they found the market value of the company. Which wasnt really the equity value, because a huge chunk of that subscriber base was built using the debt. Additionally, this answers my question why is the enterprise value at all important. Well, because it is what a DCF model produces!

Kaplan asserts that getting the correct free cash flows is more important than getting the correct discount rate. Honestly I felt otherwise, but lets take this as given.

When calculating the FCF multiplying EBIT by (1-t) doesnt serve any other purpose, rather than seprating the tax shield. It would have been wrong just as it seems wrong, if this weren;t the purpose.

The discount rate for the FCF in the APV method isn’t the same as the cost of equity in the WACC model. The principal difference is that in the APV model the discount rate is calculated using the unlevered beta (derived most commonly from the average of the actual betas of comps, properly unlevered) while for the WACC model we use the levered beta derived in the same way + relevering.

Kaplan argues for the superiority of the APV method due to greater flexibility and that APV better fits situations where leverage significantly changes (since WACC assumes fixed capital structure). The third method, which Cash flow to levered equity is used when 1) valuing financial institutions and 2) when valuing equity investments in leveraged buyouts. Cash flow to levered equity differ in that we no longer disregard the interest and debt repayments / disbursements. I remember as far back as at GNG we showed (to ourselves mostly) that this is identical method to the WACC.