Equity Valuation Techniques: EBIT

My previous post was an attempt at valuing Ralph Lauren from some knowledge I gained during university on the Accounting course and from my wider reading. I want to use this post to explore more valuation techniques used in the industry.

The goal for every firm should be the creation of value or wealth for its shareholders. Therefore, understanding the value of the company is vital in order for an investment decision to be made. However, components of valuation can be subjective due to the different interpretations of data as well as the "story" of the company. That said, there are many quantitative methods such as ratio analysis to help paint the picture. Using a combination of both we should arrive at a congruent and reasonable valuation for the underlying company.

There are several ways to estimate the value of a company:

• Public Comparables Analysis - relative value to its peers.
• Acquisition Comparable Analysis - relative value based on historic transactions in the industry.
• Discounted Cashflow Analysis (DCF) - calculates the intrinsic value of a firm by projecting estimated unlevered free cash flows and calculating the present value.

What will someone pay? There are many factors to consider, for example Common Affordability Analysis can be done:

• Merge consequences  analysis - impact to the financial position of a buyer and determines what they can afford to pay for a target company.
• Leveraged buyout (LBO) analysis - when the buyer is a private equity firm primarily funded with debt.

As well as other factors that needs to be considered. For example, a strategic buyer (e.g. competitor) would be willing to pay more than a financial buyer like a private equity firm. Also, hostile takeovers tend to drive up share prices more than friendly acquisitions.

As Volkswagen AG was another company I was bullish about at the beginning of the year, let us use them as an example for the rest of the analyses.

The simplest ways to estimate the value of a company is by looking at the equity value, also known as the market capitalisation. From the official "fact sheet" we can calculate the market cap to be €35.13bn (119.05 x 295,089,817), which includes the diluted shares disclosed in their latest income statement. This gives an indication of what current investors thinks the company is worth. With this metric, we can also calculate the enterprise value, which includes the value of both equity and debt:

Enterprise value = Equity Value + Total Debt - Cash & Equivalents

• Equity value = €57.54bn
• Despite calculating the market cap above, in order to maintain consistency we will use the value from their latest (2011) balance sheet, under equity attributable to shareholders of VW AG.
• Diluted shares should be used which includes all options, warrants and convertibles. The treasury stock method (TSM) assumes the proceeds from in-the-money options exercised will be used to buy existing shares of common stock and minimise the dilution from the options.
• Total Debt = €93.53bn
• Including interest bearing, current and non-current financial liabilities.
• Cash & Equivalents = €18.29bn
• Enterprise value = €132.78bn

Earnings Before Interest and Taxes (EBIT)

• Influences the equity and enterprise value. Quantifies the income from operations before the effects of financing and taxes, highlighting profitability from operating activities.
• Ignores the capital structure (division of capital into debt and equity) of the company.
• Comparing the EBIT for VW and one of its competitors:
• VW - €11.27bn operating profit from their 2011 income statement.
• Ford - $11.37bn operating profit from their 2011 income statement.
• This is the raw EBIT calculation, but we also need to normalise the financials to understand the underlying fundamentals of the company.
• We do this by "backing-out" one-times items which may result in gains/losses.
• These can include restructuring charges, legal settlements or gains/losses from sale of division.
• Problems can arise when these one-timers are built into other components of the cash-flow statement. In these situations we must investigate further by reading footnotes or the annual report and making the relevant adjustment.
• We must also understand the impact of these items on the company and whether it will impact the financial health of the company.
• Continuing the examples above:
• VW has a normalised EBIT of €11.05bn
• From here we can see the breakdown of income and backout Income from investment property (60), Gains on asset disposals and the reversal of impairment losses (163).
• Ford has a normalise EBIT of €11.34bn
• From here we can see the specified non-recurring expense of 33m.

Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)

• Can be used as a proxy for operating cash flow as depreciation and amortisation are non-cash expenses.
• EBITDA can be calculated by adding the depreciation and amortisation back to the EBIT.
• Normalised EBITDA can be calculated by adding normalised D&A back to the normalised EBIT.
• However, it is not actual cash flow, as it does not include interest which is paid primarily in cash.
• EBITDA also does not consider the following outflows:
• Operating activities (working capital needs).
• Investing activities (capital expenditures).
• Financing activities (cash flows to and from shareholders and creditors).
• For example:
• VW - €21.60 ( = 11.27 + 5.97 + 1.70 + 2.67) from their 2011 cash flow statement.
• Ford - €16.75 ( = 11.37 + 5.38 ) from their 2011 cash flow statement.