Session 11: Loose Ends in Valuation

Introduction

In this session, the speaker discusses how to get from estimating cash flows and attaching a discount rate value of a business to the value of equity in the business.

Steps to Get to Equity Value

• There are four additional steps needed to get from the value of a business to the value of equity.

• First, decide what to do about cash on balance sheet.

• Second, bring in cross holdings and other businesses owned.

• Third, account for any other assets that haven't been counted yet.

• Fourth, subtract out debt outstanding.

Valuing Any Business

• To value any business, estimate cash flows, attach a discount rate reflecting risk in those cash flows, attach a growth rate and terminal value.

• Then put closure with terminal value by discounting back.

• However, there are still loose ends before coming up with the equity value.

Adjustments Needed for Equity Value

The speaker talks about four adjustments needed for getting the equity value of a company after valuing it.

What To Do About Cash?

• Companies have marketable securities and cash on their balance sheets.

• The first adjustment is deciding what to do about this cash.

• Three companies with identical values but different returns on capital are used as an example:

• Company A: return on capital almost equal to its cost of capital

• Company B: return on capital well below its cost of capital

• Company C: return on capital well above its cost of capital

• For each company:

• Cash is neutral asset for Company A.

• Cash will be discounted for Company B due to bad track record of managers.

• Cash might actually trade at a premium for Company C.

Cross Holdings and Other Assets

• The second adjustment is accounting for cross holdings and other businesses owned.

• Minority holdings (5%, 6%, 8%, 10%) and majority holdings (60%) are discussed.

• This is the last chance to sweep in any other assets that haven't been counted yet.

Debt

• The fourth adjustment is subtracting out debt outstanding.

• This is done after accounting for cash, cross holdings, and other assets.

Conclusion

The speaker concludes by saying that whether cash is good or bad depends on the company's situation.

Valuing Companies with Cash and Cross Holdings

In this section, the speaker discusses how to value companies with cash and cross holdings. He explains that while $1 in cash is valued at roughly $1 for young growth companies, mature companies may have their cash discounted by up to 31%. The speaker also delves into the complexities of valuing cross holdings.

Valuing Cash Holdings

• Across all US companies, $1 in cash is valued at roughly $1.

• For mature companies like Company B, however, $1 in cash may be valued as low as 69 cents due to a bad track record or other factors.

• Giving value enhancement advice to such a company would involve returning the cash.

Valuing Cross Holdings

• Accounting for cross holdings can be difficult because there are three ways they can be accounted for: minority passive investment, equity approach, and consolidation.

• Minority passive investments only require showing dividends received from cross holdings on income statements and original investment on balance sheets.

• Equity approach requires showing a percentage of net income or loss on income statements and updating original investment for retained earnings on balance sheets.

• Consolidation requires acting like you own 100% of the subsidiary company and showing 100% of revenues and operating income on income statements while recording minority interest on balance sheets.

• Ideally, each cross holding should be valued separately based on its unique characteristics. However, this requires full financial statements for every subsidiary which is often not available.

• If a cross holding is publicly traded, its market value can be used as an approximation. If it's private but has book value information available, a price-to-book ratio based on similar publicly traded companies can be applied.

Valuing Assets and Equity

In this section, the speaker discusses how to value assets and equity. The speaker explains that assets generating cash flows should not be double-counted, and unutilized assets should be valued but not counted in cash flows. The last step is to subtract all interest-bearing debt and commitments treated as debt to come up with the cost of capital.

Valuing Assets

• Unutilized assets that have value but are not included in cash flows can exist. Examples include overfunded pension obligations.

• It's important not to double-count assets when valuing them. For example, if a company has a factory with real estate value, only the present value of the cash flows generated from operating the factory should be counted.

• Marketable securities, cross-holdings, minority holdings, and majority holdings should also be valued correctly.

Valuing Equity

• Subtract all interest-bearing debt and commitments treated as debt from the value of operating assets discounted back at the cost of capital.

• Take into account any other concerns such as potential lawsuits or liabilities that may affect the expected value of equity.