FSACV/Q3 2007

Notes on Forecasted Financial Statements and the Valuation of Holmes Corp.

Proforma financial statements are projections of financial statements. They serve as a starting point for valuation. A complete set of forecasted financial statements, as opposed to partial forecasting of subtotals such as free cash flows, allows one to see all possible dollar inputs to various valuation models as well as the required capital structure. Below is a list of conventional valuation stepsthat begin with proforma financial statements. A more detailed description of each is provided on the pages that follow. This document also serves to summarize the sequence of steps we will take in the valuation of Holmes Corporation (case 12.2, page 917 of the SBW text).[1]

Conventional Valuation Steps Using Full Forecasted Financial Statements[2]

1.Forecast the Income Statement w/o interest/ depreciation / amortization

  • Sales forecasts
  • Operating expense relations

2.Forecast the Balance Sheet and Complete the Income Statement

  • Operating assets and liabilities
  • Non-operating assets and liabilities specifically needed in I/S
  • Complete the income statement

3.Complete the Statement of Cash Flows and Estimate Free Cash Flow

  • Use the forecasted balance sheet and income statement data to derive forecasted statements of cash flow.

4.Determine Cost of Capital

  • Direct computation of weighted average cost of capital (WACC)
  • Alternative estimates of WACC

5.Estimate Terminal Value

  • Estimate the residual value of the firm beyond the forecast horizon

6.Apply Inputs to Valuation Models and Evaluate Sensitivity

  • DCF, earnings based models, other models
  • Evaluate assumptions
  • Compare reasonableness with “multiples” valuation approaches

Proforma Balance Sheets and Income Statements

Steps 1 and 2

The first two steps in Holmes’ financial statement valuation involve forecasting the balance sheet and income statement accounts; the ultimate goal is to projectcash flows and earnings for use as inputs into valuation models. As we proceed through case 12.2 numerous alternative assumptions will be discussed. Note that financial statement analysis and valuation is by its very nature analyst-specific, so observed practices may differ from the approach taken here.

  • Step 1 involves forecasting the Income Statement before interest, depreciation, and amortization expense (and by default before tax expense). One starts with sales because, as you might expect, future asset growth from operations (i.e., from non-capital contributions or debt financing sources) derives directly from the revenue activities of a firm. Recurring expenses other than those outlined above can be viewed as incurred to generate revenue, and thus are typically some reasonable function of predicted sales. A fixed cost component may or may not be estimated for each operating expense component. One typically estimates fixed costs if expenses move in a predictable fashion to revenue, or if there is some know capacity constraint. Interest, depreciation, and amortization could be estimated at this stage, but a more practical approach would be to tie these values to their respective long-term asset and liability accounts. These latter expenses are thus estimated after the balance sheet is forecasted.
  • Step 2 involves forecasting the Balance Sheet. Relationships with revenue are assumed with no ongoing changes in capital structure. This is both (i) a simple way to forecast balance sheets, and (ii) sets the groundwork for later evaluating differences in capital structure. One can use assumed growth rates in asset components, or historical turnover rates as a starting point. After the balance sheet is completed and capital structure forecasts in place, bottom-line earnings (and earnings per share) can now be estimated. Note, of course, that the income statement can be completed in step 1. But waiting until this stage is recommended as capital structure variables that may affect recorded expense amounts (e.g. expected future interest rates) should be evaluated in their own contexts.

Free Cash Flows and the Cost of Capital

Step 3

If you reached this stage successfully you have a series of completed balance sheets, income statements, and earnings estimates. Step 3 involves forecasting the Statement of Cash Flows, the objective being to estimate a future stream of nominal cash flows realized by the firm that is then recast in present value terms. This step typically involves completing an indirect statement of cash flows, with free cash flows the ultimate objective (see , Chapter 11 of Stickney, Brown and Wahlen). Assets can be valued in their entirety using unlevered free cash flows (cash flows to all investors), then adding to that the value of all non-operating assets. To arrive at the value of equity, simply deduct the market value of debt.

The choice of a valuing equity (using levered cash flows) or valuing assets (unlevered cash flows)in theory should lead to equivalent answers, given

Value of non-operating assets + Value of total net operating assets =

Value of liabilities + Value of equity.

Note that if stock equity value is estimated directly the proper discounting rate is the cost of equity. If assets are valued then WACC is the appropriate measure. For Holmes we will value assets directly, later deducting the expected value of debt to arrive at stock equity value. For further details on the choice of inputs used inthe valuation process I recommend you reviewtechnical notes F-1187, F-1274, and F-0955.

Step 4

The constant weight applied to debt (wd) in the computation of Weighted Average Cost of Capital (WACC) reflects expected changes in the capital structure that are built into the earnings or cash flow forecasts.

For Step 4, you should recall that the calculation of WACC takes the following generalized form:

where

w = weights based on market values of debt and equity

R = pre-tax cost of capital (debt or equity), and

t = effective marginal tax rate on financing

The (pre-tax) cost of debt capital is the yield to maturity of debt (i.e., the effective borrowing rate of the firm). The cost of equity capital (Re) is commonly estimated at the firm level using CAPM:

,

where

RF is the current rate on risk-free securities (e.g., 3-month US T-Bill)

 is the firm-specific beta (i.e., covariability of stock return with the market return), and

RM is the average market return.

A circularity problem arises in the estimation of WACC because one does not know the market value of equity (i.e., this is what one is attempting to measure). In practice one would assume a target level of debt and equity allocation, and approximate the weights. This type of estimation error is, of course, exacerbated the larger the difference between the cost of debt (Rd) and the cost of equity (Re).

The second component on the right-hand side of the CAPM is the market risk premium: the additional return an investor requires for taking a risk in a given security. Note that firm-specific betas frequently cluster by industry, and recent research has shown that one can use industry estimates of market risk premiums (if available) to calculate a specific firm’s cost of equity without a significant loss of information. Likewise one can use peer firm betas as appropriate proxies for beta. For Holmes we will use peer firm betas to compute WACC, with an appropriate re-levering of the cost of equity (see UVA-F-1274 and Chapter 11 of the text).

Terminal Value and Sensitivity Evaluation

The final stages are to perform a terminal value calculation and to assess the sensitivity of the overall analysis to changes in assumptions or valuation approaches.

Step 5

With a terminal value calculation the underlying assumptions are that the firm has reached as stage where (a) the incremental benefit of further period-specific forecasts of cash flows (relative to the cost of mis-forecasting) is not material after discounting to the present period, and/or (b) the firm has reached a point where growth is assumed constant and can be benchmarked against industry competitors. For Holmes, we will assume for simplicity that this takes place after five forecasted years.

To compute the terminal value (TV), the last specific cash flow value forecasted at year T is assumed to grow at a constant rate "g" in perpetuity, and thus is valued as of year T as

.

TVT is then discounted from year T to today's present value. Terminal values can take on large values. They are negatively related to the cost of capital (r) and the forecast horizon (T), and positively related to the final individual forecast of cash flow (CFT) and growth (g).

Step 6

Once a standard DCF model has been complete, you should assess the sensitivity of any conclusion to alternative assumptions and alternative valuation approaches. With respect to the latter, these might include multiples analysis based on industry norms and/or comparisons to close peer firms. With respect to the former, the most critical of assumptions that impact estimate value are typically sales growth, cost of capital, and forecast horizon. Relations across accounts (and ultimately the correlation of estimated cash flows and forecasted sales) are also critical drivers. It is recommended you review technical note UVA-F-1274 for a primer on these sensitivity analyses.

Recommended Review Material:

“Methods of Valuation for Mergers and Acquisitions” UVA-F-1274.

“Valuing Companies – An Overview of Analytical Approaches” UVA-F-1187

“A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation” UVA-F-1301

[1] Holmes Corporation is a LBO candidate from Case 12.2 in Stickney, Brown, and Wahlen’s (2007) Financial Reporting, Financial Statement Analysis and Valuation text. This document provides a broad outline of valuation steps applicable to most companies. You are encouraged to review the technical notes from second year Valuation if you need a more extensive refresher on the valuation process.

[2] There is also a “Step 0” implicit in valuation: examining the historical performance through ratio analysis, understanding the economic factors that impact the business, and evaluating management and strategic corporate objectives.