The Art of Valuation

Valuation depends mainly on understanding the business, its industry, and the general economic environment, and then doing a prudent job of forecasting. Careful thought and hard work leads to foresight. Correct methodology is only a small, but necessary, part of the valuation process.

We would like to close Part Two with two important messages. First, avoid shortcuts: They will usually cost you time in the long term. Invest the time to build an appropriate valuation model before trying to draw conclusions. The investment in a complete model always pays off:

• Your model should include complete income statements and balance sheets as well as cash flow statements and key performance ratios such as return on invested capital, operating margins, and capital turnover. A cash flow statement with no balance sheet is not sufficient.

• Ground the model in historical financial statements. The model should include 5 to 10 years of historical financial data so that the forecast can be analyzed in light of historical performance and to ensure that the forecast is anchored in fact.

• Understand the accounting and tax complications of the company's financial statements. Understanding the accounting is often critical to understanding the economics of the business.

Second, keep in mind that valuation is as much art as science and is inherently imprecise. Valuation is highly sensitive to small changes in assumptions about the future. Take a look at the sensitivity of a typical company with a forward-looking P/E ratio of 20. Changing the cost of capital for this company by 0.5 percentage points will change the value by about 12 percent to 14 percent. Changing the growth rate for the next 15 years by 1 percent per year will change the value by about 7 percent. For high-growth companies, the sensitivity is even greater. The sensitivity is also highest when interest rates are low, as they were at the end of the 1990s.

In light of this sensitivity it should be no surprise that the value of a typical company will fluctuate by 15 percent or more during any three-month period. Exhibit 13.2 shows the distribution of the quarterly share price volatility for 2,117 companies during the 10 years ended June 20, 1999

Exhibit 13.2 Quarterly Volatility of U.S. Companies

(where volatility is defined as one-half the distance between the quarterly high and low divided by the average price for the quarter).

We typically aim for a valuation range of plus or minus 15 percent, which is similar to the range used by investment bankers. Even professionals who do valuations for a living aren't always accurate. In other words, keep your aspirations for precision in check.

Heineken Case

We will now complete and analyze the Heineken valuation. First, we will calculate the equity value of Heineken for the Business as Usual scenario. Exhibits 13.3 and 13.4 show the calculation of the value of Heineken's operations using the DCF and economic profit approaches, respectively. The value of Heineken's operations in both methods is NLG 33 billion.

Note that there is a mid-year adjustment factor equal to one-half of a year's value discounted at Heineken's WACC. This is to adjust for the fact that we conservatively discounted the free cash flows and economic profits as if they were entirely realized at the end of each year, when, in fact, cash flows occur (cycles

Exhibit 13.3 Heineken—DCF Valuation

Business as usual case

Free cash flow after goodwill Discount factor

(NLG million;

Present value of FCF

(NLG million)

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