A Firm's Value
Have you ever wondered how investment banks or financial advisors calculate a firm’s value exactly? In order to evaluate company X during an M&A transaction, a peer group of comparable companies (Company A and Company B) have to be selected. Subsequently, various key performance indicators have to be calculated in order to relate them to the firm’s value. This will give you a multiple at which the companies in the peer group are traded (in relation to their performance)
One of the most common ratios certainly is FV (Firm value) / EBITDA (or EBIT). But is EBITDA really reflecting the economic situation of the firm? What happens when the companies in your peer group have different exposure to debt? Since interest on debt is tax deductible, a company with a high debt/equity ratio would therefore have higher earnings (per share) than an identical company with a lower debt/equity ratio (everything else equal)
Let’s assume the following example of two identical companies. Both companies have an EBIT of 1000. Company A is completely financed with equity. (3000) Company B is financed with 1000 equity and 2000 debt at 5%. Let’s calculate the net income for both companies:
Company A
EBIT 1000
- Interest expense 0
= EBT 1000
- Tax (35%) 350
= Net income 650
Company B
EBIT 1000
- Interest expense 100
= EBT 900
- Tax (35%) 315
= Net income 585
Although both companies have identical operations, company A’s EBT is higher than company B’ EBT as a result of different capital structures. Assuming both companies have the same tax rate (35%), company B pays less tax than company A and can also distribute relatively more earnings to its shareholders. Company B reports EPS (earnings per share) of 0.585 (585/1000) compared to 0.217 (650/3000) for company A.
The reason that company B reports higher earnings per share is that it has a higher exposure to debt and benefits from the fact that interest on debt is tax- deductible. Please check the table from above again and realize that interest on debt is subtracted from EBIT before tax is paid.
If you calculate net income for the companies in your peer group, be sure to face that problem! In order to evaluate the company's performance properly, you have to compute a fair performance indicator that doesn’t consider the company’s capital structure. Therefore, you simply reverse the tax effect from leverage and calculate the following for company B:
Net income 585
+ Interest expense 100
- Taxes saved from adding debt 35
= NOPAT 650
After adding back interest expense, taxes saved from adding debt to the capital structure have to be subtracted. (Interest expense * tax rate). The result gives you the NOPAT: Net operating Income after tax. We also assume that both companies neither have non- operational profits nor non- operational losses such as provisions for minority interest or income from unconsolidated companies (which will be explained later)
Why do we use NOPAT instead of other indicators? NOPAT is the profit from operations after tax but before financing costs. NOPAT doesn’t consider a company’s capital structure or non-operating losses/profits.
Now that we have the denominator for our multiple, we also have to calculate the numerator: The Firm Value (FV) is easy to calculate right? Market capitalization plus debt. Well, that is not even half of the story. Check out the following formula:
Common equity
+ In the money Options
+ Preferred stock
+ Minority interests
- Investment in unconsolidated entities
+ Net Debt
= Firm Value
Market capitalization of common equity can be calculated by multiplying the company’s share price of common equity by the number of shares outstanding. The market capitalization states the value of common equity and doesn’t include the value of preferred stock and outstanding options. Hence, the value of preferred equity and the value of in-the money options (strike price has to be lower than current share price) have to be added.
Additionally, minority interests have to be included. Minority interest (or non-controlling interest) is the portion of a subsidiary’s equity which is not entirely owned by the parent (controlling party – which is the company we look at). Minority interest is an ownership deduction and is stated as a separate item between equity and liabilities in the parent company’s balance sheet. Since all equity (including equity belonging to those who are not part of the controlling interest) needs to be considered as “capital invested in the firm”, minority interest are also a part of the firm value.
The complete opposite of minority interest are investments in unconsolidated entities which are a separate position on the asset side of the company’s balance sheet. This position shows minority investments in companies that are owned by someone else. (the controlling party is someone else) Since this investment is not relevant for the performance of the company we look at, it has to be subtracted from all positions above.
Finally we have to add net debt , which is outstanding debt minus cash. We subtract cash because it is assumed that a company can repay its debt with its cash at any time.
If a company has minority interest and investments in unconsolidated companies it has to be reflected in the company’s NOPAT, too. Minority interest provisions have to be added and income from unconsolidated entities have to be subtracted from NOPAT. This is done to exclusively show the performance of the company under consideration.
Let’s assume we have calculated NOPAT and FV for all companies in our peer group. We then calculate our valuation ratios by dividing FV by NOPAT. Then we multiply the average multiple(or median or min or max – depends on your view if company X should be valued at the lower or higher end of the possible range) by company X’s NOPAT. The result that we get is the anticipated Firm value of company X which equals the total M&A price. Let’s use the formula above to calculate the price of common equity:
Firm Value
- In the money options
- Preferred stock
- Minority interests
+ Investment in unconsolidated entities
- Net Debt
= Value com common equity
This formula is the same as the formula above- just in an opposite order.
I hope I was able to illustrate the calculation of a firm’s value properly. Again, I really appreciate any corrections or additions. Do you guys agree with the formulas from above? Would you incorporate anything else into the formulas?
In that simplified example, a NOPAT multiple doesn't strike me as being any more accurate than EBIT. So why go through all that trouble of backing into NOPAT
You are right, EBIT or EBITDA is often used as a proxy for NOPAT but doesn't reflect the company's tax situation which can be "biased" if the company has high exposure to debt. Additionally, EBIT also includes depreciation, NOPAT doesn't. Additionally, NOPAT accounts for income from unconsolidated entities and minority provision. In total, I believe NOPAT is the best proxy for a company's cash flows...
NOPAT includes D&A
Yeah you are right. NOPAT includes D&A - my bad...silver bananas for you!
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