6.1 Discussion/Choice of Valuation Methods
94 It is clearly evident from figure 1.24 that the ROE is following a similar trend to the ROIC. This is mainly due to the significant impact ROIC has on the ROE due to the low financial leverage. Thus, the budgeted ROE is consistent with the historical ROE, just as in the case with ROIC.
This section proceeds on the previous section, which forecasted the future performance of the BMW Group. This allows estimating the enterprise and equity value of the firm and as such the share price based on the fundamental approach used. This section starts with a discussion of the different valuation approaches and the models used. This is followed by a discussion of the WACC, the inputs to the WACC and the calculation of the WACC in regards to the BMW Group. The final part of the section estimates the value of the Group and examines how sensitive this value may be to certain inputs.
95 valuation may be more suitable to value patents, future R&D projects or natural resources and may as such apply more to pharmaceuticals, natural resource and oil & gas companies (Damodaran 2002).
The present value approach and the relative valuation approach are by far the most used methods for valuation by practitioners according to a study conducted by Petersen and Plenborg (2011), and are discussed more in-depth in the following sub-sections.
6.1.1. Present Value Approaches
There are several present value based valuation approaches that can be applied to calculate the enterprise or equity value of a firm. The type of income stream that is discounted varies depending upon the present value approach used (Petersen and Plenborg 2012). Figure 1.25 illustrates some of these many present value approaches. There are more present value approaches than those listed in figure 1.25, but only these four are discussed in this case.
Figure 1.25 – Some present value based valuation approaches
(Source: own creation using Koller et al. 2010)
The enterprise discounted cash flow model (DCF) discounts the free cash flows, meaning cash flow available to all investors (equity and debt holders) are discounted at the weighted average cost of capital
cash flow Free cash flow
Discount factor Assessment
Firms that manage their capital structure at a
WACC Highlights how a
company creates value
present value Free cash flow Unlevered cost of equity
Changing capital structure
flow Cash flow to
equity Levered cost of
Used when valuing financial services
96 (WACC) (Koller et al. 2010). The claims on cash flow of debt holders and other non-equity investors are then subtracted from the enterprise value to determine the equity value. Another way to derive the equity value is to discount the free cash flow to equity by the cost of equity also referred to as the equity cash flow model in figure 1.25. Both methods should lead to identical results if applied correctly, but Koller et al. (2010) recommends using the Enterprise approach as matching cash flows with correct cost of equity tends to be challenging.
The economic profit model highlights how a firm creates value, and if applied correctly should lead to a valuation that is identical to that of the DCF model (Koller et al. 2010). Economic Profit is defined as:
Economic Profit = Invested Capital (ROIC – WACC)
The enterprise value is the derived using the following formula, which is somewhat similar to the DCF approach:
The economic profit approach does as such illustrate the expected value creation in comparison to the DCF model; given the assumption that ROIC is a primary driver of economic profit (Koller et al. 2010).
The free cash flow models does according to Koller et al. (2010) fail to show this dynamic, as free cash flow could continue to grow even as ROIC falls.
The adjusted present value approach is variant of the DCF model and more suitable in cases where a firm plans to change its capital structure, as it accounts tax shield on net interest-bearing debt separately (Koller et al. 2010, p119 and Petersen and Plenborg 2012). The Adjusted Present Value approach can be defined as:
APV = Enterprise value as if the company was all equity financed + Present value of tax shields
The “enterprise discounted cash flow model” is in this case used to calculate enterprise value of the BMW Group. One reason being that is by far the most popular present value approach among analysts (Petersen and Plenborg 2012). Second being that the DCF approach does rely on cash flow of the company rather than accounting based earnings that could be manipulated (Koller et al 2010). However,
97 the DCF valuation approach will only be utilized to value the industrial business of the BMW Group, as the DCF approach is generally not recommended to value a financial services entity due to the complexity of their business operations and often unstable cash flows. Tim Schuldt, Equity analyst at Equinet, suggests applying the DCF approach to the industrial business of the Group only, and simply adding the book value of the financial services business to get total Group value (see appendix A.1). This approach will be followed in section 6.3.
6.1.2. Relative Valuation Approaches
Valuation based on multiples is according to Petersen and Plenborg (2011) another very popular valuation approach due to its low level of complexity and the speed by which a valuation can be formed.
Additionally, a DCF analysis is only as accurate as the input and forecasts it relies on. A multiple valuation and analysis can therefore a good method to triangulate the results from the DCF approach.
A relative valuation approach is also likely to reflect the current market value and as such is likely to provide a value different from the discounted cash flow model (Damodaran 2002). However, a thorough valuation based on multiples can be both complicated and time consuming, as there is a number of factors that affect the multiple a company are valued at (Petersen and Plenborg 2011). For instance, an EV/EBIT multiple does according to Petersen and Plenborg (2011) assume that company has similar ROIC, WACC, tax rate and terminal growth rate, which in most cases might be highly unlikely.
Furthermore, multiple models are mostly used to value and compare companies within the same industry. Additionally, using multiples from companies within the same industry who are more likely to share similar economic characteristics might reduce some of the problems listed above.
EV/EBITDA is according to Koller et al. (2010) one of the most widely used enterprise based multiples when comparing valuations across firms. Another very common enterprise based multiple is EV/EBIT.
However, in comparison to the EV/EBITDA multiple, it does include depreciation & amortization costs and can as such be affected by differences or manipulations in accounting policies . The price-earnings multiple (PE) is one of the most widely used equity based multiples among analysts, but it is according to Koller et al. (2010) distorted by capital structure and non-operating gains and losses.
Thus, the EV/EBITDA multiple is considered the most appropriate relative valuation approach to apply to the BMW Group, and is therefore used in this case to triangulate the results of the DCF valuation.