Background to this Series of Posts

This is the 14th in a Series of 17 Posts that will be published on this Blog each Tuesday and Thursday from September 16 to November 11. All 17 Posts will be filed under the Blog Category ‘Valuation of Mining Companies’. For previously issued Posts in this Series click here. We hope you find this Post Series useful.

Posts #11 – #16 of this Post Series discuss Valuation Methodologies adopted by stock market investors, stock market analysts, corporate acquirers, merger and acquisition intermediaries, and business valuation experts when they value shares in mining companies. In these Posts the following terms have the following meanings, where each is ‘point in time specific’:

1. Enterprise Value: The total value of a business including both its interest bearing debt and equity components.

2. Equity Value: The total value of the shareholders’ equity of a business, where shareholders’ equity is stated at its fair market value, not at its ‘book’ or ‘carrying’ value.

3. En Bloc Value: The value of all outstanding shares (or other ownership interests) of a business viewed as a whole.

4. Per Share Value: That portion of the ‘en bloc’ value appropriately attributed to each class of outstanding share capital divided by the number of shares of that share class that are outstanding at a particular point in time.

The following discussion is subject to important caveats:

1. Any conclusion as to whether a particular valuation methodology is reliable or who does or does not adopt it is fact and circumstance specific. Accordingly, the categorizations set out in the following table and commentary may be inaccurate in any given fact situation.

2. ‘Corporate Acquirer’ means a corporation that acquires all of the outstanding shares or control of another company where it is able to access all relevant information of the target company pursuant to a detailed due diligence process after executing Confidentiality and Non-Circumvention Agreements.

3. ‘Corporate Acquirer’ in the context of the following discussion does not mean a corporation who makes a takeover bid for a public company or portion of the shares thereof where the ‘bidder’ has access only to publicly available information with respect to the target company. In the latter circumstance the ‘bidder’, typically being a company who expects post-transaction synergies, will have specific knowledge of its synergy ‘expectations’ and be in a better position to assess the value of the ‘target’ to it than any analyst not directly advising on the transaction.

Earnings and Cash Flow Based Valuation Methodologies – Part 2

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The Discounted Cash Flow Valuation Methodology

This methodology develops either an en bloc enterprise value, or en bloc equity value if interest bearing debt and equivalents and other non-operating liabilities (e.g. unfunded pension obligations, unfunded environmental liabilities, etc.)are deducted from enterprise value. It is the most theoretically sound share and business valuation methodology. Pursuant to this methodology a detailed forecast of revenues, cash operating expenses and required prospective sustaining capital reinvestment, capital invested to support growth assumed in the forecast period, and required working capital changes are discounted to present value by a discount rate which incorporates a blend of what are taken to be appropriate after-tax rates of return on equity and long-term prospective interest rates (in ‘finance speak’, a ‘weighted average cost of capital’). Benefits related to existing future depreciation claims for income tax purposes and redundant assets are added to derive en bloc enterprise value. Interest-bearing debt and equivalents and other non-operating liabilities are deducted to derive en bloc equity value.

In our experience this methodology is the primary one adopted by Corporate Acquirers in acquisition analysis, and is adopted periodically in stock market pricing and forecasting by Securities Analysts. However, analysts typically do not have access to all relevant information resulting in share trading value and price conclusions derived by them typically being more subjective than those made by Corporate Acquirers. More than other methodologies, the DCF methodology explicitly considers the cyclical nature of commodity prices. This methodology is described in more detail in the ‘Valuation Methodologies’ E-Book found under the E-Leaning tab on the Main Navigation Line of www.StockResearchPortal.com.

The Multiple of EBITDA Valuation Methodology

This methodology develops either an en bloc enterprise value, or en bloc equity value if interest bearing debt and equivalents and non-operating liabilities (e.g. unfunded pension obligations, unfunded environmental liabilities, etc.) are deducted from enterprise value. Pursuant to this methodology EBIT-DA (earnings before interest, income taxes, depreciation and amortization) is derived either from actual historic operating results, from forecasted operating results, or from some combination of those two things and is multiplied by a ‘risk assessment based’ multiple (or multiples). Redundant assets are added to derive en bloc enterprise value. Interest-bearing debt and equivalents and other non-operating liabilities are deducted to derive en bloc equity value. This methodology may have some merit when applied to specific non-capital intensive (i.e. service) businesses, but is inherently less reliable than a discounted free cash flow methodology when applied to capital-intensive businesses where there is an annual ‘sustaining capital reinvestment’, ‘growth capital investment’ requirement, ‘growth related’ working capital requirement, and an asset base that is depreciable for income tax purposes. In our experience this methodology is:

• commonly adopted by Securities Analysts when developing prospective stock market prices pursuant to peer group analysis;

• commonly adopted by Transactions Advisers when negotiating and pricing business acquisitions or divestitures; and,

• sometimes is adopted in conjunction with other valuation methodologies by Corporate Acquirers when negotiating and pricing business acquisitions or divestitures.

In my experience it is a valuation methodology that also is adopted from time to time by Transaction Advisors when developing the terminal value component pursuant to the discounted cash flow valuation methodology.

The Multiple of Free Cash Flow Methodology

This methodology develops either an en bloc enterprise value, or en bloc equity value if interest bearing debt and equivalents and non-operating liabilities (e.g. unfunded pension obligations, unfunded environmental liabilities, etc.) are deducted from enterprise value. This methodology also is referred to as the ‘capitalization of discretionary cash flow methodology’. Pursuant to this methodology after-tax free cash flow before consideration of interest expense is multiplied by a ‘risk assessment based’ multiple (or multiples), and redundant assets are added to the result to derive en bloc enterprise value. Simplistically, after-tax free cash flow is equal to total after-tax cash flow less a tax-effected amount to account for estimated annual ‘sustaining’ capital requirements. It is derived either from actual historic operating results, from forecasted operating results, or from some combination of those two things. Prospective growth rates and related required investment in growth capital and working capital are incorporated in the ‘risk assessment based’ multiple. In my experience this methodology sometimes is adopted by Securities Analysts when developing prospective stock market prices. However, given that Securities Analysts only have access to publicly available information, which typically does not disclose the annual sustaining capital reinvestment requirement, application of this methodology by Securities Analysts in my view generally cannot be as meaningful as it is when adopted by Corporate Acquirers. Assuming post-forecast period multiples appropriately reflect ‘real’ (as contrasted with ‘nominal’ (or ‘inflation included’)) after-tax free cash flow growth rates, this methodology is the most technically valid way in which to develop the pre-interest expense DCF terminal value component, and hence for that application in my experience typically is adopted by Corporate Acquirers in acquisition analysis.

The Market Price/Gross Cash Flow Methodology

This methodology results in development of equity value in the context of stock market price, not corporate acquisition price. It is a ‘comparative market value’ methodology whereby the company being analyzed and companies taken to comprise that company’s ‘peer group’ are compared, and ‘comparative differences’ are analyzed by Securities Analysts to derive conclusions and recommendations. Pursuant to this methodology the market share price of the subject company and each ‘peer group’ company (in each case adjusted for redundant assets) is divided by the pre-tax gross cash flow derived from historic operating results, from forecasted operating results, or from some combination of those two things. This results in (subject to adjustment for comparative company risk related to interest bearing debt ratios, political risk, and so on) time-specific comparative ‘market price multiples’. While perhaps of some limited use, in my view results derived from this methodology should be viewed with scepticism. In my experience this methodology sometimes is adopted by Securities Analysts, and may in some circumstances be adopted by Corporate Acquirers when determining whether the public markets are likely to assess an acquisition as ‘accretive’ to them.

For previously issued Posts in this Series click here.

Ian R. Campbell has for over 35 years been one of Canada’s best-recognized Business Valuation Experts – see biography on this Blog.

This Series of Posts is reproduced and supplemented in E-Books titled ‘The Valuation of Mining Companies’ and ‘Valuation Methodologies’. Those E-Books can be found under the E-Learning tab in the Main Navigation Bar of www.StockResearchPortal.com. They are reviewed and amended as market conditions change and our experience dictates. Accordingly, we recommend readers of this Blog Series periodically visit www.StockResearchPortal.com and review those E-Books.

For a comprehensive discussion of Share and Business Valuation see ‘The Valuation of Business Interests’, Ian R. Campbell and Howard E. Johnson, The Canadian Institute of Chartered Accountants, 2001, available through the websites of either Campbell Valuation Partners Limited www.cvpl.com, or The Canadian Institute of Chartered Accountants www.cica.ca.

The views expressed in this Post are those of the author. The value of shares of a given company is time and fact specific. The valuation theories, principles, methodologies, observations, comments and data inputs discussed in this Post are of a general nature, and are provided for information and general guidance only. They should not be taken to include all ‘value or price relevant factors’. Nothing in this Post is intended to, nor should be taken to, constitute economic or investment advice. See Legal Disclaimer.

© 2008, Stock Research DD Inc., all rights reserved.

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