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Friday, March 27, 2015

Valuation Steps Part 2

A couple of days ago I published an article that mapped out the efforts required to perform a complete valuation of a new project or entity, and that article [LINK] seemed to have generated a lot of curiosity.  In this sequel to the Valuation Steps posting, we are going to take a slightly deeper look at how to identify specific the parameters which are needed to perform a Discounted Cash Flow valuation.

Valuation Parameters
When a risk or business analyst wants to value a project cash flow or a new entity from the outset, there are several parameters they have to identify or acquire before they can progress forwards with their main Discounted Cash Flow valuation effort.  These factors are usually acquired from a separate model that performs a relative valuation of the project's commercial risk environment.

It is not really possible to value a non-listed corporate entity or project unless the following information is made available to the main Discounted Cash Flow engine and I will take to list these factors directly here because they are important: The Risk Free Rate, The Market Risk Premium, The Equity Premium, The Project Tenor, Tax Rate, Beta and The Relative Gearing or leverage effects the opportunity may have from its internal structuring. All these individual factors are needed before the Cost of Capital (the price to finance our risky project) can be understood.

The final combination of these factors will allow the business analyst to calculate the Weighted Average Cost of Capital for their project and I have inserted a spreadsheet into this article to make it easy to follow.

There are four steps to this single calculation exercise that are normally followed and each step has been expressed above in its most simple form. However, I occasionally see analysts evolving the various steps into more sophisticated models to remove general biases. 

Step 1 swings in several other 'relative' projects that have been funded into a table so that the Average Unlevered Equity Market Beta can be ascertained.  The idea here is that we have a project which needs potential funding, so then, it follows; how well have other entities in this sector or other associated projects economically performed?

We need to ensure that the internal leverage effects of each relative project are removed out of the equation of performance and there are lots of assumptions here too that can make this assessment step fraught with error, starting with; what is a relative project anyway, what should we be comparing our opportunity with? ... This is a big discussion topic among analysts and we could debate this for quite a while.  All this aside, with the average equity beta in hand, we can then swing in our own project's or opportunity's unique leverage and tax rate information into the equation to identify its specific potential beta, just as we have done in step 2.

The exercise you see in step 1 also needs to be carried out for the cost of debt as well, we mustn't forget to do that and this calculation also has its own nuances.  Nonetheless, with both Cost Values (Debt and Equity) now available to us, we are then able to identify the final Weighted Average Cost of Capital for our project, just as we have done with our quick step 4 spreadsheet example.

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