Valuating a German business - Case adidas

Usage of the valuation methods discounted cash flow and multiples factors

Research Paper (undergraduate) 2012 33 Pages

Business economics - Investment and Finance


List of Contents

Executive Summary

List of Figures

List of Tables

List of Abbreviations

1 Introduction

2 Theoretical foundation of valuation models
2.1 Discounted cash flow
2.1.1 Discounting
2.1.2 Free Cash flows
2.1.2 Discounting rates - The costs of capital
2.2 Valuation using Multiples

3 Assessment of Adidas
3.1 Adidas in figures
3.2 Strategy and planning
3.3 Market analysis and competition

4 Applying valuation methods
4.1 Valuation of Adidas with the DCF approach
4.1.1 Forecasts of the free cash flows
4.1.2 Determination of the CAPM and WACC
4.1.3 Calculation of the shareholder value
4.2 Multiples factors
4.2.1 Definition of qualified multiples and peer group
4.2.2 Formation of the multiples

5 Comparison and assessment of the results

List of Literature


Declaration of Academic Integrity

Executive Summary

Valuation of companies is done for many reasons. The evaluation of alternative strategies for decisions to sell or buy a company is the widest known purpose among literature. The alternatives can be categorized into three parts: mergers and acquisitions, succession and continuation. The former reflects the selling or buying decision of companies, and the acquisition of shares and mergers. Succession means management buyouts, whereas continuation refers to reorganization, monitoring of financial standing and liquidity flotation, investments but also divestments and spin offs (cf. Hansa & Dvorak 2007).

Adidas has gone through several valuations already. In 1994 Adidas was sold for 1,350 million German Mark whereas in mid-1995 the company was already valued at 3,300 million German Mark when it was initially offered to public (cf. Die Welt 1995). As of December 31st 2010 the price for an Adidas share was 48.89 Euro (€), reflecting a 29.4% growth compared to 2009 (cf. Adidas 2011 a, p. 2).

The following paper on hand values the German company Adidas as of December 2010 with help of the valuation methods Discounted Cash Flow in terms of equity and entity approach as well as the market oriented multiples. Both valuation methods are theoretical defined and later applied to Adidas.

Major finding of the paper is the realistic shareholder value of Adidas amounting to about 11,000 million €. The discounted cash flow method revealed a shareholder value of 64.83 Euro per share, which is derived from an extreme optimistic forecast. Using the multiples of a peer group consisting of Nike, Puma, Deckers Outdoor and Amer Sports the result is a range between 10,431 and 14,475 million Euros. Therefore the company has sextupled its shareholder value within the past fifteen years.

List of Figures

Figure 1: Entity and equity methods

Figure 2: Relation of risk to expected return

List of Tables

Table 1: Finding the Free Cash Flow

Table 2: Examples of Entity and Equity approaches in multiples

Table 3: Forecast Income Statement in million €

Table 4: Calculation of the CAPM

Table 5: Calculation of the WACC

Table 6: Calculation of the enterprise value in million €

Table 7: Calculation of the market value of debt in million €

Table 8: Calculation of the shareholder value through FTE in million €

Table 9: Peer Group with trailing figures in million € (includes Adidas)

Table 10: Multiples of the peer group

Table 11: Application of the multiples to Adidas

List of Abbreviations

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1 Introduction

It is in the nature of humans to want to increase their own welfare. This means to search for the strategy that maximizes output with a minimal input. In order to make a decision, comparison has to be possible. In business there are many numerical criteria that can be compared: profits, sales volumes, size of the enterprise or number of customers; but also intangible criteria may apply, such as brand awareness or human capital, for example.

As of today, the traditional German company Adidas has existed for more than sixty years. Within the last twenty years the company has gone through several valuation processes. Starting in 1990 initiated by a management buyout, 80% of the former family enterprise was bought by Bernard Tapie who later sold to the French bank Crédit Lyonnais for debt redemption reasons (cf. Der Spiegel 1991). A few months later the bank sold the shares for almost double the price (cf. Libération 2008).

Eventually in 1995 the new management style lead to success and Adidas was initially offered to public. Two years later Adidas was able to acquire the ski producer Salomon with its brands (cf. Adidas 2011c). After a period of strong success some Salomon brands were not able to reach the targeted level of profitability and could not be aligned with the core competencies, therefore were sold (cf. Hainer 2005). In 2006 Adidas acquired Reebok for 2.3 billion € in order to strengthen its position in the North American market. Additional revenues were estimated at 500 million € per year coming from Reebok and synergies of the group (cf. Hainer 2006).

The paper on hand shall analyze the German company Adidas and result in a shareholder value as of 2010. The valuation methods used are defined to be Discounted Cash Flow and the market oriented approach Multiplies. These will be theoretically defined. In a second step the company Adidas will be analyzed in terms of figures, future planning and competition. Based on these data the valuations will be made in the fourth chapter. The results will be compared and a conclusion will be drawn.

Information and literature has been extracted from the internet as well as classical book literature. The latter is mainly used for theoretical definitions of the valuation methods and practical examples on the valuation process itself. Internet sources mainly contribute needed information from Adidas and their competition. Also specialized platforms for stock market information are used.

2 Theoretical foundation of valuation models

In theory there is a variety of valuation methods differentiated by criteria such as objectiveness, functionality and orientation. In practice there has been a shift from single valuations of substance towards total valuation of companies in order to capture synergy effects amongst others. In Germany predominantly there has been the capitalized earnings valuation. Since the 90s the usage of shareholder valuations, especially the Discounted Cash Flow, is preferred by consultants (cf. Peemöller et al. 1994). Market oriented valuation methods are also seen as relevant, represented by the multiples (cf. Schultze 2003, p. 71).

2.1 Discounted cash flow

The DCF (abbrev. discounted cash flow) provides different methods for valuation. First an entity or equity approach has to be decided on. The entity approach is further differentiated by the consideration of tax advantages of external financing: total cash flow, weighted average cost of capital and adjusted present value. The IDW considers the total cash flow approach to be a sub category of the weighted average cost of capital (cf. IDW 2002, p. 110).

The DCF approach reflects a present value model, meaning that forecasts of future cash flow are made and discounted. Therefore, first the term discounting will be defined, then the approaches entity and equity will be differentiated by means of cash flows and discounting rate.

2.1.1 Discounting

The DCF approach forecasts future cash flows and discounts these by a defined discounting rate. When the CF (abbrev. cash flow) is known for a defined horizon in the future, they can easily be calculated (t is year, r is the cost of capital). In theory the DCF approach has to cover the entire life of the company including the future, which is a problem for calculation. To overcome this barrier specific forecasts are made for a certain number of years. Life time then will be represented by the terminal value of constant growth assumptions in CF as well as

constant cost of capital, calculated by the perpetuity model. The terminal value (abbrev. TV) will be discounted to the present value and added:

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2.1.2 Free Cash flows

All DCF approaches value the free cash flow of a business. Free cash flow (abbrev. FCF) is defined in literature as the “total cash flow generated by the company that is available to all providers of the company’s capital, both creditors and shareholders” (cf. Copeland et al. 1990, p. 109). The usage of this measurement is the key to valuation. It underlines the indifference of dividend payouts or withholding and thereby focuses on the assets of the balance sheet. The figure is seen as the maximum payable dividend, and can also be negative (cf. Knüsel 1994, p. 73).

This means that potential dividend payouts belong to shareholders as well as creditors. Here the approach gives a solution by dividing the FCF into entity and equity: the entity method calculates the gross free cash flow (GFCF) whereas the equity approach determines the flow to equity (FTE). The consolidated statement of income calculates the earnings before interest and tax (EBIT). Notional taxes are cleared of from the EBIT, giving the NOPAT (abbrev. for net operating profit after taxes). Depreciations and amortization, changes in working capital and investment cash flows are added to view the free cash flow of the entity (GFCF). The entity method assesses the FCF as if it is not influenced by financing after the Modigliani and Miller theorem, yet the finance policy can increase the available CF for the shareholders. Cost for debt capital is deductible from the tax base. Therefore a higher degree of indebtedness leads to higher cash flow. This tax advantage called tax shield is considered in the valuation process of the equity method. Furthermore changes in liabilities as well as the actual paid interests on debt are subtracted from the GFCF. The result is the FTE (cf. Kruschwitz et al. 2006, p. 5; cf. Hachmeister 1995, p. 65).

Table 1: Finding the Free Cash Flow

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(Source: cf. Schultze 2003, p. 107)

Eventually both methods will yield the same value as the entity method in a second step subtracts the market value of debt and includes excess assets. Due to the different calculation of FCFs and consideration of the tax shield both methods are discounted differently. Figure 1 shows that the two methods should lead to the same shareholder value under different discounting rates.

2.1.2 Discounting rates - The costs of capital

Investors want to be compensated for lending their money, a return on investment. Brealey et al. state this behavior as following “accept investment opportunities offering rates of return in excess of their opportunity costs of capital” (2000, p. 98), meaning that a proposed return rate should exceed the internal rate of return (which would yield a net present value of zero). The income of an investor is therefore calculated as follows:

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Combining the possibility of financing from equity capital (EC) and debt capital (DC) is introduced by the weighted average cost of capital (WACC) approach. As shown in Figure 1 entity and equity method use different discounting rates: entity will use WACC whereas the equity method will use the capital asset pricing model, which is also needed within the WACC approach.

Figure 1: Entity and equity methods

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(source: Seppelfricke 2003, p. 24) WACC

As the name WACC says, this approach weighs the cost of capital on an average basis. The presented equation is used by adding the income of equity and of foreign capital. The capital structure of a company is presented through the proportional involvement of differentiated costs for foreign and equity capital. The resulting average cost of total capital reflects the demanded return of all investors (cf. Rappaport 1986, p. 54).

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The WACC is used for discounting in the entity method. It has to be aligned to the used FCF in the entity method. Interest payments for debt capital, ݎ஽஼, are deductible from the tax base, therefore can lead to higher CF for the shareholder. For calculating the entity value, this tax shield has to be subtracted from the cost of debt capital (1-T ).

A problem with this equation is reflected in the capital structure proportioning the market values (MV) of the capital. The valuation process itself shall lead to the market value, so it is not given information. Literature advices to use the long run preferred proportion of equity and debt capital or an estimate figure (cf. Knüsel 1994, p. 200). Further the expected return of equity capital, the costs for equity is not fixed and communicated by companies. Research among valuation firms have shown that there are more than fourteen different approaches for this calculation, the one most used is the CAPM (cf. Knüsel 1994, p. 204). CAPM

The CAPM, abbreviation capital asset pricing model, is derived by finding the equilibrium rate which investors would require as compensation for a given risk (cf. Gregory 1999, p. 74-79). The model was developed by Markowitz and enhanced in the 60s by Sharpe, Lintner and Mossin who raised the question, how much return (price) does an asset have to have in order for an investor to invest his capital into this asset (cf. Seppelfricke 2003, p. 68). The calculation is shown in following equation:

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The interest rate for a risky asset is formed by a risk free rate of return ݎ௙, an investment specific index of risk exposure of the market ߚ and a market risk premium MRP, which is derived from the expected return of the market portfolio minus risk free rate of return ( ݎ௠ െ ݎ௙). The equation only considers the systematic risk. Is it generally assumed that unsystematic risk, coming from company uncertainties, is eliminated by diversification of the market portfolio (cf. Brealey et al. 2000, p. 166-168). Inflationary effects are considered within the market risk premium due to the fact that it is derived from an expected nominal return of the market portfolio (cf. DVFA 2011, p. 16).

The link between risk and an expected return is concluded by the security market line shown in Figure 2. Under the conditions of efficient markets with risk-adverse actors there is a linear correlation between risk and return. A beta of 1 means that the share meats the overall risk of the market (cf. Knüsel 1994, p. 206).

Figure 2: Relation of risk to expected return

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(Source: Knüsel, 1994, p. 206)



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discounted cash flow DCF unternehmensbewertung entity method equity method




Title: Valuating a German business - Case adidas