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Present Value = =0
1+
2. Timing:
Because business cash flows 3. Risk:
occur over many future Because business cash
periods, we locate them in flows are risky, investors
time, then discount and add demand a higher return:
them all. The discount rate, k,
contains a risk premium.
Discount Rate: WACC
WACC = Ke x We + KdT x Wd
Ke = Rf + (Rm Rf)
KdT = Kd *(1-T)
Kd = Rf + Default Spread.
We = E/D+E
Wd = D/D+E
WACC-based Standard Method
The cost of debt and cost of equity both are opportunity cost, each
consisting of time value and its own risk premium.
WACC also contains capital structure ratios and an adjustment
reflecting the term (1 minus Corporate Tax Rate).
Together these have effect of modestly lowering the WACC.
This in turn gives a higher present value than one would obtain by
discounting at a non-tax adjusted opportunity cost.
Note that to use WACC in this fashion is to rely on one term (1
minus Corporate Tax Rate) in the discount rate to automatically
make all the adjustments required by a complex capital structure.
DCF Valuation
The cash flow will vary from asset to asset-
Dividends for stock
Coupon and face value for bonds.
After tax cash flows for business.
The Discount rate will be function of riskiness of the
expected cash flows:
Higher rates for riskier assets.
Lower rates for less riskier assets.
If the cash flows are risk free, do we still need to
discount them? At what rate?
Classifying DCF Valuation Models..
Three ways of classification:
1. Valuing a Business as a going concern as
opposed to a collection of assets.
2. Value equity in the business or valuing business
itself.
3. In the third, we layout two different and
equivalent ways of Doing DCF valuation in
addition to the expected cash flow approach- a
value based on excess returns and the adjusted
present Value.
1. Going Concern versus Asset
Valuation
Asset Valuation: Value of business is sum of
values of the individual assets owned by the
business.
Is it correct? (Growing Firms like Face-book?)
Going Concern Valuation: A business or a
company is an ongoing entity with the assets
it already owns and the assets it expects to
invest in future.
Going Concern versus Asset Valuation
Accounting Balance Sheet vs. Financial
B.Sheet.
Assets Liabilities
Assets in Place:
Existing Investments: that
Generate Cash Flows Debt
today
Growth Assets:
Expected Value that will be Equity
created by future
Investments
Going Concern versus Asset Valuation
In Accounting Balance sheet Assets = Liability.
In Financial Balance sheet?
In financial balance sheet where growth assets
are more?
Liquidation Valuation: Special Case of
Asset Valuation
In liquidation valuation we value assets based
on the presumption that they have to be sold
now.
Theoretically, it should be equal to the sum of
value obtained from the DCF valuations of
individual assets.
In Practical world?
2. Equity Valuation Vs. Firm Valuation.
Firm Valuation: value the firm with both the
assets in place and the growth assets.
The cash flows before debt payments and
after reinvestment needs are called free cash
flows to the firm, and the discount rate that
reflects the composite cost of financing from
all sources of capital is called the cost of
capital. (WACC)
Firm Value
Cash Flows from Assets in
Place prior to any debt
payments but after firm
has reinvested to create
growth Assets
Discount Rate reflects the Cost of
Raising both debt and Equity
financing. In Proportion to their
use
Growth Assets:
Expected Value that will be created
by future Investments
Present Value is the Value of Entire Firm, and Reflects the value of all Claims on the
firm.
Defining Free Cash Flows to the Firm-
FCFF
The free cash flows to the firm (FCFF)
represents the cash generated by the firm that
is available to all investors after having paid
taxes and meeting investment needs.
This money can be used to return money to
shareholders (either through dividends, or
share buyback), repay debt, acquire other
companies, provide extraordinary bonus to
key employees, and so on.
FCFF
FCFF is also called unlevered cash flow since it
represents the total amount of cash available
to distribute by all suppliers of capital,
including debt holders.
This could also be interpreted as the free cash
flow that a firm without debt (unlevered firm,
or all-equity firm) would have.
FCFF
FCFF is defined for each year as:
FCFF = EBDITA NWC Taxes CAPEX
OR
FCFF = Unlevered Net Income + Depreciation
CAPEX NWC
Unlevered Income = NOPAT = EBIT*(1-T)
FCFF
In the FCFF method, we do not include any
debt-related payment in the cash flows. The
cost of debt will be considered only in the cost
of capital, and thus impact the company
valuation through the discount rate.
Forecasting Future Cash Flows
In order to estimate FCFF, we need to
generate Proforma accounting statements for
future years.
Given the definition of FCFF, we need to
generate projections of income statement and
balance sheet going forward, so that we can
compute the different items needed for the
FCFF.
Forecasting Future Cash Flows
Start with Sales Forecasting: It requires market
research analysis as well as well competitive
positioning, which allow us to compute Forecasted
Sales Growth Rate into the future.
Then, assumptions related to the Operating Profit
Margin, must be made. Margins might be higher or
lower that in the past for fundamental reasons, such
as:
Capacity Utilization
Unit Labour Cost
Inflation
Competition local and foreign
Forecasting Future Cash Flows
Estimation of Net Working Capital: it can be
defined as percentage of sales, a fixed amount
per customer, or be based on monthly terms
(e.g., one month of credit to customers, two
months of inventories). It is important to always
look at Changes in net working capital.
Depreciation: Depreciation reflect past capital
expenditure made by the company and the
average useful life of equipment. Depreciations
will impact taxes.
Forecasting Future Cash Flows
If Depreciation = CAPEX, we are assuming that
company is only replacing its assets, but not
growing its current capacity. Thus it is no growth
company.
In this case, we can assume that net working capital
is constant, and thus on annual basis the firm will
not change its receivables, inventory and payables.
Thus NWC = 0
In this particular case, the FCFF = Unlevered NOPAT
= EBIT *(1-T)
FCFF Calculation Example..
Consider a company with:
Previous year revenues = $10,000
Estimated Revenue Growth = 5%, 4%, and 3% over the
next 3 years respectively.
COGS = 50% of Sales.
Selling, General and Admn. expenses = 15% of Sales.
Depreciation for next three years = $200, 210, and 218.
Tax Rate = 30%
Net Working Capital Requirements = 5% of Sales
Capex for next three years = $300, $294, $284.
Proforma Income Statement
Revenues 10000
Growth in Rev 5% 4% 3%
COGS/Sales 50%
SG&A Exp/Sales 15%
Tax 30%
NWC/Sales 5%
Depreciation 200 210 218
Working Capital 500
Capex 300 294 284
Year 1 2 3
Revenues 10500 10920 11248
Cost of Goods Sold 5250 5460 5624
SG&A Exp 1575 1638 1687
EBDITA 3675 3822 3937
Depreciation 200 210 218
EBIT 3475 3612 3719
Taxes 1043 1084 1116
Unlevered Income 2433 2528 2603
EBIT(1-T) 2433 2528 2603
Calculation of FCCF under First Method FCFF = EBDITA - NWC - Taxes - CAPEX
Calculation of FCFF under Second Method FCFF = EBIT (1-T) + Depreciation - CAPEX - NWC
Assumptions
WACC 9.31%
1 2 3 4 5 5
Share Value 33
Firm Valuation (Unlevered Firm)
Value of Shares vs. Terminal Growth
160
140
120
100
80
60
40
20
0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
Firm Valuation (Unlevered Firm)
Share Value vs. WACC
90
80
70
60
50
40
30
20
10
0
0% 2% 4% 6% 8% 10% 12% 14% 16%
Growth in Perpetuity
The free cash flow used in the constant
growth formula used for the terminal value
above must be a steady-state cash flow for the
year after the forecast period ends.
The assumption is that this cash flow will grow
at a constant steady-state rate in perpetuity.
Growth in Perpetuity
Necessary calculations might be required for the capital
expenditures (CAPEX) and NWC, in order to get the Final FCFF.
The CAPEX in Steady State must maintain a certain growth, because
of two reasons:
1. It is necessary to replace assets that are being depreciated.
2. If one assumes a certain long term growth rate for sales, then the
assets of the company also have to grow over time.
Thus it is common to assume a certain constant long-term assets/sales
ratio, which means that in steady state efficiency of the assets will be
maintained.
If we assume growth in revenues for the calculation of the FCFF but do
not allow for growth in CAPEX, we would be assuming an infinite
improvement in the efficiency of the assets in place.
The same principle is applied to NWC.
FCCF : Terminal Value Growth Rate
It is advisable to dedicate substantial amount of time
and efforts on computing the steady-state growth rate.
In perpetuity, no firm can grow faster than the overall
economy. This means that the growth rate can never
be higher than the nominal GDP growth rate.
Also no firm can keep growing faster than the industry.
Finally growth rate can not exceed the cost of capital in
perpetuity.
Common practice is to use inflation rate as the
terminal growth rate. However, for certain declining
industries it is reasonable to assume negative terminal
growth rate.
Equity Valuation
Second way is to just value the equity of the
firm.
The cash flows after debt payments and
reinvestment needs are called free cash flows
to the equity.
The discount rate that reflects just the cost of
equity financing. (ke)
Equity Valuation
Present Value is the Value of just the Equity, and Reflects the value of Equity Claims
on the firm.
Inputs to the Discounted Cash flow
Models
Expected Cash Flows
The timing of the cash flows
Discount rate.
1. Discount Rates
Discount rate used on a cash flow should reflect
its riskiness, with higher risk cash flows having
higher discount rates.
There are two ways of viewing Risk:
1. Likelihood that an entity will default on a
commitment to make payment such as interest
or principal due, this is called default risk. (when
looking at the debt, the cost of debt is the rate
that reflects this default risk.) KDT=KD*(1-T)
2. Variation of actual returns around the expected
returns. (beta and CAPM for Equity)
2. Expected Cash Flows..
Dividend Discount Models
Free Cash flow to Equity Models.
Free Cash Flow to the Firm Models.
3. Expected Growth
There are three generic ways of estimating
growth:
1. Look at the companys past and use the
historical growth rate posted by that company.
(peril: past growth may not continue).
2. Obtain estimates of growth from more informed
sources. (Co. Mgt, consensus of analysts).
3. How much the earning is reinvested back into
the firm and how well these earnings are
reinvested. (Retention Ratio* ROE)
Relative Valuation..
How the market prices similar assets.
Thus, when determining what to pay for a house,
we look at what similar houses in the
neighborhood sold for rather than doing an
intrinsic valuation.
Extending this analogy to stocks, investors often
decide whether a stock is cheap or expensive by
comparing its pricing to that of similar stocks
(usually in the peer group).
P/E Ratio, P/Book Ratio, Price/Sales. Price/ARPU,
Price/SQRFT.
The Methods of Comparable
The idea behind price multiples is that a stocks price
cannot be evaluated in isolation. Rather, it needs to be
evaluated in relation to what it buys in terms of
earnings, net sales, net assets.
Obtained by dividing price by a measure of value per
share, a price multiple gives the price to purchase one
unit of value.
EX.. Price/EPS = 20, means that it takes 20 units of
currency (say, Rs. 20) to buy one unit of earnings (say
Rs. 1 of earnings).
This scaling of price per share by value per share makes
possible comparison among various stocks.
Methods of Comparable..
Required
Rate of Expected
Return growth rate
of Dividends
for the Stock
P/E Ratio Depends upon:
Dividend Payout Ratio
Expected Required Rate of Return.
Expected Growth Rate in Dividends.
Example: Expected Payout Ratio of 50%.
Required Return = 12%, growth rate = 8%
If k = 13%
If g = 9%
If k = 11% and g = 9%
Interpretation of the Relative
Valuation Techniques..
Step1. compare the valuation ratios (P/E, P/Cash
Flow, P/B) for a company to the comparable
ratio for the market or/and the stocks industry
to determine how it compare that is:
Is it similar or
Continuously at discount or Premium.
Step2. understand and compare what factors
determine the specific valuation ratio and
compare factors for the stock vs. the same factors
for market, industry..