You are on page 1of 14

1.

Identify equity valuation models and


explain the information required to
value equity securities . (p. 13-3)

2.

Describe and apply the discounted


free cash flow model to value
equity securities. (p . 13-4)

ash-Flow-Based
Valuation

uring the mid-2000s, many companies experienced growth both in valuation and fundamentals. However, 2008 and 2009
rought the beginning of a recession . Many companies faced cutbacks or belt-tightening measures in an effort to respond
to perceived future uncertainties. It is yet unclear whether this period
marked a retrenching necessitated by unfounded expansion or the
beginning of a new, positive era for businesses.
One industry, however, that stood apart from the crowd was that
of healthcare where the market continued to grow unabated. Moreover,
government spending on healthcare continues to expand and the demoraphics (aging population) fuel further expansion . The following graphic reveals the growth of healthcare costs relative the
eneral business trends reflected in the Dow-Jones Industrial Average (DJIA).
c:
~ $1 ,500 ~------------------------~- 14 , 000

- 13,000

ti
$1 ,000
0

- 12,000

0
~
~

- 11 ,000
$500

- 10,000

$0

9,000
8,000

1i
~

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201 1

- . Dow-Jones

Healthcare cost

Among healthcare firms, Johnson & Johnson {J&J) is a common favorite for investors as it has a diversified base and
plays a dominant role in the industry. For many years, J&J has engaged in the development of products that have funded both
its future growth and solid returns to its shareholders. As the graph below shows, the company has witnessed steady growth
in its free cash flows (FCF) over the past decade, and a steady, if not slightly upward, movement in its stock price.
00

70

lii

I.I

;:

c..

50

40
30

20

"'
.

10

""

(/)

60

~-------------------1 -

3
Price
FCF/Share ,___ ___. 2

...
~

c.

::0
u:
~

t/)

ca

u..

0
2001 to Present

(continued on next page)


13-2

(continued from previous page)

Module 13 I Cash-Flow-Based Valuation

Many investors use measures of free cash flows to form value estimates of the company. The use of free cash fl ows as
the payoff of choice in valuation models is common in practice and their application in business valuation must be understoOd

13-4

sold. The value of an equity security is, then , based on the present value of expected dividends plus
the present value of the security at the end of the forecasted holding period. This dividend discount
111odel is appealing in its simplicity and its intuitive focus on dividend distribution. As a practical
matter, however, the model is not always useful because many companies that have a positive stock
price have never paid a dividend, and are not expected to pay a dividend in the foreseeab le future.

by market participants.
.
.
.
.
.
When we examine Johnson & Johnson for valuation purposes at least two questions 1mmed1ately anse. First, how has
Johnson & Johnson managed to create and sustain free cash flow growth over the past decade despite the economic uncertainties domestically and globally? Second , given its pattern of increasing free cash flows , why does the stock of Johnson &
Johnson continue to remain entrenched in the range of $50 to $70 per share? To begin to answer these and related questions
we must understand what factors drive the Johnson & Johnson stock price.
More generally, understanding cash-flow-based-valuation can yield insights into how measures of cash flow i~p.act stock
price and whether analysts expect Johnson & Johnson's price to rise or fall in the future. This. module .~rov1des insights and
answers to these questions. It explains how we can use forecasts of cash flows to price equity securities such as those of

Discounted Cash Flow Model


A more practical approach to valuing eq uity securities focuses on the company 's operating and
jnvesting activities; that is, on the generation of cash by the business rather than the distribution
of cash to the shareholders . This approach is called the discounted cash flow (DCF) model. The
focus of the forecasting process for the DCF model is the company's expected.free cash flows to
the firm , which are defined as operating cash flow s net of the expected new investments in net
operating assets that are required to support the business .

Johnson & Johnson's stock.


Sources: Johnson & Johnson 10-K and Annual Reports; Yahoo Finance, www.usgovernmentspending.com .

Residual Operating Income Model

0 3:
lJ 0

Another approach to equity valuation also focuses on operating and investing activiti es. It is
known as the residual operating income (ROPI) model . This model uses both net operating
profits after tax (NOPAT) and the net operating assets (NOA) to determine equity value; see
Module 3 for complete descriptions of the NO PAT and NOA measures. This approach, presented
in the next module, highlights the importance of return on net operating assets (RNOA) , and the
disaggregation of RNOA into net operating profit margin and NOA turnover.

Cash-Flow-Based Valuation

C> 0
l> c

rNm

l>
-I

Discounted Cash

Equity Valuation Models

Dividend Discount Model


Discounted Cash Flow Model
Residual Operating Income Model
Model Equivalency

Flow Model

When the DDM was introduced in Module 12, it was based on the following relation:

Model Structure
Steps for Application

D,

Extending t he Model

This module focuses on valuing equity securities (we explain the valuation of debt .securities in
Module 7) . Specifically, we describe the discounted cash flow model (DCF); the residual operating income model (ROPI) is explained in the next module . It is important that we understand .the
determinants of equity value to make informed decisions. Employees at all levels of an orgaruzation , whether public or private, should understand the factors that create shareholder value so that
they can work effectively toward that objective . For many senior managers , stock value serves as a
scorecard. Successful managers are those who better understand the factors affecting that scorecard .

+!Vi

!Vo= - - - 1 +re

Illustrating the Model

Both the DCF and ROPI model s derive from this basic starting point and are , therefore, mathematically equivalent. Any differences between the estimated valuations of equity using these models arise due to implementaStep 1-Understandlng the Busl,_. Environment
and Accounting Information
tion issues rather than the frameworks themselves. AssumpModules 1 and 2
tions such as forecast horizon length or terminal growth rate
(discussed later in thjs module) can be easier to determine
Step 2-Adjustlng and As-Ing Financial Information
and Accounting Information
with less uncertainty for a particular company using a parProfitability Analysis-Module 3 Investing- Modules 6. 9, and 10
ticular valuation model , which can lead to a more reliable
Credit Analysis-Module 4
Financing-Modules 7 and 8
Operations - Module 5
value estimate. Following our 4-step process from Module 1,
the quality of our value estimate (Step 4) is based on the qualT
Step 3-Forecastlng Financial Information
ity of our forecasts of future payoffs (Step 3) . Further, those
Module 11
forecasts are only as good as the adjustments/assessment of
financial information made (Step 2) and our understanding of
Step 4-Ualng Information for Valuation
Cost of Capital and Valuation Basics-Module 12
the company's business environment (Step 1). If the forecasts
Cash-Flow-Based Valuatior;-Module 13
made are identical across the different payoffs, the resulting
Operating-Income-Based Valuation-Module 14
Market-Based Valuation-Module 15
value estimates from the models will also be identical .

J:

EQUITY VALUATION MODELS


LO 1 Identify equity
valuation models and
explain the information
requi red to value
equity securities.

Module 7 explains that the value of a debt security is the present value of the interest and pri.n~i
pal payments that the investor expects to ,re~eive in the .future. Th.e v~luatio.n of equity secun.t1es
is similar in that it is also based on expectations . The difference hes m the mcreased uncertainty
surrounding the timing and amount of payments from equity securities.

Dividend Discount Model


There are many equity valuation models in use today. Each of them defines the value of an equity
security in terms of the present value of forecasted amounts . They di~er ~~imarily in t~rms o~
what is forecasted . Module 12 introduced us to the DDM and some sunphf1ed assumpt10ns fo
the terminal dividend .
The basis of equity valuation is the premise that the value of an equity security is determined by
the payments that the investor can expect to receive. Equity investments i~vol ve two types of pat
offs: (1) dividends received during the holding period and (2) proceeds received when the secun ty 15
13-3

DISCOUNTED CASH FLOW (DCF) MODEL


The rationale for using the discounted cash flow (DCF) model is that cash flows are "tangible"
and easy to understand. Cash is often viewed as the ultimate source of value for investors. We
~old an ~q~ity ~ecurity (or any asset) as an economic resource that will allow for future consumption . Thmkmg m terms of cash value allows us to easily quantify the amount of consumption the
ass~t is exp~cted to provide. Additionally, cash flows are readily comparable across differing time
honzon s usmg standard present value techniques. These characteristics lead to the widespread use
of the cash-flow-based valuation model.
1

Th.e future stock price is, itself, also assumed to be related to the expected dividends that the new investor expects to
receive; as a result , the expected receipt of dividends is the sole driver of stock price under this type of valuation model.

L02 Describe and


apply the discounted
free cash flow model to
value equity securities.

13-5

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation

The DCF valuation model requires forecasts of all future free cash flows ; that is , free cash
flows for the remainder of the company's life. Generating an infinite stream of forecasts is not
realistic . Consequently, analysts typically estimate FCFF over a horizon period , often 4 to 10
years, and then make simplifying assumptions about the FCFF subsequent to that horizon period.

The DCF model defines firm value as follows:


Firm Value = Present Value of Expected Free Cash Flows to Firm
The expected free cash flows to the firm include cash flows arising from the operating side of the
business; that is , cash generated from the fi~~ s operatin~ activiti~s (but not from nonoperating
activities such as interest paid on debt or d1v1dends received on investments), and they do not
include the cash flows from financing activities.

ANALYSIS DECISION

You Are the Chief Financial Officer

Assume that you are the CFO of a company that has a large investment in plant assets and sells its
products on credit. Identify steps you can take to increase your company's cash flow and, hence,
your company's firni value. [An swer p. 13-15]

DCF Model Structure


Free cash flows to the firm (FCFF) equal net operating profit after tax that is not used to grow
net operating assets . Using the terminology of Module 3 we can define FCFF as follows (see the
following Business Insight box for a more traditional definition) . The derivation of this equation
is in Appendix I 3C. That derivation shows that NOPAT - ~OA , where fl. represents "change,"
equals the sum of payments to creditors as interest and principal (NNE and -~NO , respectively)
and to shareholders as capital and dividend distributions (-fl.CC and DIV, respecti vely). This
means that FCFF is the net payments to holders of both net nonoperating obligations and company equity, which can be written as follows:

Steps in Applying the DCF Model


Application of the DCF model to equity valuation involves five steps:

1. Forecast and discount FCFF for the horizon period .2


2. Forecast and discount FCFF for the post-horizon period, called terminal period.3
3. Sum the present values of the horizon and terminal periods to yield firm (enterprise) value.

FCFF = NOPAT - Increase in NOA

4. Subtract net nonoperating obligations (NNO), along with any noncontrollino- interest from

fir~ value .to yield.firm equity .value. If NNO i s positive, the usual case , we s~btract it i'n step
4; if NNO. 1s ne.ga~1~~ we add 1t. (For many, but not all , companies , NNO is positive because
?onoper~ting hab1ht1es exceed nonoperating assets; for convenience, any noncontrolling
interest 1s often included in NNO.)

where
NOPAT = Net operating profit after tax
NOA= Net operating assets
Net operating profit after tax is normally positive and the net cash flows from increases in net
operating assets are normally negatie assuming that net operating assets increase each period.
The sum of the two (positive or negative) represents the net cash flows available to credi tors and
shareholders . Positive FCFF imply that there are funds available for distribution to creditors and
shareholders , either in the form of debt repayments, dividends, or stock repurchases (treasury
stock) . Negative FCFF imply that the firm requires additional funds from creditors and/or shareholders, in the form of new loans or equity investments, to support its business activities.

5. Divide firm equity value by the number of shares outstanding to yield stock value per share.
BUSINESS INSIGHT Cash Flows: Nominal (Risk-Adjusted) vs Real
Module 12 explained that the value of payoffs (such as cash flows) is unaffected by whether nominal (~isk-a~justed) or real amounts are used provided that nominal cash flows are discounted using
nominal discount rates and real cash flows are discounted using real discount rates. In practice, we
nearly always see nominal cash flows and nominal discount rates used; analysts do not forecast
real cash flows.

Definitions of Free Cash Flow

BUSINESS INSIGHT

We often see free cash flows to the firm (unlevered free cash flow) defined as follows:
FCFF

= Net cash flow from operating activities -

Illustrating the DCF Model

Capital expenditures

Although somewhat similar to the definition in this book, NOPAT - Increase in NOA, there are
important differences:

Net cash flow from operating activities uses net income as the starting point; net income, of
course, comingles both operating and nonoperating components (such as selling expense and
interest expense). Analysts sometimes correct for this by adding back items such as after-tax net
interest expense, which is the approach used by the Oppenheimer analysts in Appendix 138.

Income tax expense (in net income) includes the effect of the interest tax shield (see Module 3);
the usual NOPAT definition includes only the tax on operating income.

Net cash flow from operating activities also includes nonoperating items in working capital, such
as changes in interest payable and dividends payable, as well as inflows from securitizat ion of
receivables (see Module 1O); NOA focuses only on operating activities.

The FCFF definition in this box consists of net income, changes in working capital accounts,
and capital expenditures; the usual NOA consists of changes in operating working capital
accounts, capital expenditures, and changes in long-term operating liabilities.

We must be attentive to differences in definitions for free cash flow so that we understand the analytical choices we make and their implications to equity valuation. It also aids us in drawing proper
inferences from analyst research reports that might apply different definitions of free cash flow.

To illustrate , we apply the DCF model to Johnson & Johnson . J&J's recent financial statements
are reproduced in Appendix l 3A . Forecasted financials for J&J (forecast horizon of2011-2014 and
terminal period of 2015) are in Exhibit 13.1.4 The forecasts (in bold) are for sales, NO PAT, and
N?A . Th~se forecasts assume an annual 4.0% sales growth during the horizon period, a terminal pen.ad sales growth of 1% , net operating profit margin (NOPM) of 21 %, and a year-end
net operating asset turnover (NOAT) of 1.3 (which is the 20 I 0 turnover rate based on year-end

When di scountin g FCFF, the appropriate di scount rate (rw) is the weighted average cost of capital (WACC) , where
the weights are the relati ve percentages of debt (d) and equity (e) in the capital structure applied to the expected return s
on debt (rd) and equity (r, ), respectivel y: WACC = r "' = (rd X % of debt) + (r, X % of equity); see footnote 7 for an
exampl e. See Module 12.
3

For an ass umed growth , g , the terminal period (T) present value of FCFF in perpetuity (beyond the horizon period)
.

FCFF7

given by, r,, - g where FCFFT 1s the free cash flow to the firm for the terminal period , rw is WACC , and g is the
assume.d long-term growth rate of those cash fl ows. The resulting amount is then di sco unted back to the present usin o
the horizon -end-period di scount factor.
"
IS

We use a four-.period horizon in the text and assi gnments to simplify the exposition and to reduce the computational
burden . In practice: analysts use spreadsheets to forecast future cash flow s and value the equity security, and typically
have a forecast hori zon of fi ve to ten periods .

13-6

13-7

Module 13 I Cash-Flow-Based Valuation

i EXHIBIT 13.1

Module 13 I Cash-Flow-Based Valuation

1. Compute present value of horizon period FCFF. We compute the forecasted 2011 FCFF of

Application of Discounted Cash Flow Model


Horizon Period

(In mllllons, except per share


values and discount factors)

Report.eel

Sales (unrounded) . . . . . . . . . . . . . . . .

$ 61,587

2010

2011

$64,050.48
(61 ,587

61,587
13,065

Sales (rounded) . . . . . . . . . . . . . . . . . .
NOPAT* . .. . .. . . . ... . ... .. .. ... ..

2012

1.04)

64,050
13,451

2013

$66,612.50
(64,050.48

1.04)

66,612
13,989

2014

$69,277.00
(66,612.50

1.04)

$72,048.08
(69,277.00

69,277
14,548

72,048
15,130

1.04)

$72,768.56
(72,048.08

x 1.01)

72,769
15,281

$9,876 million from the forecasted 201 l NOPAT less the forecasted increase in 2011 NOA . The
present value of this $9 ,876 mjllion as of 20 lO is $9,144.5 million , computed as $9 ,876 mjllion
X 0.92593 (the present value factor for one year at 8%). Similarly, the present value of 201 2
FCFF (two years from the current date) is $ 10,303.5 million , computed as $ 12,01 8 mjllion x
0 .85734 , and so on through 2014. The sum of these present values (cumulative present value)
is $38 ,923 mi ll ion .
2. Compute present value of termina l period FCFF. The present value of the terminal period

NO~** _:_:_:_ : ____ :_:_:____ _:_:_:_:__ _:_:_:__ .:.:.:.:. .:_: ---------~-~.6~~--4.9.!~-~9. ______________~~ ~-4.~ ..................~!~~---- ---------~!~.2.2. ..................~~,976
Increase in NOA ... ... .. . . . ... ... .
FCFF (NOPAT - Increase in NOA) . . . .
Discount factor [1 /(1 + rw)~ '. ........ .
Present value of horizon FCFF . . . . . . .
Cum present value of horizo n FCFF .. .
Present value of terminal FCFF . . . . . .

3,575
9,876 0.92593
9,144

1,971
12,018
0.85734
10,304

2,050
12,498
0.79383
9,921

2,132
12,998
0. 73503
9,554

554
14,727

$ 38,923
154,640
193,563
(10,885)

Total fi rm value ... .. . . . . . . . . .... . .


Less (plus) NNOt . . . .. .. . . .. . . .. . .
Firm equity val ue .. . ... .. . .. . . ... .

$204,448

Shares outstand ing . .. . . . ... . . . . . .


Stock value per share . . . . . . . . . . . . .

2,738.1
74.67

"Given J&J's combined federal and state statutory tax rate of 36.0% as reported in the tax footnote to its 2010 10-K, NOPAT for 2010 is computed as
follows ($ millions): ($61 ,587 - $18,792 - $19,424 - $6,844) - ($3 ,61 3 - {0.360 x [$455 - $107 - $768]}) = $13,065. A note on rounding : To forecast
sales, we multiply prior year's unrounded sales by (1 + Growth rate); th is is done for the horizon and terminal periods. Then, we round each year's
forecasted sales to whole units and use rounded sales to compute NOPAT and NOA, where both are rounded to whole units. At each successive step, we
round the number to whole units before proceeding to the next step.
' "NOA computations for 2010 follow($ millions): ($102,908 - $19,355 - $8,303) - ($46,329 - $7,617 - $9, 156) = $45 ,694.
tNNO is the difference between NOA and total shareholders' equity; in this case NNO ($ millions) = $45 ,694 - $56,579 = $(10,885). J&J 's NNO is negative
because it carries substantial cash and securities that exceed its debt.
:j:For si mplification, present value computations use discount factors rounded to 5 decimal places.

NOA ; year-end amoun ts are used because we are fo recasting year-end account balances, not
average ba lances) .5 6
The bottom line of Exh ibit 13 . l is the estimated J&J equity value of $204 ,448 mi ll ion, or a per
share stock val ue of $74.67 (computed as $204,448/2 ,738 .1 shares). The present value computations
use an 8% WACC(r.) as the discount rate.7 Specifically, we obtain this stock valuation as follows:
5

NOPAT eq uals revenues less operatin g ex penses such as cost of goods sold , sellin g, general, and admini strati ve
ex penses, and taxes . NO PAT excludes any interest revenue and interest expense and any gains or losses from fi nancial
in vestments. NOPAT refl ects the operatin g side of the firm as opposed to nonoperatin g acti viti es such as borrowing and
security investment activiti es. NOA equals operatin g assets less operatin g li abilities. (See Modul e 3 .)

c l4,727 million)

FCFF is $ 154,640 million , computed as

u.us - o.oi
4
( 1.08 )

or ($ 14 727/0 07)
'

'

x O 73503

3. Compute firn_i equity va~ue . Sum present values from the horizon and terminal period
FCFF to get firm (enterpri se) value of $ 193,563 million. Subtract the value of J&J 's net
n_onoper~ting obligation s of $( l0 ,8~5} million to get firm equity value of $204,448 . Dividing
firm equity value by the 2,738. l m1 ll 1on shares outstanding (computed as 3,119,843 ,000 less
381 ,746,000) yields the estimated per share valuation of $74 .67 .
We perform thi s valuation as of February 25 , 201 l , which is the SEC filing date for J&J 's 10-K .
J&J s stock closed at $59 .13 on February 25 , 2011. Our valuation estimate of $74.67 indi cates
that the stock is unde~valued as of that date. J&J 's stock price climbed steadi ly through the spring
of 20 l l and was tradmg for $65 by July at which point J&J was still recommended as a strong
BUY stock .

BUSINESS INSIGHT

Analysts' Forecasts

Earn ings and cash-flow estimates are key to security valuation. Following are earni ngs estimates as
of Au gust 2011 , for Johnson & Johnson from Yahoo.finance. About 20 analysts provid ed earnings
estimates. The median (consensus) EPS estimate for 2011 (current year) is $4.97 per share, with a
high of $5 .02 and a low of $4.93. This compares to an actual diluted EPS of $4. 78 in 201 o. For 201 2
{slightly more than one year ahead), t he consensus EPS estimate is $5.29. The average buy rating
for J&J stock is 2.2 on a scale that runs from 1.0 (Strong BUY) to 5.0 (Strong SELL) .

Estimate Period

Total Analysts

Ave. EPS Est.

High EPS Est.

2011 Fiscal Year . . . . . . . . .


21
$4.97
$5.02
2012 Fiscal Year . . . . . . . . .
19
$5.29
$5.38
Average recommendation : 2.2 (1 = Strong Buy, 3 = Hold, 5 = Strong Sell)

LowEPS
Est.
$4.93
$5 .19

NOPAT and NOA are typi call y forecasted usin g the detailed forecastin g procedures di scussed in Modul e I I . In this
modul e we use the parsimoni ous method to multiyear forecas ting (see Modul e 11 ) to foc us attenti on on the valuation
process.

The weighted average cost of capital (WACC) for J&J is computed usin g the foll owin g th ree-step process:
l.

T he cost of eq uity capital is given by the capital asset pri cing model (CA PM): r, = r + 13 (r,,, - r), where
1
13 is the beta of the stock (an estimate of stock pri ce variability that is reported by several services such as
Standard and Poors) , r is the risk-free rate (commonl y assumed as the 10-year treasury bond rate), and r,,,
is the expected return {o the entire market. The expression (r,,, - r) is the "spread" of equiti es over the riskfree rate , often assumed to be about 5% to 7%. For J&J , given a beta of 1.00 and a 10-year treasury bond
rate of 3.58% (r) as of February 28 , 2011 , r, is estimated as 9 .58%, computed as 3.58% + ( 1.00 X 6%).

2.

Two alternati ve computati ons for pretax cost of debt capital are: ( I) Interest ex pense/ Average interest-bearin g debt,
and (2) Weighted-average effective interest rate on debt. For the latter, J&J reports its 5 .25 % rate in footnote 7 to its
I 0-K, whi ch we use. To obta in J&J 's after-tax cost of debt capital , we mu ltipl y 5.25% by I - 0 .360 , where 36.0%
is the federal and state statutory tax rate from its tax footnote , yielding 3.36% (J&J's after-tax cost of debt).

3.

WACC is th e weighted average of the cost of equity capital and the cost of debt capital. J&J capital structu re is 77%
equity and 23 % debt. Thus , J&J's weighted average cost of capital is (77 % X 9 .58%) + (23 % X 3 .36%) = 8. 15%,
rounded to 8% . (The capital structure of J&J depends on its stock price. To achi eve an internall y consistent value
estimate, an itera ti ve process can be used where the estimated value !in thi s case $74 .67 1 is used to recompute its
capital structure a nd get an updated WA CC estimate. After several iterati ons, the valuati on estimate and the weights
used to compute WACC converge .)

Extending the DCF Model


The Johnson & Johnson ill ustration makes several assumptions that can be refi ned to derive more
precise stock values. We describe some of these refinements here .
Horizon Peri~~- The ill ustration uses a relatively short horizon period . It might be more reasonable to anticipate growth for longer than four years before the company achieves a Joncr-term
g~o~th of l %, as in our example . The downside to much longer horizon periods is that it more
d1~1 cul t to ~ccurately project growth as the time horizon extends. Thus , the shorter horizon period
ought provide a more conservative stock value .

i:

Growth Rate. The ill ustration assumes a constant growth rate , NOPM and NOAT durincr the
horizon period . _As an alternative, we can alter these, even having different rates for each yea; For
example , we might assume that the recent economic downturn will depress J&J's sales for 2011
and 2012 an_d , thus, we mi ght forecast a growth rate less than 4 % for those two years fo llowed by
4% growth in 2013 and 2?1 4 . Simi larly, we could change NOPM and/or NOAT for each year to
better match our expectations of future profitabi lity and/or asset efficiency.

13-8

13-9

Module 13 I Cash-Flow-Based Valuation

Financial Statement Forecasts. The illustration uses a parsimonious method to multiyear fore.
casting to focus attention on the valuation process. As an alternative, we can prepare detailed year.
by-year forecasts of the income statement and balance sheet to derive NO PAT and NOA , respective.
Jy. Year-by-year forecasts allow us to more precisely model relations on the income statement, and
between the income statement and the balance sheet. For example, the parsimonious model assumes
a constant NOPM of 21 % for the J&J illustration . This implies that all expenses vary in exactly the
same way with revenue growth. We can refine that assumption by including different growth rates
for different expenses. As another example, the parsimonious model assumes one turnover rate for
all net operating assets. In the J&J example, we apply a NOAT of 1.3 , which is the average historic
turnover rate across accounts receivable, inventory, PPE, accounts payable , and so forth. A year-by.
year forecast would allow the turnover rates to vary across different operating assets and liabilities
and potentially yield more precise estimates for future expected NOA .
Terminal Growth Rate. A crucial assumption in valuation is the choice of a terminal growth
rate. This rate reflects all future FCFF beyond the forecast horizon , which is captured in terminal
value. Many valuations are sensitive to variations in terminal growth rate. The choice of a forecast horizon is influenced by whether the company has achieved a long-run steady state where
a pattern of future FCFF is expected to persist for the long-run of the company. Ideally, the
forecast horizon is sufficiently long to allow steady state to be achieved within the horizon . The
terminal growth rate can be a positive percentage (but not exceeding the discount rate) , or zero,
or negative (but not Jess than -100%). An increase in the terminal growth rate for Johnson &
Johnson from I % to 2% would increase the present value of the terminal FCFF from $154,640
to $180,413 [$14 ,727/(0.08 - 0.02)/ L.08 4 ], yielding an increase in estimated value per share of
$9.41 [($180,413 - $154,640)/2,738.1]. This shows the sensitivity of a valuation to a terminal
growth rate. The quality of our forecasts within the horizon period directly impacts the quality of
our terminal growth rate estimate.
Sensitivity Analysis of Stock Price. The illustration uses only one set of assumptions and
derives only one stock price. To refine our valuation we can perform sensitivity analyses. For
example, the J&J illustration uses 8% for WACC , which is our best estimate of the company's
weighted average cost of capital. We might derive stock value using a larger and smaller WACC
to gauge how sensitive the stock price is to changes in the discount rate. For example, the Oppenheimer analysis simultaneously varies the growth rate and the WACC assumptions by 1 percentage point, in 50 basis-point increments. This generates 25 different stock values-Oppenhe~er
displays the different assumptions as rows and columns in a table in Appendix l 3B. Extendmg
this idea, we commonly derive a "worst case" stock value by simultaneously applying the lowest
reasonable assumptions for growth, NOPM , and NOAT, and the highest reasonable assumption
for WACC. We also commonly derive the "best case" scenario by applying the highest reasonable
assumptions for growth, NOPM, and NOAT, and the lowest reasonable assumption for WACC.
This provides a range of reasonable stock values and gives us more information and confidence
about potential outcomes.
Mid-Year Adjustment. Payoffs in our valuation model are assumed to occur at year-end and are
discounted for the entire year. An alternative is to assume that payoffs occur evenly during the
year. A common adjustment in this case is to multiply the estimated value by a mid-year ad!ustment factor defined as (1 + r J 05 . Another common approximation of the adjustment factor is (1
+ [r 12]). The Oppenheimer report in Appendix I 3B applies a mid-year adjustment factor. For
J&J, wour WACC estimate of 8% would yield an adjustment factor of 1.04, which increases the
valuation estimate to $212,626 ($204,448 X 1.04), or $77.65 per share.
Reverse Engineering. One alternative to sensitivity analysis is to use reverse engineering in
an attempt to "unlock" the market's assumptions in determining price . The process of reverse
engineering uses observed price combined with valuation assumptions to solve for one ~f the
valuation parameters such as discount rate or terminal growth rate. If the observed market pnc~ ~f
Johnson & Johnson of $59 .13 at February 25, 2011, is used with the other assumptions in Exhibit
13.1, we can solve for the terminal growth rate (often implemented using reiterative estimation).
In our case, this process yields an implied terminal growth rate of -1.6%. An investor or a~alyst
could then decide whether he or she believes this rate to be too high or too low as a basis for
determining a buy or sell decision.

Module 13 I Cash-Flow-Based Valuation

summary. In summary, the DCF model is frequently used in valuation due the appeal of relying
on actual cash flows ; a readily understandable concept. The model appears to avoid the need to
understanding accounting's intricacies. However, when forecasting cash flows it almost always
includes forecasting accounting numbers. Moreover, cash flows and accruals are simultaneously dete~mined . For example, in Exhibit 13.1 , we began by forecasting sales as a first step in
implementing DCF, and some of those sales are in cash whereas some are on credit. A serious
implementation issue with DCF is the choice of forecast horizon and terminal growth rate. The
farther out the forecast horizon, the Jess reliable forecasts tend to be. Still , we demand a Jong
enough _forecast horizon to reach steady state so we can identify an appropriate terminal growth
rate. Th1s balance can make cash-flow-based valuation a difficult process to implement as FCFF
often requires a very long horizon.
BUSINESS INSIGHT

Cash Flows: Pretax vs Afte.....Tax

Should cash flows be computed pretax or after-tax for valuation? Let's consider an example where
pretax cash flows of $100 million are expected in one year; the tax rate is 40%, so the after-tax cash
flows are $60 million [(1 - 0.40) x $100 = $60). Further, let's assume that this company's capital
structure is 70% debt with a pretax cost of debt capital of 6%, and its 30% equity has a pretax cost
of equity capital of 12%. The pretax and after-tax weighted average cost of capital CNACC) follows:

Debt .... ... ......


Equity .... ..... ...

Pretax

Pretax

Proportion

Rate

WACC

Tax Effect

70%
30%

6%
12%

4.2 %
3.6%

40%

100%

7.8%

After-Tax
WACC
2.52%
3.60%
6.12%

If pretax cash flows and pretax WACC are used, value is estimated as $92.8 million ($100 x
1/1 .078). If after-tax cash flows and after-tax WACC are used, value is estimated as $56.5 million
($60 x 1/1 .0612). We see that using pretax or after-tax numbers impacts valuation, which derives
from the debt tax shield (deduction). After-tax cash flows and after-tax WACC are what we should
use for valuation. When not explicitly stated, assume that after-tax numbers are used.

ANALYZING GLOBAL REPORTS


There are no differences in the method or technique of valuing equity securities using IFRS financial statements. We can use the DCF method with IFRS data as inputs and determine intrinsic
values. Regarding other inputs , it is important to note that WACC varies across countries. This
is readily apparent when we recognize that the risk-free rate used to compute WACC is country
specific; for example, following is the yield on 10-year government debt for several countries as
of October 2011 (www.bloomberg.com/markets/rates-bonds/government-bonds/). In comparison
to countries such as Japan and Germany, the countries such as Greece and Brazil are riskier
because of their debt levels and economic troubles. The higher the country risk , the higher the
yield demanded on that country's debt.

ntry
Japan .................. .
Germany . . . . .. ... ..... .. .
United States . .. . ... .... . .
United Kingdom . ....... . . .

Yield to maturity
0.99%
2.00%
2.06%
2.47%

Country
Australia .. ........ . ..... .
Brazil. .................. .
Greece ................. .

Yield to maturity
4.24%
11.52%
23.24%

MODULE-END REVIEW
Follo~ing are forecasts of Procter & Gamble 's sales, net operating profit after tax (NOPAT), and net
operating assets (NOA). These are taken from our forecasting process in Module 11 and now include a
terminal period forecast that reflects a long-term growth rate of l %.

13-10

13-11

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation


continued from prior page
Horizon Period
2014

2015

Tenninal
Period

4.6%
$94,484.26
($90.329.12 x 1.046)
$ 94,484
13,984
111,158

4.6%
$98,830.54
($94.484.26 x 1.046)
$ 98,831
14,627
116,272

1%
$99,818.84
($98,830.54 x 1.01)
$ 99,819
14,773
117,434

Reported
2011

(In mllllons)
Sales growth . ... . . .. .. .
Net sales (unrounded) . ..

$ 82,559

Net sales (rounded) .... .


NOPAT .. ... . . ........
NOA . . ... .......... ..

$ 82 ,559
12,193
97,247

2013

2012
4.6%
$86,356.71
($82,559 x 1.046)
$ 86,357
12,781
101,596

4.6 %
$90,329.12
($86,356. 71 x 1.046)
$ 90,329
13,369
106,269

Use the forecasts above to compute P&G's free cash flows to the firm (FCFF) and an estimate of its
stock value using the DCF model. Make the following assumptions: discount rate (WACC) of 8%,
shares outstanding of 2,765.7 million, and net nonoperating obligations (NNO) of $29 ,607 million
(which includes $36 1 million in noncontrolling interest).

$
3,120
(3,531)
77,773

3,120
(3,058)
70,306

20,783

19,780

Total shareholders' equity . . ..... ....... . . .... .. . .. ............. . .. . .. . ..... .. .

56,579

50,588

Total liabilities and shareholders' equity . . . .... . ........ .. .... . .. . . ...............

$102,908

$94,682

2010

2009

2008

Sales to customers ...... .. ... ..... . .. . .......... . ..... . .. . ... . .. .


Cost of products sold ...... . .... ...... . . . . ... . ...... ... . . . .. .....

$61,587
18,792

$61 ,897
18,447

$63,747
18,511

Gross profit. .. . . ....... . ....... .... ....... . .. . ...... .... ... .. .. .


Selling, marketing and administrative expenses .. .. . ... .... . .... . . . ... .
Research and development expense .. .. . ..... ... ..... . ..... . .. ..... .
Purchased in-process research and development. .... .... ............ . .
Interest income . ... ..... .. .... .... . ... . . .. . .... .. ......... ......
Interest expense, net of portion capitalized . ............ . ............. .
Other (income) expense1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
Restructuring .. . .. . . ............ . ...... . ..... ... ........... . ... .

42,795
19,424
6,844

43,450
19,801
6,986

(107)
455
(768)

(90)
451
(526)
1,073

45,236
21,490
7,577
181
(361)
435
(1,015)

Earnings before provision for taxes on income . ........ ... . . . . .. . ..... .


Provision for taxes on income ... .... . ... ... .... . .................. .

16,947
3,613

15,755
3,489

16,929
3,980

$13,334

$12,266

$12,949

JOHNSON & JOHNSON

I Year Ended ($ millions)

JOHNSON & JOHNSON FINANCIAL


STATEMENTS
JOHNSON & JOHNSON
Balance Sheet
2010

2009 .,,

Assets
Cash and cash equivalents ..... . ....... .. .. ... . . . ..... .. . ..... .... .. .. . .. .. .. .
Marketable securities ..... . . . .. ... ..... . ..... . ... .... .. .... . .... ..... . . ..
Accounts receivable trade, net of allowances for doubtful accounts $340 (2009, $333) .. . .
Inventories ... .. . . ... ... .. ...... . ........ . ...... . ....... .. ... .. .. .
Deferred taxes on income ...... .. .......... ... ... ...... . . ....... .... .
Prepaid expenses and other receivables ... . . . ... ...... . ..... ... .. .. . ....... ..... .

$ 19,355
8,303
9,774
5,378
2,224
2,273

$15,81 0
3,61 5
9,646
5,1 80
2,793
2,497

Total current assets ..... . ............... . . .. ....... ... ......... . .... . .... .

47,307

39,541

Property, plant and equipment, net . .. ..... ..... ... ...... .. ..... ... .... . . . ... ...
Intangible assets, net ................ . ....... .. ......... . ... .. . ..... ..
Goodwill ... .. . . .. ... ... ...... . . . .. . .... .. ......... .... .... .. .. .. .......... .
Deferred taxes on income .. . . .... .. .. .. . . .. .. .... ..... . .... . .. ..... ... ... ... .
Other assets . . .. ..... .. ... . . . .. .. .. ... .. .. .. .. .. . . ... ...... ..... .

$ 14,553
16,716
15,294
5,096
3,942

$14,759
16,323
14,862
5,507
3,690

Total assets . ... .. ..... . . .......... . .. ...... .. ... .........

$102,908

$94,682

At Fiscal Year End ($ millions, except shares and per share)

Liabilities and Shareholders' Equity


Loans and notes payable . ......... . .......... . . . .. . .. ... . . . . .... ..... ...
Accounts payable . . ..... . .......... ... ... ...... . .... . .......... . ..... .. ... .
Accrued liabilities ............ ....... ..... . ... .. . . . .. .. .. .. .................
Accrued rebates, returns and promotions .. .. . . . .... .... .. . . ........... ... ...... . .
Accrued compensation ........... . .... .. ....... . .... .. .... . .. .. . ..... . . . . .. . .
Accrued taxes on income .. . . ... . . . ... .. . . .............. . . . ........ . ... . ..

--$ 6,31 8
5,541
4,625
2,028
2,777
442

$ 23,072

$21,731

.
.. .

9,156
1,447
6,087
6,567

8,223
1,424
6,769
5,947

Total liabilities ... . . .. . ....... . . . . .......... . .... .. .......... . ... . . .. ...

$ 46,329

$44,094

Total current liabilities ... ... . .... . ..... . ...... .. .... .. . .... ... ... . .. . . . ..
.. . .. ..
..... . . ..
. . . ... . ..
. .. .. ... ....

Net earnings . .... ... ........... .. . . ....... .... ... . . .. ... .......

---

---

1 We classify Other (Income) Expense as nonoperating because it includes, among other items: royalty income; gains and losses
related to the sale and write-down of investments in equity securities; currency gains and losses; non-controlling interests; and hedge
1neffect1veness.

JOHNSON & JOHNSON


Statement of Cash Flows

"Fiscal Year Ended ($ millions)

7,617
5,623
4,100
2,512
2,642
578

Long-term debt . . ........ .. . . . ..... . .. . ....... . . .. . ... ... . . ..


Deferred taxes on income ............. ... .......... . ... ... ... ..
Employee related obligations ........ .. ..... . .. .... .... . . .. .... ..
Other liabilities ... .......... ..... .. ........ .. .. . .. .. . .. . . .. ...

Income Statement

The solution is on page 13-27.

APPENDIX 1 3 A:

Shareholders' equity
Preferred stock .. . . ..... .. . .. .. .... . ..... . .. . .... ... ... .. . .. ... . ............ .
Common stock-par value $1 .00 per share
(authorized 4,320,000,000 shares; issued 3,119,843,000 shares) .......... ... .. ..... .
Accumulated other comprehensive income .... .... .. .......... . . . .. ... .. .. ...... . .
Retained earnings .. ... ..... .... . . .... . ... . . . ... .......... . ... .... . ..... . ..
Less: common stock held in treasury, at cost
(381 ,746,000 shares and 365,522,000 shares) . .. .... . . . . .. .. ... ... .. . . .. ... . . ... .

Cash flows from operating activities


Net earnings ..... ... .... ... ... . .. ... .. . ... .......... . .. . . ... ... .
Adjustments to reconcile net earnings to cash flows:
Depreciation and amortization of property and intangibles ... . . . . . ..... .
Stock based compensation ........ ... ........ . ... ... .... . ...... .
Purchased in-process research and development . ... ... . ........ . . . . .
Deferred tax provision . . ..... ... ................... . ... .. .. .. ... .
Accounts receivable allowances ....... . ................... .. ..... .
Changes in assets and liabilities, net of effects from acquisitions:
(lncrease)/decrease in accounts receivable ..... ... .... .... .... .... . .
(lncrease)/decrease in inventories . . . .. . . .. .... ..... ... ... . ... .. .. .
lncrease/(decrease) in accounts payable and accrued liabilities . .. ... . .. .
(lncrease)/decrease in other current and noncurrent assets . . ...... . ...
Increase in other current and noncurrent liabilities . ..... . ............. .
Net cash flows from operating activities .... .. .. ...... ... ... .. . . .. . .. .

2010

2009

2008

$13,334

$12,266

$12,949

2,939
614

2,774
628

356
12

(436)
58

2,832
627
181
22
86

(207)
(196)
20
(574)
87

453
95
(507)
1,209
31

(736)
(101)
(272)
(1,600)
984

16,385

16,571

14,972

continued
continued

13-12

13-13

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation


1 u.s..S.millions. exceot oe~d atal

continued from prior page

Cash flows from investing activities


Addition to property, plant and equipment. . . .. . . . . . . .... . .. . ..
Proceeds from the disposal of assets . .. . . . . .... . ... . . . . .. . . . .
Acquisitions, net of cash acquired . . . . . . .. . ...... . . . . .
Purchases of investments . . . ..... . . . . .. . .. . .. . . . . .
Sales of investments .. .. . . . . .. . . .. .. .. . . . .. . ... . . . .
Other (primarily intangibles) .. . . . . ... . .. . . . ....... . .. . .

(2 ,384)
524
(1 ,269)
(15,788)
11 ,101
(38)

(2,365)
154
(2,470)
(10,040)
7,232
(109)

Net cash used by investing activities ... .. . .. . . ... . .. . .. .. . . .

(7,854)

(7,598)

Cash flows from financing activities


Dividends to shareholders . ... . . . .... . ... . .. . .. .. .. .
Repurchase of common stock .... . . . .. . . . . . . . .. . . . . .
Proceeds from short-term debt . . ....... . . . .. . . . . . . . . .
Retirement of short-term debt . .. . . .. .. . .. . . . ...... . . . . ..
Proceeds from long-term debt . . . .. .. ... . . . . .... . .. .. . . .. .
Retirement of long-term debt . .... . ... . . . . .. . . . .. . .
Proceeds from the exercise of stock options/excess tax benefits . . . . . .. . . .

(3,066)
785
(1,214)
(3,668)
3,059

(4, 187)

(5,804)
(2,797)
7,874
(6,565)
1,118
(32)
1,226

(5,327)
(2 ,130)
9,484
(6,791)
9
(219)
882

(5,024)
(6,651)
8,430
(7,319)
1,638
(24)
1,486

Net cash used by financing activities . .. . . . .. .. .. . . . . .. .. . . .. .

(4,980)

(4,092)

(7,464)

Effect of exchange rate changes on cash and cash equivalents ... . . . .. .. .

(6)

161

Increase in cash and cash equivalents .. . .. . . . . . . . . . . . .


Cash and cash equivalents, beginning of year . . . . . . . . ... . . .. . . . .

3,545
15,810

5,042
10,768

Cash and cash equivalents, end of year .. . . ... . . .. . .. . .

$19,355

$15,810

---

~)
2,998
7,770

-$10,768
- --

liOater & Gamble DCF Model


Net Income
Plus: Interest Expense (After-Tax)
Plus: Depreciation & Amortization
Less: Capital Expenditures
Plus/Less: Chang_es in W/C & Other
Unlevered Free Cash Flow
pV of Unlevered Free Cash Flow

F2012E
12,435
598
2,962
(3 ,845)
526
12,676
11,603

PV of Free Cash Flow


Plus: PV of Residual Value
Enterprise Value
Less: Total Debt/Prefer-rec.I
Equity Value
Equity Value (Adjusted)
Shares Outstand ing_
i8hie Per Share

F2013E
13,318
652
3,077
(3,564)
399
13,862
11 ,615

F2014E
14,141
730
3,198
(3,724)
399
14,743
11,308

F2015E
15,017
805
3,323
(3 ,869)
981
16,256
11,414

56,659
162,907
219,566
(30,480)
189,086
197,633
2,746

c
c

Assum~ions:

Risk-free Rate
Beta
Market Risk Premium
Cost of ~u i!l_

5.00%
0.90
6.00%
10.40%

16,678
10,719

Tax Rate (Statutory)


Cost of Debt_iPre-Tax.l_
Cost of Deb~fter-Tax.l_

35.00%
4.00%
2.60%

Cost of Preferred

5.00%

Shares Outstanding
Price
Market Cap
Total Debt
Preferred
Total C~talization

Terminal Free Cash Flow Growth Rate

F2016Ej
15,955
870
3,453
(4,02 1)
421

1.5%

2.0%

2.5%

3.0%

3.5 %

8.2%

$75

$80

$87

$94

$104

8.7%

$69

$73

$79

$85

$93

9.2%

$63

$67

$77

$83

9.7%

$59

$62

$66

$71

$76

10.2%

$55

$58

$61

$65

$69

Capitalization
Equity
Debt
Preferred
WACC

2,748

~
179,319
29,246
1,234
209 ,799
Current
85%
14%
1%

Residual FCF Growth Rate

Sources: Company f1nanc1al statements and O ppenheimer & Co. Inc. estimates.

App END IX 1 3 B: OPPENHEIMER VALUATION OF


PROCTER & GAMBLE
We expl ain the forecasting process in M odule 11 and reproduce an analyst report on forecasted fi nancial statements
for Procter & Gamble in A ppendi x 11 A. In thjs appendix, we extend that report and reproduce an analyst forecasted stock price for P& G . We i nclude below, two excerpts from the Oppenheimer valuation. The first excerpt
prov ides a qualitati ve and quantitati ve analysis from Oppenheimer 's report as of October 28 , 2011 (reproduced

with permission) :

We make four observations regardin g this analyst report regarding P&G 's target stock price .

1. The analyst report defi nes unlevered (before debt) free cash flow as fo llows. Earlier in th is module we
described differences in thi s type of FCFF computation from our FCFF defi ni ti on.

+
+
+

Net income
Interest expense
Depreciation and amortization expense
Capital expenditures
Decreases in working capital
Unlevered free cash flow

Investment Thesis w e remain confident in P&G's ability to execute in a challenging environment, as evidenc.ed
by its healthy organic growth outlook. In addition , P&G's anticipated pricing actions on commod1ty-intens1ve
products and internal cost savings should help mitigate the risk of commodity cost 1nflat1on'. Further., we expect
the company to continue to gain global market share through higher spending .on marketing. and innovation .
This growth profile and its solid handle on its cost structure should provide s1gnif1cant operating leverage and
position the company well for meaningful EPS growth in 2011 and beyond, whil e valuation 1s compellhng.
Price Target Calculation Our 12- to 18-month price target for P&G of $72 per share is derived from our fiveyear discounted cash flow analysis, using a weighted average cost of capital of 9.2% , a terminal (fiscal 2016)
unlevered free cash flow estimate of $16.7 billion and a residual free cash flow growth rate into perpetuity of
2.50%.
Key Risks to Price Target Risks to the shares achieving our price target i ~clude , but are not limited to, management's ability to continue to deliver growth above market averages, ac.h1eve its targeted top- and bottomline synergies from the Gillette acquisition , and weather intense compet1t1on through product 1nnovat1on and
marketing .

Our second excerpt is a set of assumptions and computati ons developed by Oppenheimer analysts to forecast
P&G 's target stock price reported as of October 20 11 (reproduced with permission)

2. T his analyst report uses th e same D CF computation we descr ibe in this module. T he analyst highl ights the
importance of the term inal year computation w ith a matrix th at quantifies the impact on stock price of ( 1)
growth rates subsequent to the forecasti ng horizon and (2) WACC . T hi s type of sensitiv ity analys is is a
useful way to identify cruci al assumptions. We see that a l percentage point change in WA CC results in a
roughly 20% change in stock price estimate. Further, a 1 percentage point change in the termi nal growth rate
results i n a roughly 15% change i n stock price estimate.
3. The cost of equity capital i s estimated using the capi tal asset pricing model (CA PM) as we describe in the
module. T he analyst's estimated WACC is 9.2%, higher th an the WACC of 8% that we assumed in the
module. It is not uncommon that model assumptions differ am ong analysts, and highlights the i mportance of
sensiti v ity analyses th at quantify the effects of varying model assumptions.
4. B ottom l ine: We see th at thi s analyst 's $72 stock price target is higher than the $5 1.62 stock price estim ate
that we i ndependently determjned in thi s module. T here are a number of differences between our forecast
and that of the Oppenhei mer analyst. We assumed a constant horizon-period growth rate of 4 .6% and a
termin al growth rate of I %. The Oppenheimer report shows a growth rate in unlevered free cash fl ow of
9.4% for 201 3, 6.4% for 2014 , 10.3% for 2015 , and a terminal growth rate of 2.6%. These rates vary over
time and are more optimistic than ours and contribute to the higher stock price target. Another difference is
Oppenheimer's use of a mid-year adjustment factor (l .05 in the P&G report). The discount factors we use
assume that the cash flows occur at year-end. H owever, fi rms generate cash flow s throughout the year. The
mid-year adjustment factor corrects for thi s. One simplified adj ustment is to multiply the firm equity value
by,.,/( l + WACC) or in the P&G report by,.,/( l .092) = l .045, w hich Oppenheimer apparently rounded to
1.05 . Thi s yi elded a 5% increase in the target stock price compared to our price . Again, stock pri ces are
opinions about the intrinsic value of the stock and as w ith any opinion, they can differ.

Tur9fil
85%
14%
1%
9.2%
2.50%

13-14

13-15

Module 13 I Cash-Flow-Based Valuation


Module 13 I Cash-Flow-Based Valuation

APPENDIX 13C: DERIVATION OF FREE CASH FLOW


FORMULA

Computing Free Cash F lows to the Firm (FCFF) (L02)


Halliburton Company reports net operating profit after tax (NOPAT) of $2 ,032 million in 20 10. Its net
operating assets at the beginning of 20 IO are $9 ,937 million and are $ 12 ,160 million at the end of 20 IO .
What are Halliburton 's free cash fl ows to the fi rm (FCFF) fo r 20 IO? Show computations.

Deri vatio n of the free cash fl ow formul a fo llows; our thanks to Professo r Jim Boatsman fo r this ex pos ition:
Assets =
NOA=
aNOA =
aNOA =
aNOA =
- NOPAT + aNOA =
NOPAT - aNOA =
I

_J

Free cash flows


to the firm
(FCFF)

Liabilities + Stockholders' Equity (SE)


NNO +SE
aNNO + aSE [in change form , where a refers to change)
aNNO + aContributed Capital (CC) + Net Income - Dividends (DIV)[substituting for SE]
aNNO + aCC + (NOPAT - NNE) - DIV [substituting for NI)
aNNO + ace - NNE - DIV [rearranging terms)
NNE - aNNO - aCC +DIV [multiplying by - 1)

Estimating Share Value Using the DCF Mod el (L01, 2)


Follow ing are fo recasts of Target Corporation 's sales, net operating profit after tax (NO PAT), and net
operating assets (NOA) as of January 29 , 2011 .

(In mllllons)

_J

Sales . ... . . .. . ... .


NOPAT . .. .. . . ... .
NOA . .. . .. . . . ....

Net payments to holders


of net nonoperating
obligations and stock

2012

2013

2014

2015

Terminal
Period

$67,390

$70,086
3,504
30,472

$72,889
3,644
31 ,691

$75,805
3,790
32,959

$78,837
3,942
34,277

$79,625
3,981
34,620

29,501

(HAL)

TARGET
CORPORATION
(TGT)

2011
3,397

HALLIBURTON
COMPANY

Horizon Period

Reported

13-1 6

Answer the fo llowing requirements ass uming a terminal period growth rate of I%, discount rate
(WACC) of 7%, shares outstanding of 704 million, and net nonoperating obligations (NNO) of $ 14,01 4
million.
You Are the Chief Financial Officer Cash flow can be increased by reducing assets. For example, receivables
can be reduced by the following:

Encouraging up-front payments or progress billings on long-term contracts

Increasing credit standards to avoid slow-paying accounts before sales are made
Monitoring account age and sending reminders to past-due customers

Selling accounts receivable to a financial institution or special purpose entity

a.

Estimate the value of a share of Target common stock using the discounted cash fl ow (DCF) model
as of January 29 , 20 I I .

b.

Target Corporation (TGT) stock closed at $49 .99 o n March 18, 20 I I . How does your valuation
estimate compare with this closing price? What do you believe are some reasons for the diffe rence?

As another example of asset reduction , plant assets can be red uced by the fo llowing:

Selling unused or excess plant assets


Forming alliances with other companies to share specialized plant assets

Owning assets in a special purpose entity with other com panies


Selling production facilities to a contract manufacturer and purc hasing the output

E13-10. Estimating Sha r e Value Using the DCF Model (L01, 2)


Following are forecasts of Abercrombie & Fitch 's sales , net operating profit after tax (NOPAT) , and net
operating assets (NOA) as of January 29 , 2011 (Current-year NOPAT is lower due to transitory items;
we use a longer term estimate fo r NOPM of 8%.).
Horizon Period

Reported

Sales .... .. .. . . . .
NOPAT .... . .. . . .
NOA . . . . .. . . . .. .

Ex plain how info rmatio n contained in fin ancial statements is useful in pricing secur!ties . ~re. there so'.11e
components of earnings that are more useful than others in this regard? What nonfmancial info rmation
might also be useful ?
In general, what ro le do ex pectations pl ay in pricing equity securities? What is the relation between
security prices and expected return s (the di scount rate , o r WACC, in this case)?

Q13-3.
Q13-4.
Q13-5.
Q13-6.

What are free cash fl ows to the fi rm (FCFF) and how are they used in the pricing of equity securities?

2011

2012

2013

2014

2015

$3,469
152
1,032

$3,989
319
1,173

$4,587
367
1,349

$5,275
422
1,551

$6,066
485
1,784

Terminal
Period
$6,187
495
1,820

Defin e the weighted average cost of capital (WACC).

Answer the fo llow ing requirements ass umi ng a discount rate (WACC) of I0%, a terminal period growth
rate of 2%, common shares outstanding of 87 .2 million, and net nonoperating obligations (NNO) of
$(858) million (negati ve NNO reflects net nonoperating assets such as in vestments rather than net
obligations) .

Define net operating profit after tax (NOPAT).

a.

Define net operating assets (NOA).

b.
Assignments wit h the ~ logo in the ma r gin a r e available in an online homework system.
See the P reface of the book for details.

ABERCROMBIE &
FITCH
(ANF)

(In millions)

Q13-2.

Estimate the value of a share of Abercrombie & Fitch common stock using the di scounted cash
fl ow (DCF) model as of January 29 , 20 I l.
Abercrombie & Fitch (A NF) stock closed at $56.71 on March 29 , 2011 . How does your valuation
estimate compare with this clos ing price? What do you believe are some reasons fo r the diffe rence?

E l3-11. Estimating Sha r e Value Using the DCF Model (L01, 2)


Following are forecasts of sa les , net operating profit after tax (NOPAT), and net operating assets (NOA)
as of February 26, 20 I l , fo r Best Buy, Inc.

BEST BUY
(BBY)

STARUUl:"S
(SBUX)

Interpreting Earnings Announcement Effects on Stock P r ices (L01, 2)


In a recent quarterl y earnings announcement , Starbucks announce~ that its earnings ,had mar~edly
increased (up 7 cents per share over the prior year) and were I cent higher than analysts expectations .
Starbucks' stock "edged higher," according to The Wall Street Journal, but did not marked ly increase.
Why do you believe that Starbucks' stock price did not markedl y increase given the good news?

Horizon Period

Reported

(In millions)
Sales .... . . . .. . ..
NOPAT . . . . .... . .
NOA .. .. ..... . . .

Terminal

2011

2012

2013

2014

2015

Period

$50,272
1,389
7,876

$52,786
1,584
8,248

$55,425
1,663
8,660

$58,196
1,746
9,093

$61 ,106
1,833
9,548

$61 ,717
1,852
9,643

13-17

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation

Answer the following requirements assuming a disco_u~t rate (WACC) of 11 %: a term_inal_period growth
rate of 1%, common shares outstanding of 392 .6 million , and net nonoperatmg obligations (NNO) of
$ 1,274 million.

a.
b.

Identifying and Computing Net Operating Profit after Tax (NOPAT) and Net Nonoperating
Expense (NNE) (L01, 2)
Following is the income statement for Halliburton Company.

Estimate the value of a share of Best Buy 's common stock using the discounted cash flow (DCF)
model as of February 26 , 20 11 .
Best Buy (BBY) stock closed at $30.20 o n April 25 , 2011 . How does yo ur valuation estimate compare with this closing price? What do you believe are some reasons for the difference?

(HAL)

At December 31 (MIHlons of dollars and shares)

At December 31 (mllHons of dollars)

,:

2009

Assets

Cash and equivalents. .. .. . ..... ... .. . . . ...... . ..... . ......


Receivables, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . ..... . . . . . . . . . . .... . . . ... . .. . . . . . . ... . .. ...
Investments in markeatable securities . . . ....... . ... .. ........
Current deferred income taxes . . .. . . . . . . .... . . . . . . . . . . ...... .
Other current assets . .. . .. .. . . .. . . . . .... . .... .. . . .. ... ... . .

$ 1,398

Total current assets . .. .. .. . .. ... . ..... ... . . . ... . . . . .. . .. . .


Property, plant and equipment-net . ... . .. . .. .. .. . . . . . . . . . . . .
Goodwill . . . ... . .... . . .. . . . .. . .. .......... . .. . .......... .
Other assets ..... . ..... . .... ..... .. .... .. .. . .. . . . ....... .

8,886

Total assets . . . . ... ... . .. . . .. . .. . . .. .. .... .. . . . . . .. .. .. . . .

3,924
1,940
653
257
714

$ 2,082
2,964
1,598
1,312
210
472

2009

2008

Services . : . . .. . .. . .. . .. . .. . .. . . . , . . . . . . . . . . . . . .
Product sales . . ... . . . . . .... ... .. ...... ...... .. ...

$13,779
4,194

$10,832
3,843

$13,391
4,888

Total revenue .. . .. ..... .. . . . . . . ..... . . . .. ... .....


Operating costs and expenses

17,973

14,675

18,279

Cost of services . . . . .. .. . .. .... . .... . . . ........ .. .


Cost of sales .. . ..... .. ... .. .. .. .. . . . ...... . ... . ..
General and administrative .... ..... ....... .. .. . . . . .. .
Gain on sale of operating assets, net. . .. . . .. . .... . .... .

11,237

9,224
3,255
207
(5)

10,079

Total operating costs and expenses . ... ... .. .. .... . .. . .

14,964

12,681

14,269

Operating income .. . ... .. ..... .. ... . .. . . . . . . . . .. . . .


Interest expense, net of interest income
of $11 , $12, and $39 . . . . .. ... . . ....... .... . ...... .
Other nonoperating expenses, net .. . . . .... . .. . . . . ... . .

3,009

1,994

4,010

(297)

(285)
(27)

(128)
(33)

(853)

1,682
(518)

3,849
(1 ,211)

3,508
229
(10)

(57)

3,970
282
(62)

8,638
5,759
1,100
1,041

Income from continuing operations before


income taxes ...... ... ... . . .... . ..... . . . . ... . . . .
Provision for income taxes ... .. . . ... . . ..... . .... .... .

$18,297

$16,538

Income from continuing operations ........ . ....... .. .


Income (loss) from discontinued operations,
net of income tax . .... . ... . ... .... . ... . . ........

1,802

1,164

2,638

40

(9)

(423)

Accounts payable . .......... . .. . . .... . . . .. . . .. .. ... .... .


Current maturities of long-term debt . . . . . . . .. ... . ......... . . . .
Accrued employee compensation and benefits .. . . .. .... . ..... . .
Deferred revenue .... .. . . . .... .. . . . .... . .. . .............. .
Other current liabilities . ... . .......... . . . . . . . . ... . ...... . .. .

$ 1,139

Net income .. .. .. . . .. .. .. . ...... . .. . . ... ... . ..... .


Noncontrolling interest in net income of subsidiaries .. ... .

1,842

1,155
(10)

Net income attributable to company .. .. . ... . . . . . .. . .. .

$1,835

Total current liabilities .................... . ... .. .... . . . . ... .


Long-term debt . . . . .. .. . ....... .. .. . ... . ........... . .. . . .
Employee compensation and benefits ... . . . .. .. . .... . ... ... . . .
Other liabilities . . .... . . . ..... . ...... .. . ... . . ... . . . . . . . ... .

2,757
3,824
842

2,889
3,824
462
606

Total liabilities . . . .... . . .. . . . ....... . . .. . .. . .. . . . ........

7,910

7,781

6,842
1,315
1,254

---

Liabilities and Stockholders' Equity

Shareholders' equity
Common shares, par value $2 .50 per share-authorized 2,000 shares,
issued 1,069 shares and 1,067 shares .. . .. .. .......... . . .. . .

787
750
514
215
623

716

266
636

487

2,655

(7)

$ 1,145

2,215
9
$ 2,224

Compute net operating profit after tax (NO PAT) for 20 I 0, assuming a federal and state statutory tax
rate of 35% .

E13-14. Estimating Share Value Using the DCF Model

(L01, 2)

Following are forecasts of Halliburton Company's sales , net operating profit after tax (NOPAT) , and
net operating assets (NOA) as of December 31, 20 I0.

HALLIBllllTllN
l:UMPANY
(HAL)

2,674

2,669

Paid-in capital in excess of par value . ... ... . . . .. ... .. . ... . ... .

339

411

Accumulated other comprehensive loss . ...... . . . ... . . . . . . . .. .

(240)

(213)

Retained earnings ..... . . ... .. . .... .. . . . . .. .... . . . . . . .... .

a.
b.

2010

Revenue

.~

2010

(HAL)

HAWBUATON COMPANY

Following is the balance sheet for Halliburton Company.

HALLIBURTON COMPANY
Consolidated Balance Sheets

HALLIBUllTllN
CllMl'ANY

Consolldated Statements of Operations

E13-12. Identifying and Computing Net Operating Assets (NOA) and Net Nonoperating Obligations
(NNO) {L01, 2)

HALLIBURTllN
t:llMPANY

13-18

12,371

Reported

(In millions)
Sales . ..... . .. .. .
NOPAT . . .. . . .. ..
NOA . .. . . . ......

10,863

Treasury stock, at cost-159 and 165 shares ... .. .... . .. . .. . . . .

(4,771)

(5,002)

Company shareholders' equity .. ... .... .. . . . . .. . .... . ...... .

10,373

8,728

Noncontrolling interest in consolidated subsidiaries . . ... .. ... . .. .

14

29

Total shareholders' equity ........ . . . . . .... . .. . . .... ... .. . . .

10,387

8,757

Total liabilities and shareholders' equity. . . . . . . . . . . . . . . . . . . . . . . .

$18,297

Horizon Period

Tennlnal

2010

2011

2012

2013

2014

Period

$17,973
2,032
12,160

$21,028
2,376
14,208

$24,603
2,780
16,624

$28,786
3,253
19,450

$33,680

$35,027
3,958
23,667

3,806
22,757

Answer the following requirements assu ming a discount rate (WACC) of 10% , a terminal period growth
rate of 4%, common shares outstanding of 910 million, and net nonoperating obligations (NNO) of
$ 1,787 million .

$16,538

---

Compute net operating assets (NOA) and net nonoperating obligations (NNO) for 2010 .
For 2010 , show that: NOA= NNO + Stockholders' equity.

a.
b.

Estimate the value of a share of Halliburton's common stock using the discounted cash flow (DCF)
model as of February 17, 2011.
Halliburton Company (HAL) stock closed at $48.43 on February 17, 2011. How does your
valuation estimate compare with this closing price? What do you believe are some reasons for the
difference?

13-19

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation

13-20

continued from prior page

J P13-15.

Forecasting and Estimating Share Value Using the DCF Model

(L01, 2)

Following are the income statement and balance sheet for Intel Corporation .

INTEL
1:1mroRATlllN
(INTC)

INTEL CORPORATION
Consolidated Statements of Income
December
~!. 2009
$35,127
15,566

December

20,844
5,722
5,452
710

18

19,561
5,653
7,931
231
35

---

12,903

13,850

11 ,890

15,588
117
231
109

5,711
(147)
(23)
163

8,954
(1 ,380)
(376)
488

16,045
4,581

---

5,704
1,335

---

7,686
2,394

$11,464

$ 4,369

$ 5,292

December
Year Ended (In millions)
Net revenue . .. ...... .... .. ... .. ........ ..... . .. .. . ... . .
Cost of sales ... .. . . .. . . . .... . . .. .... . . ... .. . .. ..... ... . .

25,2010

Gross margin . . . . . . .. .. . . . . . . ... . . .. .. .. ..... . .. . .. ... . .


Research and development . .... . .. . .... . . . . . ... .. . . . .. . . .. .
Marketing , general and administrative . . .. . ... . . . . .. . .... ... . . .
Restructuring and asset impairment charges ... . . . . . . .. .. . .... .
Amortization of acquisition-related intangibles . . ...... ..... .... .

28,491
6,576
6,309

Operating expenses .. . . . . . . . .. . . . . . .. .. .. . . ..... . . . . . .. .. .


Operating income ... . .. . ... . . . .. . . . . . . . . .. . .. . ... . . .... . . .
Gains (losses) on equity method investments, net. ... .. . . . . . . . . . .
Gains (losses) on other equity investments, net. . . . . . .. .. . . .. . . . .
Interest and other, net . .. .. . ....... ... . . . .. ...... . . . . . . .. . .
Income before taxes . . . . . .. . . . . ... ... ... .. ... . . . ... . . . . ...
Provision for taxes . .. . .. . .. .. . . .. .. .. . . .... . .. . . ... . .. .. . .
Net income . . .. .. . .... . . .. .. .. ... . . .. . . . . . . . .... . . .. .. . . .

$43 ,623
15,132

14,993

Accumulated other comprehensive income .. . . .... ... .. .. .. . . . . .


Retained earnings . . . .. . . .. . . . . . . .. ..... .... .. . . .... .. . .... .

333
32,919

393
26,318

Total stockholders' equity .. . . . .... . .. .. . . .... . . . . . . . . ..... ... .

$37,586
16,742

Total liabilities and stockholders' equity . ... ..... . . ... . .... .. .. . . . .

INTEL CORPORATION

'

1 These

December 25,

2010

2009

Assets
Current assets
Cash and cash equivalents ...... ... . . ...... . .. . . .. . . . . .. . . . . .
Short-term investments .. .. . . . .. . . .. . .. . .. ... ..... ... .. . . ..
Trading assets . .... . ... . . . .. . .... . . . . . . . .. . ..... . . ... ... . . .
Accounts receivable, net ... . . . . .. . . . . . ... . .. . ... .... .... . . .
Inventories . . . . . .. .. . .. . ... . . .. .. . ... . . . . . . ... . . . . . . .. .. . .
Deferred tax assets . .. . . . .. . . .. . . . .. . . .. . .. . . ... .. .... . . . .. .
Other current assets .. .. . . . . . .. ... ... ... . . .. .. . . ..... . . . . .

$ 5,498
11 ,294
5,093
2,867
3,757
1,488
1,614

$ 3,987
5,285
4,648
2,273
2,935
1,216
813

Total current assets .. . . . . . . . . . . . . . .. ... . .. . .. ... . .. . . .. . . ..


Property, plant and equipment, net ... . . .. .. . . . . . . . . . . ... . ... ... .
Marketable equity securities . .. . .. . .. .... . .. . .. .. . . ... . .. .. .. . .
Other long-term investments1 . . . . .. . . .. . . . . .. ..... . . . . . . . . ... .
Goodwill . . . . . ..... . . . .... . . .. . ... ....... . . . .. . . . . .. . . . . .. . .
Other long-term assets . . ... .. . ... . . . ... .. . . .. .. . . . . . . .. . . ... .

31 ,611
17,899
1,008
3,026
4,531
5,111

21 ,157
17,225
773
4,179
4,421
5,340

Total assets . . .. . . . .... .. . . . .. .. . .. . . .. . . .... . . . . . . .. .. . . . . . .

$63,186

$53 ,095

172
1,883
2,448
773
593
1,722

Total current liabilities . .. ... .. . . . . . . . . .. . . . . . . . . . . ... . . .... . .

9,327

7,591

Long-term income taxes payable . . .. . . .. . . .. .. ..... .. . . ... . . . . . .


Long-term debt ... . . . . .. . . . . . . ... . . ... . . . . . .. .. ..... . . . ... . .
Long-term deferred tax liabilities . ... . . . . . . . . .. . ... . . .. .. .. . . .. . .
Other long-term liabilities . . . . . . ... . . . . . ...... .. . . . . . .... . .. . .. .

190
2,077
926
1,236

193
2,049
555
1,003

Total liabilities .. . .. ... .. .. .. . . ... .... . . ... .. . ... .... ... . .

13,756

11 ,391
continued

41 ,704

---

$63,186

$53,095

Required

a.
b.

c.

e.

38
2,290
2,888
1,007
622
2,482

49,430

- --

investments are operating assets as they relate to associated companies .

d.
December 26,

Liabilities
Current liabilities
Short-term debt . . .. .. . . .. . . .. . . .... . . . . . . . . . . .. .. .. . ... .. .
Accounts payable .. . .. . .. . . . . . . ..... . . .. . . . . .. . . . . .. . . . .. . .
Accrued compensation and benefits . . . . . . . . . . . . .. . . .. ... . .... .
Accrued advertising . ... . . . . . .. . .. .. . . . ... . . .. . . .. . . . . . . .. . .
Deferred income on shipments to distributors .. . .. . . . . .. .. ..... . .
Other accrued liabilities ..... .... . . .. ... .. . . ... ..... .. ..... . .

16,178

27,2008

Consolidated Balance Sheets

Aa of Year-Ended (In millions, except par value)

Stockholders' equity
Preferred stock, $0.001 par value .. ....... . .... . . .. . . .... ... . . .
Common stock, $0.001 par value, 10,000 shares authorized ;
5,581 issued and 5,511 outstanding and capital
in excess of par value . . . . .. .. . ... . . . .. .. . . . . . . ... ... . . . .. .

Compute In te l's net operating assets (NOA) fo r year-end 20 10 .


Compute net o perating profit afte r tax (NOPAT) fo r 20 10 , ass uming a federal and state statutory
tax rate of 37 %.
Forecast Intel's sales , NOPAT, and NOA for years 20 I l through 2014 using the fo llowing assumptions:
Sales growth .. . ... ...... . .. . . . . . ... ... .. . . ...... .

10%

Net operating profit margin (NOPM) .. . ...... . .. .. .. .. .

26%

Net operating asset turnover (NOAT) at year-end . . . .... .

1.50

Forecast the terminal period value assuming a I% term inal peri od growth and using the NOPM and
NOAT ass umptions above.
Estimate the value of a share of Intel common stock using the di scounted cash fl ow (DCF) model
as of December 25 , 2010 ; assume a discount rate (WACC) of 11 % , common shares outstanding
of 5 ,5 l l million, and net nono perating obligations (NNO) of $(20 ,778) million (NNO is negative
which means that Intel has net nonoperating investments).
Intel (INTC) stock closed at $22 .14 on February 18 , 2011. How does your valuation estimate
compare with thi s clos ing price? What do you be lieve are some reasons for the difference? What
investment decisio n is suggested fro m your results?

Pl3-16. Forecasting and Estimating Share Value Using the DCF Model

(L01, 2)

Following are the income statement and balance sheet fo r CVS Caremark .

1:vs l:AllEMAllK
(CVS)

CVS CAREMARK INC.


Balance Sheets
Rlhtcetrnb491' 31 (In mllllons, except per share amounts)

2010

2009

Assets
Cash and cash equivalents ....... ... . .. . . . . . . . . . . . . . .. .. .... .. . .. .. . . .... .
Short-term investments . . . .. .. . . . ....... . . . . . ... . . . . . . .. ........ .... . ... .
Accounts receivable, net .. ............ . .... . .. . . . . . . .. . . . ... . . . . .. .. . .. . .
Inventories .. . ..... . . . . .. . . . . . .. . . . . . . . .. . . ......... .... ... . .. .. .. . . . .
Deferred income taxes . . . . .. . .. . . ... .. . .. . . . .... . . . .... . ..... . ..... . ...
Other current assets . . .... . . . . ....... .. . ..... .. . .. . ... .. . . .. . . ... . .. . . . . .

$ 1,427
4
4,925
10,695
511
144

$ 1,086
5
5,457
10,343
506
140

Total current assets ... . . . . .. . .. . .. . . . . . .. . . . .. ... . .. . .. . .. . . . . . ....... .


Property and equipment, net . . .. . ....... ... ... . .. . ... . . . ... . . . .. . .. .. . . . . .
Goodwill . . . . ..... . . . ... .. ... . .... .. . ... . . .. . . . .. .. . . .. . . .. .. . .. . .. . .. .
Intangible assets, net .. . . . .... . .. ... .. .. . .. ... . .. . . . . ... ... . .. .. . . ... . . . .
Other assets .. ... . . ... .... . . ... . . . . . . . .. .. .. . ... . . . ...... . . ... . . . ... . . .

17,706
8,322
25,669
9,784
688

17,537
7,923
25,680
10,127
374

Total assets ........ .. ... . . . . . .. .. ... .... ... . ... . .. ... . .. ... . ..... . . . . . . . .

- --

---

$62 ,169

$61 ,641
continued

13-21

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash -Flow-Based Valuation

c.

continued from prior page


Liabilities
Accounts payable ... . . .. . . ... .. . . . . . . . ..
Claims and discounts payable . ... .. . .. . . ... . ... . ..
Accrued expenses ... . .. ... . . .. . .... . . .. . ..
Short-term debt . . .. . .. ... .. .. .. . . . . . . . . . .. . .
Current portion of long-term debt . .. . . . . ... . . . . . ..

$ 4,026
2,569
3,070
300
1,105

Total current liabilities . . . ........ . . .. . . ... .


Long-term debt . . .. . ... . ....... . ...
Deferred income taxes . ... . ..... . .. .. ..
Other long-term liabilities ... . ..... .. .... .
Redeemable noncontrolling interest ....... . . . ..... .

11 ,070
8,652
3,655
1,058
34

Total liabilities . ... . ... . . .. .. .. ... .. .. .

24,469

Shareholders' equity
Common stock, par value $0.01 : 3,200 shares authorized; 1,624 shares issued
and 1,363 shares outstanding at December 31 , 2010 .. ... .... .

$ 3,56Q
3,075
3,246
315
2, 104

12,300
8,756
3,678
1,1 02
37
25,873

16
(9,030)
(56)
27,610
19,303
(143)

16
(7,610)
(56)
27,1 98
16,355
(135)

Total shareholders' equity . .. .. . . ..... .... . ...

37,700

---

35,768

---

Total liabilities and shareholders' equity . . .. . . .. .. . .. .

$62,169

$61,641

Treasury stock at cost: . ... . . . ... .. . ......


Shares held in trust. .. ... ... ... . .. . .. ..
Capital surplus ... . . . . .... . ... . ... . . . . ..
Retained earnings . ... . .. . . ... . . . .....
Accumulated other comprehensive loss . ..... . . .. .. ..

l'

CVS CAREMARK INC.


Consolidated Statements of Income

2008 ,;

2010

2009

Net revenues . ... . . ... . ..... . . ... . . . .


Cost of revenues . . .... . . ..... . ... . ....

$96,413
76,156

$98,729
78,349

$87,472
69,182

Gross profit. . . .. .... . . ... .. ... . ...... . . .


Operating expenses . ............... . . .. . ...

20,257
14,092

20,380
13,942

18,290
12,244

Operating profit . ... . . ... ..... ... . .... . .


Interest expense, net . .... . . . . . ... . . .. .. .. ..

6,165
536

6,438
525

6,046
509

Income before income tax provision . ....... ... . .. . .. .


Income tax provision . .. . . .. . . .. .. .. . . ..... . . .

5,629
2,190

5,913
2,205

5,537
2,193

Income from continuing operations ... .. . ... . . . . . . . .....


Loss from discontinued operations, net of income tax benefit . .. . .. . .

3,439
(15)

3,708
(12)

3,344
(132)

Net income .. .. . ... ... . . .. .. ... . . . . .


Net loss attributable to noncontrolling interest ..... . . . .... . ..
Preference dividends, net of income tax benefit ... . . . . ... .

3,434
3

3,696

3,212

Net income attributable to CVS Caremark .. ... .... .. .. . . .

$ 3,427

For the year ended December 31 (In mllllons)

(14)
$ 3,696

$ 3,198

---

d.

e.
P13-17.

13-22

Forecast CVS 's sales , NOPAT, and NOA for 201 1 th rough 201 4 using the fo llowing assumptions:
Sales growth . . . . ... .. .. .. .... . . . . . . . . . . . . . . ... .. .

5%

Net operating profit margin (NOPM) ........... . .. . . . . .

4%

Net operating asset turnover (NOA1) at fiscal year-end . .. .

2.10

Forecast the terminal period value assuming a I% terminal period growth and using the NOPM and
NOAT assumptions above .
Estimate the value of a share of CVS common stock using the discounted cash flow (DCF) model
as of 0 f"<;: emb!:'r 31. 20 J O; assume a discount rate (WACC) of 7%, common shares outstandi ng of
1,363 million, and net nonoperating obligations (NNO) of $8,660 million.
CVS 's stock closed at $33.06 on February 18, 20 11. How does your valuation estimate compare
with this closing price? What do you believe are some reasons for the differe nce?

Forecasting and Estimating Share Value Using the DCF Model (L01, 2)
Following are the income statement and balance sheet for Abbott Laboratories (ABT) .

ABBOTT
LABllHA TlllllES

ABBOTT LABORATORIES
Balance Sheet
December 31 ($ mllllons)

(ABT)
2010

2009

Assets
Cash and cash equivalents . . . . .... . .. .. . . .. . .. .. .. .... . .. . . . .. . .
Investments and restricted funds . . . . .. . . .. ... ... . ..... . .... . . .. . .
Trade receivables, net ........ . . . .. .. ... . .... . . . ...... .. . . . ... . .
Total inventories . ... ...... . .. . . . .... . .. . . . .... . . . . .. . . .. . . . ..
Deferred income taxes . . .. . . ... . . ... . ... . .. . ...... . .. ... .. ... .. .
Other prepaid expenses and receivables . . . .. . .. . ..... . ... . .. .. . ... .

$ 3,648.371
3,675.569
7,184.034
3,188.734
3,076.051
1,544.770

$ 8,809.339
1,122.709
6,541.941
3,264.877
2,364.142
1,210.883

Total current assets . . ... .. .. ... . ... . . .. ... .. . . .. . . .. ... . ... ... .

22 ,317.529

23,313.891

Investments .. ..... . ... . .... .. ... . . . . . . . .. . . . .. . . .. .. . .. . . .. . .


Property and equipment, net .. . . . ... . . . . .......... ... .. .. ... .. . . .
Intangible assets, net of amortization . .. ..... . ..... . . . . . .. .. . . . ... .
Goodwill .. ... .... . . . .. ... .. . . . . . . . . .. . .... . . . ... . .. . . . . . . .. . .
Deferred income taxes and other assets . .. . .... .. . ... . . ... . .. . . . . . .

302.049
7,970.956
12,151.628
15,930.077
790.027

1,132.866
7,619.489
6,291 .989
13,200.174
858.214

Total assets . . .. ... .. .. .. ... . . . . .. . . . . . ... ... . . . . . . . . . . . ... . .. .

$59,462 .266

$52,416.623

Liabilities and Shareholders' Investment


Short-term borrowings .... .. . . ..... . ...... . ... . .. .. .. ... ... . . .. .
Trade accounts payable . . . ... . .. ..... . .. .. ... . .. ..... .. ... .. ... .
Salaries, wages and commissions . . .. .. .. .. ... .. . . . . . . . . .. .. . .. . . .
Other accrued liabilities . . .. . . .... .. ... .. . . . . . .. . .. . . . .. . . . .. . .. .
Dividends payable . .... . . . .... . .. . . . . . .. .. . . . . . . . . .... .. .. .. ..

$ 4,349.796
1,535.759
1,328.665
6,014.772
680.749

$ 4,978.438
1,280.542
1,117.410
4,399.137
620.640

Income taxes payable ... . ... .. . .. . . .. .. . .... . . . . ... .... . .. .. . . .


Current portion of long-term debt ...... . . .. . . . . . .. ...... . .. ... . . . .

1,307.723
2,044.970

442.140
211 .182

Total current liabilities ... . . .... . . ... . . . . ... . .... . . .. . . . ... . .. ... .

17,262.434

13,049.489

Long-term debt ... .. .. ... . . ... .. . . . . . . . .. .. .. .. .. .. .. . ....... .


Post-employment and other long-term obligations ... . . . .. .. ......... .
Shareholders' investment
Common shares, without par value. Authorized: 2,400,000,000 shares.
Issued: 1,619,689,876 and 1,612 ,683,987 .. ... . ... . . ... ... . .. .. . . .
Common shares held in treasury: 72 ,705,928 and 61,516,398 . . .. ... ... .
Earnings employed in the business .. .. . .. . . . . .. . ... .... .. .. . . . . .. .
Accumulated other comprehensive income (loss) . . ... . ...... .. ... . .. .

12,523.517
7,199.851

11 ,266.294
5,202.111

8,744.703
(3,916.823)
18,927.101
(1 ,366.846)

8,257.873
(3,310.347)
17,054.027
854.074

Total Abbott shareholders' investment. . . . ... . .. . . ...... . .... . ... . .


Noncontrolling interests in subsidiaries . . .. .. .. . . .. . . . . . .. . .. . . .. . . .

22,388.135
88.329

22,855.627
43.102

Total shareholders' investment. ... . ... . . . .. . ... .. . . . .. . . . .. . ..... .

22,476.464

22 ,898.729

Total liabilities and shareholders' investment . .. . . .. .. .... . . . . ... . .. . .

$59,462.266

$52,416.623

13-23

Module 13 I Cash-Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation

ABBOTT LABORATORIES AND SUBSIDIARIES


Consolidated Statement of Earnings

KELLOGG COMPANY AND SUBSIDIARIES


Consolidated Balance Sheet

Year Ended December 31


(dollars In millions)

(millions, except share data)

2009

2010

2009

Net sales .. . .... . .. . ... . .. . . . .... . . . .. .. .. . . .. .. . .. . . $35,166.721


Cost of products sold . ... ........ . . .. .. .. . .. . . . . . . . . .. . 14,665.192
3,724.424
Research and development .. ... . .. . . . . . . .. . . . . ..... . .. .
313.200
Acquired in-process research and development ... .. . .. ... . .
Selling, general and administrative .... . ..... .... . . . . . . . . . 10,376.324

$29,527.552
12,612.022
2,688.811
97.256
8,435.624

Current assets
Cash and cash equivalents .. . . . ....... . ..... . .. . ..... ... .... . .. .
Accounts receivable, net ........ ... .. . .. ... . . . . . . . .. .... . .... . . .
Inventories .... . . ... ... .. .. . . . . . . . . . .. . ... . .. . . .. . . .. . ........
Other current assets .. . .. ... . . . . . .. . . . . . . ... . .. . . . . . . ........ . . .

29,079.140

24,528.966

23,833.713

Total current assets . . .. . . .. .. .. .... . . .. . . . .. .. . . .. . .. . . ... ... .

2,915

2,558

Property, net . . ... . . . . . . . . ... . .. . . . ... . . . .. . . .. . .... . ..... . . .. .


Goodwill
::::::::::::::::::::::::::::::::::::::::::

3,128
3,628
1,456
720

3,010
3,643
1,458
531

Total assets .. . .. . . . .. .. .. . . . . .. ..... . .. .. .... . . . ..... .. . .

$11,847

$11 ,200

Total operating cost and expenses .. .. .. . . .. .. . . . .. . . . ..


Operating earnings .... . . . . ... . . . ... . . . . ... . . . . . . . .. . . .
Interest expense ...... . ..... . ..... ... . . .. . ... . .. . . . . . .
Interest (income) ...... .. . . . . . . . . ... . . . . . . . ...... . . . . . .
(Income) from the TAP Pharmaceutical joint venture . .. .. . . . . .
Other (income) expense, net . .... . . . . . . ... .. . .. .. . . . . . . .

6,087.581
553.135
(105.453)

6,235.741
519.656
(137.779)

(72.935)

(1 ,339.910)

5,693.839
528.474
(201.229)
(118.997)
(370. 695)

Earnings from continuing operations before taxes . ... . . . . .. .


Taxes on earnings from continuing operations . .. .. ..... . . . .

5,712 .834
1,086.662

7,193.774
1,447.936

5,856.286
1,122.070

Earnings from continuing operations . . . .. .. . .. . . .. .... .. . .


Gain on sale of discontinued operations, net of taxes ...... .. .

4,626.172

5,745.838

4,734.216
146.503

Net earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,626.172

$ 5,745.838

a.
b.
c.

d.

e.

Compute net operating assets (NOA) for year-end 20 10.


Compute net operating profit after tax (NO PAT) for 20 I0 assu ming a federa l and state statutory tax
rate of 35.4% .
Forecast Abbott Laboratories ' sales, NOPAT, and NOA for 2011 th rough 20 14 using the following
ass umptions:
Sales growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10%

Net operating profit margin (NOPM) . .. ... . . . .. .. . . .. . .

14%

Net operating asset turnover (NOAl), year-end. . . . . . . . . .

1.0

Forecast the term inal period value assuming a I% terminal period growth and using the NOPM and
NOAT ass umptions above.
Esti mate the value of a share of Abbott Laboratories' common stock using the discounted cash flow
(DCF) model as of December 3 1, 201 0; assume a discount rate (WACC) of 7% , common shares
outstanding of 1,547 million, and net nonoperating obl igations (NNO) of $ 12 ,061 million .
Abbott Laboratories (ABT) stock closed at $46.88 o n February 18, 2011. How does your valuation
estimate compare with thi s clos ing price? What do yo u believe are some reasons fo r the differe nce?
What investment decision is suggested fro m your results?

P13-18. Forecasting and Estimating Share Value Using the DCF Model
(K)

2009

2008

$12,575
7,184
3,390

$12,822
7,455
3,414

Operating profit . . . . . . . . . . .. .. . ..... . . ..... .. . . ..... .. .. . . .


Interest expense .. ... .. .. . .. . .. .. . . .. . . . .. .. . . ....... . . . .. .
Other income (expense), net . . .. . .... ... ... .. . . ... ... . . . . . . . .

1,990
248

2,001
295
(22)

1,953
308
(14)

Income before income taxes . ... .. . . . . . .. . .. . .. . ... ...... .. .


Income taxes . . . .. ... . . . .. . .. . .. .. .... .. ... . .. . .. . . . . . . .. .

1,742
502

1,684
476

1,631
485

Net income ... ... .... . . . .. .. . . .. . . . . . . . .. . ... . . ... .. .. . . . .


Net loss attributable to noncontrolling interests . . ..... . . ... . .. . . .

1,240
(7)

1,208
(4)

1,146
(2)

2010

Net income attributable to Kellogg Company . . . . . . . . . . . . . . . . . . . . $ 1,247

$ 1,212

$ 1,148

---

444
1,190
1,056
225

952

44

334
1,093
910
221

44
1,077
1,166

.. . ... . . . ... . . . . . ..... ... .. . . . . . . . . . . . ....

Total current liabilities .. . . . . . . . . .. . ....... .. . . .. .. . ... .. . .. . . ..

3,184

2,288

Long-term debt .. . . . . .. . . . .. . .. . .. . . . .. .... . .. ... . . .. . . . . .. . .


Deferred income taxes .... . .. .
Pension liability . ... . . ...... . . . . .. . . ... .. . . . . ...... . .... . .. . . . .

4,908
697
265
639

4,835
425
430
947

105
495
6,122
(2,650)

105
472
5,481
(1,820)

. . . . ... . . ....... . ... . . ... .. . . . ... .

Other liabilities .... . . .. . . . . .. .. . .... . . . ... .. .. . ..... . . .... .. . ..


Equity
Common stock, $.25 par value, 1,000,000,000 shares authorized
Issued: 419,272,027 shares in 2010 and 419,058,168 shares in 2009 ... .
Capital in excess of par value ... . ... . . . . . . .. ..... . . ... . .... . . . .. .
Retained earnings . ... . . . . .. ... ... . . . .. .... . . .. ..... .. .. .. .. . . .
Treasury stock at cost: 53,667,635 shares in 2010 and 37,678,215
shares in 2009 . . . . . . . .. ... .. .. .. . ... . ...... . . . .. .. .. . . . . .. .. .
Accumulated other comprehensive income (loss) . . . .. . ..... .. .. . .. . . .

(1,914)

(1, 966)

Total Kellogg Company equity . . . .. . . .. . . ..... . . . ...... .. . .. ... .


Noncontrolling interests . . .. .. . ... . .. . . ... . . . .. . . .. . . . . . . .. .... . .

2,158

2,272

(4)

Total equity . . . ... . . . ... . . .. . . . . . ... . .. . . . . . .. ... .... . . . ..

2,154

2,275

Total liabilities and equity ........ . .. . . . ... .. .. . . .. . ... . ... .... .

$11,847

$11 ,200

Required

c.

Net sales . .. .. . .. . ....... .. ..... . . . . . .... . .. . .. . . . . . .. . .. . $12 ,397


7,108
Cost of goods sold . . .... . . .. . . . . .. .... . . . . .. ..... . . . . .. . . . .
3,299
Selling, general and administrative expense ... .. . . .. ... . .. . .... .

1,149
1,039

b.

Following are the income statement and balance sheet for Kellogg Company .

For Year Ended (In mllllons)

Current liabilities
Current maturities of long-term debt ... . . .... . ..... .. .... .. . . . . . . . .
Notes payable . . . .. . . . .. . . . . . ... .. . .. . . . .. .. . . . . . . . . . . . . . .... .
Accounts payable .. ...... . ... .
Other current liabilities
. .. ... .. . . .. . . . . .. . . . ... . .. . . . . . .

a.

(L01, 2)

KELLOGG COMPANY AND SUBSIDIARIES


Consolidated Statement of Income

g!~:~ :;::t~~'.~s:. :n~~:

$ 4,880.719

Required

KELUll:I: 1:11.

2010

$30,764.707
13,209.329
2,743.733
170.000
8,405.904

d.

e.

Compute net operating assets (NOA) as of year-end 20 10.


Compute net operati ng profit after tax (NO PAT) for 20 I0 , ass umi ng a federa l and state statuto ry
tax rate of 36.4% .
Forecast Ke llogg 's sales, NO PAT, and NOA for20 I I through 20 14 us ing the fo llowing assumptions :
Sales growth... . ... .. . . . . .. . . . . . . .. . . . . . ...... . . .

4%

Net operating profit margin (NOPM). . . . . . . . . . . . . . . . . . .

11 %

Net operating asset turnover (NOAl), year-end . . . . . . . . . .

1.6

Forecast the ten:n inal period value assumi ng a I% terminal period growth and using the NOPM and
NOAT ass um ptio ns above.
Esti m~te the value. of a share of Kellogg common stock us ing the discou nted cash flow (DCF)
model, assume a discount rate (WACC) of 6%, common shares outstandinu of 365 .6 mill ion and
net nonoperating obligations (NNO) of $5 ,456 mj JJion.
"'
'
K ~llog~ 's sto~k clo~ed at $53.56 at February 28 , 20 1I . How does your valuation estimate compare
with this clos ing pn ce? What do you believe are some reasons for the difference?

13-24

13-25

Module 13 I Cash- Flow-Based Valuation

Module 13 I Cash-Flow-Based Valuation

continued from prior page

113-19.

Forecasting and Estimating Share Value Using the DCF Model

(L01, 2)

Following are the income statement and balance sheet for Tesco, PLC , a UK-based grocery chain.
T he company 's fi nancial statements are prepared in accordance wi th IFRS.

52week8
2011

Continuing operations
Revenue (sales excluding VAT) .. ... . .... . ......... ... .. . . ... ... ... .
Cost of sales ............. . .... .. . . .... .. . . ....... ... . . .. .. ... . .

60,931
(55,871)

56,910
(52,303)

Gross profit .. . ..... . .. . .. ...... .. .. .. . . . .... . . .. . . . . ... .... .. . .


Administrative expenses . .. ... .. .... . . .. . . . . . .. . ................ .
Profit arising on property-related items ... . ..... . .......... . ... ..... .

5,060
(1,676)
427

4,607
(1,527)
377

Operating profit . .... . . . ... . .... . . .... .. .... ............. . .... . .


Share of post-tax profits of joint ventures and associates ....... .... . . . .
Finance income . ...... . ........... . . .. . . ..... .. ... .. . ..... . . . . .
Finance costs . . . ..... . .. . .. . .. ...... .. .. . . . ... . ..... . ... . . .. . . .

3,811
57
150
(483)

3,457
33
265
(579)

Profit before tax . ............. . .... .... ... . . .. . .. . . ...... ... ... .
Taxation ....... . . .. ....... . . . .... . . ... .. . .... .. .. ..... ....... .

3,535
(864)

3,176
(840)

Profit for the year .......... . . .... .. . . .... .. .. .. .. ... ........ . . . .


Attributable to:
Owners of the parent . . . . .. . . .. . . ... . . .. . . . . ...... .. ... . .. . . . ... .
Non-controlling interests . . . ... . . . .. . ..... . .... . .. .... . .. ... . . ... .

2,671

(17,731)

(16,015)

(10,289)
(1,356)
(1,094)
(113)

(12,520)
(1 ,840)
(795)
(172)

(12,852)

(15,327)

402
4,896
40
11,197

399
4,801
40
9,356

Equity attributable to owners of the parent . .. . ....... .. . . . ... . .


Non-controlling interests . . . ... . ..................... . . .. . . .

16,535

88

14,596
85

Total equity ... .. . ......... . .. . .. ... ..... . . ... . . . .. . . . . . . .

16,623

14,681

Equity
Share capital. . ... ..... . . . . . .. .. . . . .. .. . . ... . . . .. . . . . . . . .
Share premium account . . . . .. .. . . . .... . . .. . .......... . . ... .
Other reserves .. . . .. . . . ... ... .. ... ....... . ... .. ......... .
Retained earnings ... . .... ....... ... .. ..... ... ...... . . .. . .

a.
b.

2,655
16

2,327
9

2,671

2,336

c.

Compute net operati ng assets (NOA) as of year-end 20 11 .


Compute net operati ng profit after tax (NOPAT) for 20 11 , assumi ng a marginal tax rate of 25%.
Forecast Tesco's sales , N O PAT, and N O A for 20 12 through 20 15 using th e followi ng assumptions:

Sales growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating profit margin (NOPM). . . . . . . . . . . . . . . . . . .
Net operating asset turnover (NOAT) . . . . . . . . . . . . . . . . . .

6%
4.8%
3 .8

Estimate the termin al peri od value assuming a l % termi nal peri od growth and using the NOPM and
N OAT assumptions , above .
26 February 2011 27 February

Total non-current assets .. . . ...... .... ........ . ..... .. . . . . .


Current assets
Inventories .. . .. . . .... ... .. . ... .. .. .. . .. . .. . . . ... .. . .... .
Trade and other receivables .. .. . . ... . . . . . . ... . .. . .. ..... ... .
Financial assets . .. ....... . ... .. .... . .. .. . . .. . . . .. .. . . . . . .
Current tax assets . .. .. .... . . . . . . . .. . . . . . .. . .. . .. ....... . .
Short-term investments . . . . . ... .. . . . .. . . . . .. . ... . .. . ...... .
Cash and cash equivalents . .. ... . . ....................... . .

(9,442)
(1 ,675)
(4,387)
(472)
(39)

Required

2,336

TESCO PLC
Group Balance Sheet

Non-current assets
Goodwill and other intangible assets .. . . ... .. . . . . .. .. . .. . . .. . .
Property, plant and equipment. ... . ... . . ... . . . ..... ... .. . . .. .
Investments in joint ventures and associates .. ..... . . .. . . . .. . . . .
Other investments .. .. . .. .. ..... . ..... ... .... ... .. .... . . . .
Financial assets . . . . . ... . . . ... . .... . ........ . ....... .. ... .
Deferred tax assets ... ......... . ... .. . . . . . . .. .... . . . ..... .

(10,484)
(1,641)
(5,110)
(432)
(64)

Total current liabilities .. . .. ... .... ....... . .. . . .. . . . ... .. . . .


Non-current liabilities
Financial liabilities .. .... . . . .. .. . . . . .. . . . . .. .... ....... . ... . .
Post-employment benefit obligations . .... . .. ... . . ... .. .. . ... .
Deferred tax liabilities .. . ... . . . .. ... ... . ..... .. .... . ....... .
Provisions . .. .. ........ ... .. . .. ... . . .. . . ... .... . ........ .

Tesco, PLC
Group Income Statement

Year ended 26 February 2011

Current liabilities
Trade and other payables ... . . . .. .... . . . . . .... . .... . ... .. .. .
Financial liabilities .. . . ..... . .. . .. ...... ...... .. . .. . ... ... . .
Customer prepayments and deposits .. ...... . ............. .. .
Current tax liabilities . . . . . . .. ...... .. .. . . .. ... . .. .... .. . . . . .
Provisions ... .. ... . .. .. . . . . . . . .. . .. . . . .... . ...... . . . . .. . .

2014

d.

24,398
316
2,971
3,266
48

4,177
24,203
152
2,594
3 ,094
38

35,337

34,258

3,162
2,314
3,066

2,729
1,888
2,636

4,338

1,022
1,870

1,31 4
2,819

Non-current assets classified as held for sale ... .. . . . .. . . . .... . .

11,438
431

11 ,392
373

Total current assets .. . . .... .. . .. . . .. . . . ..... . . .... . ...... .

11,869

11,765

continued

e.

Esti mate the value of a share ofTesco 's common stock (which trades on the London Stock Exchange)
using the discounted cash flow (D CF) model; assume a discount rate (WACC) of 8%, common shares
outstanding of 8,046.5 million, and net nonoperati ng obligations (NNO) of (608). (Note : NNO is
negati ve which means that Tesco has net nonoperating investments and fi nancial assets.)
Tesco 's stock price was 3.93 on A pril 19 , 20 11. How does your valuation estimate compare w ith
this closing pr ice? W hat do you believe are some reasons for the difference?

13-26

13-27

Module 13 I Cash- Flow-Based Valuation

Module-End Review
Solution

The following DCF results yield a P&G stock value estimate of $51.63 as of August 10, 20 11. P&G's s
closed at $58.51 on that date . This estimate suggests that P&G 's stock is margi nally overvalued on that
Horizon Period
(In millions, except per share
values and discount factors)

Reported

2012

2013

2014

Increase in NOA" ...... . ...........

$ 4,349

$ 4,673

$ 4,889

FCFF (NOPAT - Increase in NOA) .. . ..

8,432

8,696

9,095

9,513

+ r wl1 .... . ... . .

0.92593

0.85734

0.79383

0.73503

Present value of horizon FCFF . ... . ...

7,807

7,455

7,220

6,992

Discount factor [1 / (1

2011

2015

Terminal
Period

$ 5,114 $ 1,162
13,611

Cum present value of horizon FCFF . . . . $ 29,474


Present value of terminal FCFF ..... . .

142,921 b

Total firm value .............. . .. . . .

172,395

Less NNO .. . ................ . ... .

29,607

Firm equity value . .. . . ... . ....... .. $142,788


Shares outstanding . . . . . . . . . . . . . . .
Stock value per share . . .. .. . .. ..... . $

2,765.7
51 .63

NOA increases are viewed as a cash outflow.


3,611 million

Computed as ($ ~. 8 _ O.Q1 y(1.0 ),


8
(terminal period) growth rate.
b

, or ($13 ,611 million/0.07) x 0.73503 , where 8% is WACC and 1% is the long-term