Simple Valuation

This tutorial introduces valuation. First, the tutorial covers the method of calculating the WACC or weighted average cost of ca cash flows for a company are computed. Finally, the free cash flows and dividends are used to value the stock of a company u growth valuation model as well as the dividend discount model.

ACC or weighted average cost of capital. Next, the free ed to value the stock of a company using the constant

Calculating Weighted Average Cost of Capital

Weighted average cost of capital is the average cost of a companies debt and equity. The cost of debt or equity is the cost of raising capital through the issuance of debt or equity. In order to give a company money, lenders and investors require interest on the money. When a company is evaluating the costs and returns of projects they must include the cost of borrowing the capital needed for the project. The weighted average cost of capital is the measure they use.

WACC 1 T rD wD rS wS

T = Tax Rate rD = Required Return from Lenders wD = Weight (percentage of debt) rS = Required Return from Stockholders rW = Weight (percentage of stock)

The tax rate is the total state and federal taxes the company must pay on income. The income taxes only affect the debt portion of the calculation because payments on loans reduce income where as dividends are paid after taxes have been taken out. The required rate of return is the rate the lenders require in order to lend the company funds. In the case of debt this will be the interest rates on loans, in the case of equity this will be the return stock holders require in order to invest in the company. The weight for each is the percentage of the capital structure. Example: JonesCo has a capital structure of 40% debt and 60% equity, required returns are 8% and 10% respectively. The companies total income taxes amount to 35%. WACC= = = = (1-35%)*40%*08% + 60%*10% .65*.4*.08 + .6*.1 .0208 + .06 .0808 or 8.08%

The companies average cost of raising capital for investments or projects is 8.08%

Calculating Free Cash Flows

Free cash flows are the funds that can be distributed to investors after the operating costs have been deducted. Operating costs are the costs incurred while running the business and making a product or providing a service. These costs include but are not limited to: materials, labor, rent, taxes, interest, loan payments, etc. The remaining cash or Net Operating Profit after Taxes, can be used to reinvest in the company, distribute to investors, or reduce debt. In order to support growth or at least maintain capacities and keep a company running, it must invest some of the profits back into the business. The portion of profit that goes back into the business is considered Investment in Operating Capital. Free Cash Flows are the profits that remain after the Investment in Operating Capital has been deducted from the Net Operating Profit after Taxes. First we will calculate Net Operating Profit after Taxes, second we will calculate Investment in Capital, and finally we will calculate Free Cash Flow

1. NOPAT - Net Operating Profit after

NOPAT = P(1-T) P - Operating Profit T - Tax Rate

Example: JonesCo's profit after operating expenses was $1,500,000 and its tax rate is 35%. NOPAT = $1,500,000 (1 - 35%) = $1,500,000 * .65 = $975,000

2. Investment in Operating Capital

Operating Capital is the amount of capital that the company needs to support the businesses activities. Operating capital includes both short term and long-term capital. The short term capital is Net Operating Working Capital (NOWC) and long-term capital is Plant Property and Equipment (PPE). The difference between last periods Operating Capital and this periods Operating Capital is the Investment in Operating Capital. The investments can be used to facilitate growth or maintain current capabilities. NOWC Net Operating Working Capital

Net Operating Working Capital equals Operating Current Assets minus Operating Current Liabilities. Operating Current Assets are the cash, inventory, and accounts receivable. Operating Current Liabilities are accounts payable, accruals, and other operating current liabilities.

NOWC = Operating Current Assets - Operating Current Liabilities

NOWC = $750,000 - $300,000 = $450,000 PPE Plant, Property and Equipment Plant, Property, and Equipment are the long-term assets required to do business.

Total Operating Capital Total Operating Capital is the sum of the Net Operating Working Capital and Plant, Property, and Equipment. Total Operating Capital = NOWC + PPE Example: JonesCo has Operating Current Assets of $750,000 and Operating Current Liabilities of $300,000. Plant, Property and Equipment equal $10,000,000. The total Operating Capital last period was $10,200,000. Total Operating Capital = NOWC + PPE = ($750,000 - $300,000) + $10,000,000 = $10,450,000 Investment in Operating Capital = Operating Capital (current period) - Operating Capital (last period) = $10,450,000 - $10,200,000 = $250,000

3. Free Cash Flow

As stated previously, Free Cash Flow is the remaining profit that can be used to distribute to share holders or pay off debt. Depending on the position and goals of the business it can choose to do either or both of these activities. The difference between NOPAT and the Invested Capital is the Free Cash Flow. Free Cash Flow = NOPAT - Investment in Operating Capital Example: The Free Cash Flow for JonesCo would be calculated as follows: Free Cash Flow = $975,000 - $250,000 = $700,000

Constant Growth Valuation Model

The constant growth valuation model assumes that the company will grow at a constant rate. Using the growth rate, Weighted Average Cost of Capital, and Free Cash Flows we can find the present value of a company that is presumed to grow indefinitely. This model is useful because it is difficult to project the financial statements for a company far into the future. This model only requires data from one period and an average growth rate which can be found from past statements. The model can be used to calculate three values, first the present value of future operations, second the present value of equity, and finally the present value of its stock.

1. Present Value of Operations

The Present Value of Operations is the present value of all future Free Cash Flows from the company.

Vop

FCF (1 g) WACC g

2. Present Value of Equity.

The Present Value of Equity is the present value of operations after subtracting the companies long-term debt obligations in other companies. Other debt obligations would be investments in other companies through stocks or bonds. Ve = Vop - Value of Other Obligations

3. Present Value of Stock

Vs = Value of Equity/ # shares of stock

Example: JonesCo's has had a constant growth rate of 5% over the past years and projects that they will continue to grow at that rate. It has a Free Cash Flow of $700,000 and WACC is 8.08%. The own $100,000 of stock in company X, and they have 1,000,000 shares of stock outstanding.

V op

$ 700 , 000 . 0808

* (1 . 05 ) . 05

V op $ 21 , 590 , 909
Ve $21,590,909 $100,000 Ve $21,490,000
$21,490,000 1,000,000 Vs $21.49 / share Vs

Discounted Dividend Valuation Model

The present value of stock can also be found using the Discounted Dividend Model. The Dividend Discount Model uses the present value of the stock, the expected future dividends, and the growth rate. This model is similar to the Constant Growth Model accept it discounts the dividends at the expected return instead of discounting the free cash flows at the weighted average cost of capital.

D (1 g ) VS 0 rS g

V S = Stock Value D 0 = Dividnend at time 0 (most recent) g = Growth rate r S = Stockholders Required Rate of Return

Example: As stated previously, JonesCo has a constant growth rate of 5% and the stockholder required rate of return is 10%. The last dividend paid was $1.023. Using this model what is the value of their stock?

$ 1 .023 (1 5 %) 10 % 5 % V S 21 .483 VS
The value of the stock is $21.483. Using the Constant Growth Model the value of the stock was $21.49, as you can see the value of the stock is approximately the same under both models.