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The three key components of valuation are

Cash flow

You cant eat earnings

Long term

Not a one year measure, but the PV of entire future stream of CFs

Risk

via the expected value cash flows and via the opportunity cost of

capital

Valuation by components

Shareholder Value

Corporate Value

Present value

of Free Cash

Flows

and other

obligations

investment and financing decisions

Shareholder

Value

Free Cash Flow

Value

Growth

Duration

Discount

Rate

Sales growth

Operating

Profit Margin

Tax rate

Fixed capital

Investment

Working cap

Investment

Cost of

Capital

Operating

Decisions

Investment

Decisions

Financing

Decisions

Debt

Policy

FCFE

Equity Valuation

The value of equity is obtained by discounting

expected cashflows to equity, i.e., the residual

cashflows after meeting all expenses, tax

obligations and interest and principal payments, at

the cost of equity, i.e., the rate of return required

by equity investors in the firm.

The dividend discount model is a specialized case

of equity valuation, and the value of a stock is the

present value of expected future dividends.

Some analysts assume that the earnings of a firm represent

its potential dividends. This cannot be true for several

reasons:

Earnings are not cash flows, since there are both noncash revenues and expenses in the earnings calculation

Even if earnings were cash flows, a firm that paid its

earnings out as dividends would not be investing in new

assets and thus could not grow

Valuation models, where earnings are discounted back

to the present, will over estimate the value of the equity

in the firm

The potential dividends of a firm are the cash flows left

over after the firm has made any investments it needs to

make to create future growth and net debt repayments

(debt repayments - new debt issues)

FCFE

Free Cash Flow to Equity (FCFE) = Net Income - (Capital

Expenditures - Depreciation) - (Change in Non-cash

Working Capital) + (New Debt Issued - Debt Repayments)

This is the cash flow available to be paid out as dividends

or stock buybacks.

FCFE

If we assume that the net capital expenditures and working capital changes

are financed using a fixed mix of debt and equity. If d is the proportion

that is raised from debt financing,

Free Cash Flow to Equity

= Net Income

- (Capital Expenditures - Depreciation)(1 - d)

- (Change in Working Capital)(1-d)

FCFE

If there is preference dividend

Free Cash Flow to Equity (FCFE) =

Net Income - (Capital Expenditures -Depreciation) - (Change

in Non-cash Working Capital) + (New Debt Issued - Debt

Repayments) Preferred Dividends + New Preferred Stock

Issued

In a discounted cash flow model, increasing the debt/equity ratio will

generally increase the expected free cash flows to equity investors

over future time periods and also the cost of equity applied in

discounting these cash flows.

Which of the following statements relating leverage to value would

you subscribe to?

Increasing leverage will increase value because the cash flow

effects will dominate the discount rate effects

Increasing leverage will decrease value because the risk effect

will be greater than the cash flow effects

Increasing leverage will not affect value because the risk effect

will exactly offset the cash flow effect

Any of the above, depending upon what company you are

looking at and where it is in terms of current leverage

FCFE

A free cash flow to equity model is a model where we

discount potential rather than actual dividends

Assumptions when we replace dividends with FCFE

There will be no future cash build-up in the firm, since

the cash that is available after debt payments and

reinvestment needs is paid out to stockholders each

period.

The expected growth in FCFE will include growth in

income from operating assets and not growth in income

from increases in marketable securities.

FCFE

Expected Growth rate = Retention Ratio * Return on Equity

The use of the retention ratio in this equation implies that

whatever is not paid out as dividends is reinvested back into the

firm.

This is not consistent with the assumption that free cash

flows to equity are paid out to stockholders which underlies

FCFE models

Consistent to replace the retention ratio with the equity

reinvestment rate, which measures the percent of net

income that is invested back into the firm

= 1 [ FCFE / Net Income]

FCFE

Non-cash ROE

(Net Income - After tax income from cash and marketable securities) / (Book

Value of Equity - Cash and Marketable Securities)

Expected Growth in FCFE = Equity Reinvestment Rate * Non-cash ROE

Designed to value companies that are growing at a stable rate

and hence in a steady state

Ve = FCFE1 / (ke gn)

Caveats

very similar to the Gordon growth model in its underlying

assumptions and works under some of the same constraints

a 'stable' growth rate cannot exceed the growth rate of the

economy in which the firm operates by more than one or

two percent

Capital expenditures, relative to depreciation, are not

disproportionately large and the firm is of 'average' risk

best suited for firms growing at a rate comparable to or lower

than the nominal growth in the economy

better model to use for stable firms that pay out dividends that

are unsustainably high (because they exceed FCFE by a

significant amount) or are significantly lower than the FCFE

if the firm is stable and pays outs its FCFE as dividend, the value

obtained from this model will be the same as the one obtained

from the Gordon growth model

designed to value a firm which is expected to grow much

faster than a stable firm in the initial period and at a stable

rate after that

FCFEt = Free Cashflow to Equity in year t

Pn = Value at the end of the extraordinary growth period

ke = Cost of equity in high growth (hg) and stable growth (st)

periods

The terminal price is generally calculated using the infinite

growth rate model,

Pn = FCFEn+1 / (ke gn)

Caveats

the assumptions made to derive the free cashflow to

equity after the terminal year have to be consistent with

the assumption of stability. For instance, while capital

spending may be much greater than depreciation in the

initial high growth phase, the difference should narrow

as the firm enters its stable growth phase

The beta and debt ratio may also need to be adjusted in

stable growth to reflect the fact that stable growth firms

tend to have average risk (betas closer to one)

designed to value firms that are expected to go

through three stages of growth - an initial phase

of high growth rates, a transitional period where

the growth rate declines and a steady state period

where growth is stable

Pn2 = Terminal price at the end of transitional

period

= FCFE n2+1 / (r gn)

Caveats

Since the model assumes that the growth rate goes

through three distinct phases -high growth, transitional

growth and stable growth - it is important that

assumptions about other variables are consistent with

these assumptions about growth

As the growth characteristics of a firm change, so do its

risk characteristics. In the context of the CAPM, as the

growth rate declines, the beta of the firm can be

expected to change

FCFF

Firm Valuation

The value of the firm is obtained by discounting expected

cashflows to the firm, i.e., the residual cashflows after

meeting all operating expenses and taxes, but prior to debt

payments, at the weighted average cost of capital, which is

the cost of the different components of financing used by

the firm, weighted by their market value proportions.

FCFF

FCFF = Free Cashflow to Equity + Interest Expense (1 - tax rate) +

Principal Repayments - New Debt Issues + Preferred Dividends

FCFF = EBIT (1 - tax rate) + Depreciation - Capital Expenditure -

Working Capital

FCFF = PAT + Int (1 - tax rate) + Depreciation - Capital Expenditure Working Capital

the growth rate used in the model has to be less than or

equal to the growth rate in the economy

the characteristics of the firm have to be consistent with

assumptions of stable growth. In particular, the

reinvestment rate used to estimate free cash flows to the

firm should be consistent with the stable growth rate

Reinvestment rate in stable growth

= Growth rate / Return on capital

The cost of capital should also be reflective of a stable

growth firm. In particular, the beta should be close to one

- between 0.8 and 1.2

Firms that have very high leverage or are in the

process of changing their leverage

The calculation of FCFE is much more difficult in these cases

because of the volatility induced by debt payments (or new issues)

and the value of equity, which is a small slice of the total value of

the firm, is more sensitive to assumptions about growth and risk.

cashflows relating to debt do not have to be considered explicitly,

since the FCFF is a pre-debt cashflow, while they have to be taken

into account in estimating FCFE

where the leverage is expected to change significantly over time,

this is a significant saving, since estimating new debt issues and

debt repayments when leverage is changing can become

increasingly messy the further one goes into the future

FCFF Problems

free cash flows to equity are a much more intuitive

measure of cash flows than cash flows to the firm.

most of us look at cash flows after debt payments (free

cash flows to equity), because we tend to think like

business owners and consider interest payments and the

repayment of debt as cash outflows.

free cash flow to equity is a real cash flow that can be

traced and analyzed in a firm.

free cash flow to the firm is the answer to a hypothetical

question: What would this firms cash flow be, if it had no

debt (and associated payments)?

FCFF Problems

focus on pre-debt cash flows blinds the real problems with

survival.

a firm has free cash flows to the firm of $100 million

but because of its large debt load makes the free cash

flows to equity equal to -$50 million. This firm will

have to raise $50 million in new equity to survive and,

if it cannot, all cash flows beyond this point are put in

jeopardy

Using free cash flows to equity would have reflected

this problem, but free cash flows to the firm are

unlikely to reflect this.

FCFF Problems

the use of a debt ratio in the cost of capital to incorporate

the effect of leverage requires making implicit assumptions

that might not be feasible or reasonable

assuming that the market value debt ratio is 30% will

require a growing firm to issue large amounts of debt in

future years to reach that ratio. In the process, the book

debt ratio might reach stratospheric proportions and

trigger covenants or other negative consequences

Value of equity = Value of Firm in FCFF Model Debt

Will be same as given by FCFE Model if we make

consistent assumption about firms leverage

Estimating Value

Long forecast period has own problems

Error of false precision

A detailed forecast for 5 years where complete

balance sheets and income statements are

developed with as much linkage to real

variables as possible

A simplified forecast for remaining years,

focussing on a few important variables, such as

revenue growth, margins and capital turnover.

Estimating Value

Usually a number of years are forecast explicitly

Called the forecast period

The company generally has some value remaining after the

forecast period: that value is often referred to as

Continuing value (McKinsey)

Residual value (Alcar)

Terminal value (usually implies liquidating)

Exit value (usually used in LBO deals, or interim financing deals.

Forecast

Build the revenue forecast. This should be based on volume

growth and price changes.

Forecast operational items such as operating costs, working

capital, PP&E by linking them to revenues or volumes.

Project non-operating items

Project the equity accounts. Equity should be equal to last

years equity plus net income and new share issues less

dividends and share repurchases.

Forecast

Use the cash and/or debt accounts to balance the

cash flows and balance sheet

Calculate the ROIC tree and key ratios to pull

elements together and check for consistency

Is the companys performance on the value drivers

consistent the companys economics and industry

competitive dynamics?

Is the revenue growth consistent with the industry growth?

If the companys revenue is growing faster than the

industrys, which competitors are losing share. Will they

retaliate? Does the company have the resources to mange

the rate of growth?

Is the return on invested capital consistent with the

industrys competitive structure? If the entry barriers are

coming down, shouldnt expected returns decline? If the

customers are becoming more powerful, will margins decline?

Conversely, if the companys position in the industry is

becoming much stronger,should you expect returns to

increase? How will the returns look relative to competition?

How will technology affect the returns? Will they

affect risk?

Can the company manage all the investments it is

undertaking?

Income statement

Forecast method

Net sales

Cost of goods sold (COGS)

Selling, general & administrative (SGA)

Depreciation

Operating profit

Forecasted

Percent of sales

Percent of sales

Percent of net PPE

Calculated: Sales-COGS-SGADepreciation.

Interest rate on short-term

investments multiplied by the

amount of short-term investments at

the beginning of the year.

Interest rate on short-term and longterm debt multiplied by the amount

of the debt at the beginning of the

year.

Calculated: Operating profit +

Interest income-Interest expense.

Calculated: Tax rate (EBT)

Calculated: EBT- Taxes.

Constant growth relative to previous

year

Calculated: Net income Dividends.

Interest income

Interest expense

Taxes

Net income

Dividends

Additions to retained earnings

Contd

Balance sheet

Forecast method

Assets

Cash

Short-term investments

Inventory

Account receivable (AR)

Total current assets

Net PPE

Total assets

Percent of sales

Plug: zero if operating assets are

greater than sources of funding;

otherwise, it is the amount required

to make the sheets balance (i.e., the

excess of funding over operating

assets)

Percent of sales

Percent of sales

Calculated: Cash + Short-term

investments + Inventory + AR.

Percent of sales

Calculated: Total current assets +

Net PPE.

Account payable (AP)

Accrued expenses

Short-term debt

Long-term debt

Total liabilities

Common stock

Retained earnings

Total common equity

Total liabilities and equity

Contd

Percent of sales

Percent of sales

Plug: zero if sources of funding are

greater than operating assets;

otherwise, it is the amount required

to make the sheets balance (i.e., the

excess of operating assets over other

funding).

Calculated: AP + Accrued expenses

+ Short-term debt.

Percent of operating assets

Calculated: Total current liabilities +

Long term debt.

Constant (same as previous year)

Calculated: Prior years retained

earnings + (Net income - Projected

dividends).

Calculated: Common stock +

Retained earnings.

Calculated: Total liabilities +

Common equity.

Estimating Value

Value = PV of CF during explicit period + PV of CF

after explicit forecast period

ROCE=Earning / CSE

= RNOA + (FLEV X SPREAD)

Interest expense and MI

Level 1

RNOA= OI / NOA

=*ROOA + (OLLEV x OLSPRREAD)

Level 2

Level 3

PM = OI / sales

Sales PM

Ratio

Dell, Oracle,

HUL, GM,

MICROSOFT

Other items PM

Ratios

liability turnovers

Borrowing cost

drivers

Earnings = Comprehensive income, CSE = Common shareholders equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial

expenses, NFO = Net Financial obligations.

Ratios:

ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability

leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset

turnover

Performance Indicators

Leverage : pipelines, utilities, hotels

Low leverage : business services, printing and publishing and chemicals

Low leverage but high operating leverage : business services

High financial and operating leverage : airlines, trucking

High margins and high turnovers : printing and publishing and chemicals

Low turnovers and high margins : pipelines, shipping, utilities and communications

High turnovers and low margins : food stores, apparels, retail stores

Industry

Automobiles

efficiency

Beverages

innovation

Sales

Cellular phones

Computers

Fashion clothing

Internet commerce

Production efficiency

Margins

Pharma

Sales

Retail

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