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Analyst thinks the product sell decently this year so picked 10% growth rate.
You think the product will grow faster than the analyst thinks, so you go 12%
So whats left?
We know what our revenue and costs will be over the next 5 years, we know NWC and the depreciation and CapEx. Weve reached free cash flow, but we need to figure out what the cash flows are worth today. We need to discount them back to the future. But what discount rate do we use? How do we find an discount rate that reflects the diversity of risk within our specific company?
Essentially: How much return all of our financiers get = How much return the equity holders demand * weighting of equity + How much return the debt holders demand/get * weighting of debt
Cost of Debt
In order to find what the company pays to its debt holders, we should find what the weighted average interest rate for their debt is (on the 10-K) We then weight the average interest rate they pay (by multiplying it by what percentage of their capital comes from debt capital) then multiply it again by (1-tax rate) to adjust for the tax deductibility of interest expense. (Average Interest Rate * %debt) * (1-tax Rate)
Cost of Equity
Market Premium = Return in the Equity market (Rm) Risk-Free Rate (Rf)
Essentially how much an extra return an investor gets for taking on equity risk.
Can take a 5-20 year average of S&P or DOWs returns or just a 1 year.
It increases, since now in order to compete for financing dollars through equity, the company must effectively yield more returns to entice investors.
WACC
So what is the calculation for it?
WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity
How much a company pays out on its debt (its interest rate), adjusted for how much debt it holds
How much a company return to equity holders (by dividends or share price appreciation) in order to entice people to invest in its equity
STOP!
We just learned how to calculate WACC, the value we will be using for our discount rate. IT IS IMPERATIVE YOU YELL AT ME AND ASK QUESTIONS!
Discounting
We use the PV equation to discount each cash flow back to its present value. Remember: PV = (FV/ (1+ Discount Rate) ^ years away)
Discounting
Were still missing part of the value of the company, the company wont stop functioning after 5 years, technically we need to do this for the entire life of the company to find what the company is worth. We call the estimation of a companys cash flows from t=5 to t= infinity its terminal value
Critical Thinking
If were taking the PV of an infinite number of years cash flows, shouldnt the PV end up being infinity?
No- as you get further and further into the future, a dollar becomes worth less and less until it eventually becomes worth nothing. If I offer you $1 100 years from now, it will cost more to buy a post-it note to remember I owe you money than the PV of $1
Terminal Value
2 ways to calculate this:
Exit Multiple Approach Long-term growth rate approach
12%
3%
Problems you may encounter: In companies with low WACC, this makes the terminal value VERY high, making this method ineffective.
So
At this point weve figured out how to forecast a companies revenues and costs to get to free cash flow. After this, we discount the cash flows and a terminal value back to the present value using our WACC as a discount rate. So now we have a pile of PVd cash, and need to figure out a share price from this.
We do this
By turning this lump of cash into its enterprise value (more on this next slide), then figuring out equity value from this through some simple algebra.
Enterprise Value
We need to discuss another way to measure the size of a company. Previously we said market cap was a way to size a company (Price * shares outstanding) But this had the issue of not taking into account the debt that was used to fund a company. We adjust for this problem by calculating Enterprise Value
Enterprise Value
EV is essentially the amount of money you would have to pay to take over a company, buying all of its debt and equity.
EV = Market Cap + Debt Cash +Preferred Shares + Minority Interest
We take out cash because when we buyout a company, we are paying cash for cash, which cancels out.
So essentially, we are left with Market Cap after taking out all the debt and stuff from our big pile of PVd cash. Since market cap is just Price * shares oustanding, we divide the remainder of the PVd cash (after everything else is taken out) by shares outstanding to get an implied share price.