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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
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.
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
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
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
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
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
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
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
Contd
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.
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
Dell, Oracle,
HUL, GM,
MICROSOFT
Other items PM
Borrowing cost
drivers
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
Automobiles
Beverages
Sales
Cellular phones
Computers
Fashion clothing
Internet commerce
Production efficiency
Margins
Pharma
Sales
Retail