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1 Steps For Valuation
1 Steps For Valuation
1 Steps For Valuation
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Agenda
• Why Valuation?
– To help you understand why study this course
– What is output of your project?
• What matters in valuation?
– What are the required inputs for your project
• Discounted Cash Flow (DCF) approach
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Important to Note
• Some concepts from Book
– Valuation: Measuring and Managing the Value of
Companies, 7th Edition [2020]
– McKinsey & Company Inc., Tim Koller, Marc
Goedhart, David Wessels
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Why Valuation
“Financial crises occur when people make bad
valuations” [KGW, 2020]
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Why Valuation?
The value maximization game
Capital allocation (investor perspective)
• Which firms/industries/asset classes will have the best growth?
• Where can money be best put to use?
Capital allocation (corporate perspective)
• Invest in growth or pay back money to investors?
• Sell assets/Restructure?
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More on Value
A firm does not have a value in its own right
• what we value is the ownership of a share in the company
• The right to make decisions (control rights)
• The right to receive future dividends (cash flow rights)
Risks
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What matters in Valuation?
[1. Cash Flows]
The lazy view:
• “The value of an asset equals what somebody is willing to
pay for it”
• YOU RISK OVERPAYING FOR THE ASSET!
Other perspective:
• Value is determined by expected future cash flows…
• The conservation of value principle (KGW, 2020):
• “Anything that doesn’t increase cash flow doesn’t
increase value”
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What matters in Valuation?
[2. Risk]
There is always a competing investment opportunity
• Investors like expected return…
• … but they do not like risk (unless appropriately compensated)
The compensation for risk that investors require constitutes the firm’s cost of capital
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Important to note
Application of valuation
• The principles of valuation (cash flows and risk) hold for any
asset
• For example:
• Real estate, bonds, paintings, and so on
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Techniques for valuation
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BUILDING BLOCKS OF DCF
VALUATION
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Discounted Cash Flow (DCF)
Required Output = Intrinsic value per share
Three basic
variables in DCF
valuation
Analytical adjustments:
• Reverse/exclude all non-core, extraordinary and financial items
from the firm’s earnings- statement
• Examples: gain/loss on asset sales, amortization of goodwill,
interest expenses
• Make the corresponding adjustments to the tax expense (to
obtain operating taxes)!
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NOPLAT
Net Operating Profit Less Adjusted Taxes
Operating revenues
less Operating costs
less Depreciation
= Operating profit (EBITA)
less Operating taxes
= NOPLAT
Notes: Non-operating revenues and costs have been excluded, as has been Finance
items (interest expense, etc). The operating tax expense corresponds to the net of the
remaining operating revenues and costs.
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Invested Capital (IC)
• IC represents the amount of capital that has been invested
in the company’s core operating assets
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Invested Capital (IC)
Key operating assets included in IC
• Plant, property, and equipment
• Accounts receivables
• Inventories
• Operating cash
• Deferred costs (prepaid asset)
Key operating liabilities subtracted
• Accounts payables
• Deferred income (prepayments from customers)
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Free Cash Flow to Firm
• FCFF is the cash flow from core operations
after deducting required investment outlays
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Free Cash Flow vs Net cash flow
• FCFF is a measure of the surplus cash flow that
could potentially be paid out to investors
– Based on operating and investing activities
• Cash generated through operations
• Effectiveness and efficiency of operations
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Calculating Free Cash Flow to Firm
Direct Method [Using Cash Flow Statement]
Free cash flow = Cash flow from operations – Capital
expenditures [Simplest – assuming 100% equity]
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Calculating Free Cash Flow to Firm
Indirect Method [Deriving the FCFs]
Start with Net Income or Operating Income [NOPLAT]
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Unlevered vs Levered Free Cash Flows
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Unlevered vs Levered Free Cash Flows
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Unlevered vs Levered Free Cash Flows
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Unlevered vs Levered Free Cash Flows
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FCFF
Cash Flow Statement and Income Statement
Using Cash Flow from operations
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FCFF
Income Statement and Balance Sheet
Using EBIT (Operating Income)
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FCFF
Income Statement and Balance Sheet
Using Net Income
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Value Drivers of FCFs
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3 more concepts in DCF valuation
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Why a cost of capital (WACC)?
• WACC is a measure of the firm’s cost of capital
– We use it as a discount rate…
– …to adjust future cash flows for risk
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Discount rate
Weighted Average Cost of Capital (WACC)
D E
WACC rd 1 t re
D E D E
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Return on Invested Capital (ROIC)
• ROIC is defined as:
– NOPLAT/IC
EP = IC · (ROIC – WACC)
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Why Economic Profit (EP)
• EP is a direct measure of the shareholder value
that is generated in a particular period
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VALUATION BY DCF
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DCF Valuation
• The value of an asset is
– the sum of the present value of its forecasted expected
free cash flows
FCFFt
Value of asset t0 t
t 1 (1WACC)
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Two-stage valuation models
• To increase precision (accuracy) in the valuation, it is
often divided into two (or more) steps
Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value
Net Debt
Equity Value
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Equity Cash Flow, Debt Cash Flow, Free
Cash Flow and
Cost of Equity, Cost of Debt and WACC
Value of Equity
Equity Cash Flow and Value of Equity :
PV of Cash Flows at
Dividends less Equity Issued Cost of Equity
+ +
Value of Debt
Debt Cash Flow and Market Value of Debt :
PV of Cash Flows at
Net Interest plus Net Debt Payments Incremental Cost of Debt
= =
Value of Enterprise
Free Cash Flow:
PV of Cash Flows
EBITDA – Op Taxes – Cap Exp – WC Chg At WACC
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Terminal Value in Corporate Model
Year after explicit
period to establish
stable cash flows
Gordon’s
CFt x (1+g)/
(WACC-g)
Explicit Forecast
History Terminal Value EV/EBITDA
Period that Reflects
PV of Cash Long-term
Growth Rate
Year t Infinity and ROIC
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The 2-stage FCFF model
FCFFt n1
t n
FCFFt kw g n
Vt 0
t 1 1 k w 1 k w
t n
• Where:
• kw = WACC = weighted average cost of capital
• g = growth rate (growth in FCFF)
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Valuation of operating assets by DCF,
example
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Enterprise value
• In a DCF valuation of a company, total asset value is
referred to as Enterprise value
– ”Enterprise DCF”
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Non-operating assets
Non-core operating assets
• Equity accounted investments
• (20-50% ownership, influence but not control)
• Investments in business ventures where ownership <20% ownership (no
control, no influence)
• E.g. joint ventures, strategic investments
Financial assets
• Investments in traded securities (shares, bonds, etc)
• Derivative assets (net of derivative liabilities)
• Excess cash (more than what is required for operations)
• And so on
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Quantifying enterprise value
• So: the main present value-calculation focuses on the
core, operating assets of the firm
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Example enterprise value
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Equity value
• To arrive at the value of equity (which is what
we attempt to value), non-equity claims must
be subtracted
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Example equity value
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Steps in DCF-valuation
Carry out analysis of firm and industry (incl. historical performance)
Subtract non-equity claims (debt etc) from enterprise value to obtain equity value
Divide equity value by number of shares outstanding to obtain your estimate of the share price
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