Corporate Finance & Valuation Methods

Professional Certificate

Discounted Cash Flow (DCF) and Other Valuation Methodologies

Discounted Cash Flow (DCF) and Other Valuation
Methodologies

9 •
Overview of Discounted
Cash Flow Methodologies 11
Cash flow projections used in valuation
Discounted Cash Flow
Analyses
• Valuing a company’s equity
models
• Valuing the firm
• Time horizons
• Analysis and critique of discounted
• Choice of discount rate cash flow analyses

10 •
Elements of Cash Flow
Projections 12
Types of cash flows and their projections
Alternate Valuation
Methodologies
• Enterprise value
• Overview of primary financial • Economic profit/economic value
statements added
• Analytic frameworks to support cash
flow projections
• Types of cash flow projections
• Terminal values

A FINANCIAL TIMES COMPANY 2

 Discounted Cash Flow (DCF) and Other Valuation
Methodologies

13 Relative Valuation Techniques

•
•
Valuation multiples
Selecting comparable companies
• Price/earnings (P/E) ratios
• Price/earnings growth (PEG) ratio
• Book multiples
• Enterprise value ratios
• Other valuation ratios

A FINANCIAL TIMES COMPANY 3

 Learning Objectives

By the completion of this lesson, you will be able to:

• Explain importance of cash in company valuation
• Demonstrate how different qualitative factors impact on value
• Discuss alternative valuation methods
• Calculate free cash flow forecasts
• Calculate the terminal value of a business
• Calculate the enterprise and equity value of a business
• Discuss behavioral issues in forecasting cash flows
• Describe the components of the widely used valuation ratios and
how they are employed in assessing relative value

4
 Module 9

Overview of Discounted
Cash Flow Methodologies

A FINANCIAL TIMES COMPANY 5

Company/Equity Valuation
• Primary approaches to valuation
• Cash flows
• Asset/liquidation value

• Cash flow valuation

• Rationale
• Candidates for cash flows to be valued
• Dividends
• Earnings
• Free cash flow (to the firm or to the equity holders)
• Issues complicating cash flow valuation
• Time pattern of cash flows
• Accuracy of forecasts
• Risk of future cash flows
• Discount rate to use in valuing future cash flows

6
Discounted Cash Flow (DCF)
Valuation
• Rationale for use of free cash flows
• Complications with using dividends
• Complications with using earnings
• Free cash flows

• Appropriate discount rate

• Valuation based on cost of capital needed to finance investment
• Free cash flow to equity holders – cost of equity capital (ke)
• Free cash flow to the firm – weighted average cost of capital
(WACC)

7
Discounted Cash Flow Valuation

CF1 CF2 CF3 CF∞

Price (PV) = + + +! +
(1 + k)1 (1 + k)2 (1 + k)3 (1 + k)∞

CFN = Cash Flow at time N

Exponent/Subscript = Timing of cash flow
k = Discount rate (interest rate)

Conceptually the same as bond pricing, the price

equaling the present value of the future cash flows

8
Dividend Discount Model (DDM)
• Analogous to bond pricing
• Price should reflect the present value of future cash flows to security
holder
• Dividend payment used in place of bond coupons
• What about principal at maturity? Equities priced as perpetuities

• DDM is based on value of dividends to infinity

• Difficulty of forecasting dividends very far into future
• DDM resolves issue by making assumptions regarding future
dividend growth
• No growth model
• Constant growth model
• Variable growth model

9
Dividend Discount Model

D1 D2 D3 D∞
Value = 1
+ 2
+ 3
+!+
(1+k1 ) (1+k2 ) (1+k 3 ) (1+k∞ )∞

DN = Dividend paid at time N

kN = Discount rate for time N. Equals the risk-free

rate plus an equity risk premium.

10
Dividend Discount Model
No Growth Model
• Assumes k and d constant over time
D1
Value =
k
Example:
$4 per share annual dividend; 10% annual discount rate
D1 = $4/shr k = .1
$4.00 / shr
Value = = $40.00 / shr
0.1

• Typically only used for valuing preferred stocks

11
Dividend Discount Model
Constant Growth Model
• Assumes k constant and d growing at a constant rate.
DN+1 = D1 × (1+g) where g is the constant rate of
dividend growth.
D0 ×(1+ g) D1
Value = =
k-g k-g

Example: $4/share dividend (payable year end), growing at

an 8% rate, 12% annual discount rate.
D0 = $4 g = .08 k = .12

4 ×1.08 $4.32
Value = = = $108.00 / shr
.12−.08 .04

12
Dividend Discount Model
Constant Growth Model

D0 ×(1+ g) D1
Value = =
k-g k-g
Apple Inc. dividend - annual % increase 2012-2018:
to: 2013 2014 2015 2016 2017 2018 Annual average
15.1% 7.9% 10.6% 9.6% 10.5% 15.9% 11.57%

Last 4 quarters per share dividends: $2.7 k = 13%

2.72×1.1157 $3.0347
Value = = = $212.22 / shr
.13−.1157 .0143

k = 14% $124.88
13
Growth Rate (g) in Constant
Growth Variant of DDM
• Appropriateness of assuming a constant growth rate
• Many companies have maintained relatively stable dividend
growth rates for protracted periods of time
• Likely candidate companies for use of constant growth DDM

• Forecasting growth rates

• Historic averages
• Use return on equity to estimate sustainable growth rate

• Ascertaining sustainability of growth rate

• Growth relative to GDP
• Sector and industry life-cycle stage

14
Sustainable Earnings Growth Rate

g = (1 - dividend payout ratio) × ROE

• Where:
• ROE = expected return on equity
• Dividend payout ratio = percentage of earnings expected to be paid
as dividends. (1 - dividend payout ratio) is also called the retention
rate. Many source use b to represent the retention rate, in which
case: b × ROE = g

• This is the growth rate that a firm can sustain relying

solely on internally generated funds (i.e. funding growth
via retained earnings)

15
Constant Growth DDM
• Factors complicating use of constant growth DDM

• Dividend-related issues
• Company pays no dividend
• Dividends per share changing over time

• Growth rate-related issues

• Questionable assumption of constant growth forever
• Nonsensical result of model unless g < k

• Risk-related issues
• Will risk remain constant?
• Risk-free rates and equity risk premiums change over time

16
Dividend Discount Model – Variable
Growth Model
• Assumes g and k vary over initial, periods followed by
constant g and k, d0=$4.00/share
DN ×(1+ g constant )
D1 D2 DN 1+ k constant
Value = 1
+ 2
+!+ N
+
(1+ k 1 ) (1+ k 2 ) (1+ k N ) (1+ k constant )N+1

Growth rates and discount factor - year one through year 5 and beyond
Growth rates Discount rates
Year One 30% 25%
Year Two 40% 20%
Year Three 25% 18%
Year Four 20% 16%
Year Five 15% 14%
Year Six + 8% 12%

17
Dividend Discount Model – Variable
Growth Model
D1 = D0 ×1+ g1 = 4 ×1.3 = 5.20
D2 = D1 ×1+ g2 = 5.20 ×1.4 = 7.28
D3 = D2 ×1+ g3 = 7.28×1.25 = 9.10
D4 = D3 ×1+ g 4 = 9.10 ×1.2 = 10.92
D5 = D4 ×1+ g5 = 10.92×1.15 = 12.56
D6 = D5 ×1+ gc = 12.56 ×1.08 = 13.56
13.56
5.20 7.28 9.10 10.92 12.56 .12−.08
Value = 1
+ 2
+ 3
+ 4
+ 5
+
(1.25) (1.20) (1.18) (1.16) (1.14) (1.08)6
= 4.16 +5.06 +5.53+6.03+6.52+213.67
= 240.98
Total differs from sum of figures due to rounding
18
Dividend Discount Valuation Exercise
• Calculate the value of the class case company based on its
current dividend and your expectations of dividend growth
• Do this alone, and then pair off with someone else to discuss
your results

19
 Module 10

Elements of Cash Flow

Projections

A FINANCIAL TIMES COMPANY 20

Corporate Cash Flows
• Cash flow
• Definition
• Cash flow versus earnings
• Reasons for use of cash flow rather than dividends or earnings
• Common cash flow measures
• Traditional: net income plus non-cash expenses
• Widely cited
• Potential problems if not used with care
• Cash flow statements
• Operating cash flows
• Cash flows from investment activities
• Cash flows from financial activities
• Free cash flow
• Free cash flow to the firm
• Free cash flow to the equity holders

21
Free Cash Flow
• Free cash flow
• General definition/description
• Reason free cash flow is the basis for valuation
• Free cash flow for the firm (FCF)
• Cash flow available to all the suppliers of firm’s financial capital
• Equity holders – common and preferred stock holders
• Debt holders – bondholders and other lenders (e.g. banks,
finance companies, etc.)
• Others – equipment lessors, owner’s of leased properties held
under long term leases
• FCF is not found on a single line in any financial statement
• Computed by adjusting earnings or cash flow from operations
• Computed on a pre-tax basis
22
Free Cash Flow

• Free cash flow to the equity holders (FCFE)

• Residual cash flow after payments to the other providers of capital
• Computed on an after-tax basis

• Either FCF or FCFE may be used as basis for valuation

• FCF (sometimes FCFF) is used for valuing the company
• FCFE is used for valuing the equity

• Discount rate depends on cash flow being used

• FCF should be discounted by the WACC
• FCFE should be discounted by the cost of equity capital
• Claims of preferred shareholders on FCFE

23
Free Cash Flows
• Free cash flow determination
• FCF and FCFE can each be computed from multiple starting points
• Necessary adjustments differ depending on the starting point
• Cash available to each group of claimants differs
• Pre and post tax position of claimants

Starting
FCFF FCFE
from

+ noncash charges + noncash charges

+ interest expense (1 – tax rate) + net borrowing
NI - net investment in fixed capital - net investment in fixed capital
- net investment in working - net investment in working capital
capital (excl. cash & ST loans) (excl. cash & ST loans)

+ interest expense × (1 – tax rate) + net borrowing

CFO
- net investment in fixed capital - net investment in fixed capital

24
Free Cash Flows
Starting
FCFF
from
EBIT × (1 – tax rate)
+ noncash charges
EBIT
- net investment in fixed capital
- net investment in working capital
EBITDA × (1 – tax rate)
+ (depreciation × tax rate)
EBITDA
- net investment in fixed capital
- net investment in working capital
FCFE
EBIT × (1 – tax rate)
+ noncash charges
- net investment in fixed capital
- net investment in working capital
- interest expense (1 – tax rate)
+ net borrowing
EBITDA × (1 – tax rate)
+ (depreciation × tax rate)
- net investment in fixed capital
- net investment in working capital
- interest expense (1 – tax rate)
+ net borrowing
25
Projecting Free Cash Flow
• Forecasting free cash flow requires making numerous
assumption
• Sales/revenues
• Profits
• Working capital
• Fixed investment (capital expenditure/CAPX)
• Capital structure
• Other
• Sales/revenue projections
• Domestic/global economic environment
• Industry growth prospects and competitive environment
• Company specific issues

26
Projecting Free Cash Flow

• Profits
• Relationship between sales and profit margins (operating leverage)
• Tax considerations (e.g. tax rates, carry forwards of losses/credits)
• Working capital
• Positively related to sales changes
• Potential gains to improved operating efficiency
• Fixed investment
• Expenditure necessary to maintain operations
• Planned expansion of capacity
• Projected depreciation would vary with fixed assets, not sales

27
Projecting Free Cash Flow
• Capital structure
• Future (not current) capital structure is basis for valuation
• Cost of fixed and floating rate debt/loans
• Managements stated aims regarding
• Reduction of indebtedness
• Substituting debt for equity
• Resulting impact on financial leverage/sales to net income
relationship
• Other considerations
• Planned acquisitions (and method of funding) or dispositions and
intended use of proceeds
• R&D
• New product impact sales, production/markets costs and profits
• Process innovation impact on costs
28
Projecting Free Cash Flow
• Management’s decision making actions
• Behavioral issues can greatly complicate cash flow forecasts
• Managers’ past behavior likely best guide to their future actions

• Economic and industry circumstances

• Both management and analysts impacted
• Managers subject to pressures
• Competitors, directors and investors
• Excessive optimism during booms
• Excessive pessimism during recessions
• Analysts’ earnings and sales projections
• Heavily colored by recent experience
• Persistent biases in direction of forecast errors

29
Primary Financial Statements Used
for Forecasting Free Cash Flow

• Major financial statements

• Balance sheets

• Income statements

• Cash flow statement

• Relationship between statements

30
Relationship Between Primary
Financial Statements

Income Statement
2018

Balance Sheet Balance Sheet

2017 2018

Cash Flow Statement

2018

31
Balance Sheet

ASSETS LIABILITIES
Things owned Things owed
(future benefits (future obligation
to firm) to others)

EQUITIES
Owner’s interest

32
Income Statement

REVENUES - Received value - net assets acquired

for provision of products or services

- EXPENSES - Gone assets - assets used/consumed

in connection with earning revenues

PROFIT

33
Cash Flow Statement
CASH FLOW FROM OPERATIONS
Net income (loss)
+ Non-cash expenses
- Gains on asset sales and investments
+ Losses and reserves increases
-/+ Increase/decrease in current assets
CASH FLOW FROM INVESTING ACTIVITIES
+ Asset sales proceeds
+ Investment sales and maturity proceeds
- Investment in business assets
- Investment in securities
CASH FLOW FROM FINANCING ACTIVITIES
+ Securities (debt and equity) issuance proceeds
- Redemption (maturity or call) cost of debt securities
- Equity securities redemption (e.g. stock buy backs)
- Dividend distributions

34
Alternative Bases of Value
EBIT (earnings before interest and taxes)
Net income + interest + taxes
EBITDA (EBIT plus depreciation and amortization)
Net income + interest + taxes + non-cash expenses
Net income (after tax profits)
Operating profit – taxes
Earnings (available to the common shareholders)
Net income – preferred dividends
Cash flow
Earnings + non-cash expenses
Free cash flow (to the firm – FCF)
Free cash flow to the equity holders (FCFE)

35
Analysis of Financial Statements

• Revenues
• Sources of revenues
• By product line
• By geographic area

• Revenue growth
• Trends over time and versus appropriate benchmarks
• Sources of change
• Analysis of sources of revenue changes

36
Analysis of Financial Statements

• Income statement expenses

• Cost of sales/cost of goods sold (cogs)
• Depreciation
• Amortization
• Research and development
• Selling, general and administrative (sg&a)
• Pension
• Interest

• Other sources of income or gains

37
Income Statement
Gross revenues
- Allowances, discounts and returns
Net revenues
- Cost of sales (or cost of goods sold)
Gross margin (or gross profit)
- Operating expenses
Operating income( or operating profit)
+ Non operating gains (- losses)
+ Investment income or gains (- losses)
- Interest expense
Total Income (income subject to taxes)
- Tax expense (tax adjustment to income)
Net income (or net profit)
- Preferred stock dividends
Earnings
- Common stock dividends
Additions to owner’s equity
38
Gross Profits

GROSS REVENUES - Recognized cash and credit sales revenues

- ALLOWANCES - For uncollectible receivables
- DISCOUNTS - For early payment or volume purchases
- RETURNS - Of products - unsatisfied customer or retainer overstock
NET REVENUES
- COST OF SALE - All costs associated directly to production and
OR distribution of goods/services recognized in
COST OF GOODS SOLD revenues
• Wages
• Materials
• Depreciation
• Amortization
• Energy
• Others
GROSS MARGIN (OR GROSS PROFITS)

39
Operations, Profitability and Return on
Investment

• Profitability analysis
• Gross margin
• Basic considerations
• Gross profit/sales
• Sources of change in gross margins

• Factors impacting gross profit

• Unit sales
• Price per unit sold
• Unit cost

40
Operating Income

GROSS MARGIN (OR GROSS PROFIT)

- SELLING, - Sales Commissions, advertising and marketing expenses
GENERAL - Salaries/wages/benefits of all non-
AND production employees; rental/
depreciation expenses of non-production
ADMINISTRATIVE facilities, furniture and fixtures
EXPENSES
- AMORTIZATION - Gradual recognition of acquisition related expenses
OF GOODWILL

OPERATING INCOME (OR OPERATING PROFIT)

41
Operations, Profitability and Return on
Investment

• Related cost and profit issues

• Fixed costs
• Variable costs
• Contribution margin
• Break even analysis

42
Operations, Profitability and Return on
Investment

• Analysis of profitability measures

• Cash flow versus profit

• Earnings quality

43
Analysis of Financial Statements
• Financial ratios
• Liquidity
• Leverage
• Efficiency
• Profitability
• Return
• Benchmarks
• Industry or comparable companies
• Mean or median ratio values
• Interpretation
• Ratios shouldn’t be basis for valuation
• Divergence from benchmarks flags
• Indicate need to assess related business issues
44
Operations, Profitability and Return on
Investment

DuPont Method

Net Income
Return on Equity (ROE) =
Equity

Return on Net Income Sales Total Assets

= × ×
Equity (ROE) Sales Total Assets Equity

45
DuPont Method: Apple Inc.

Net Income 48.531

Return on Equity (ROE)= = = .3700 = 37.0%
Equity 131.148

Return on Net Income Sales Total Assets

Equity (ROE) = × ×
Sales Total Assets Equity

48.531 229.234 348.502

= × ×
229.234 348.502 131.148

= 21.17%x65.78%x265.73% = 37.0%

46
Forecasting Free Cash Flow

• Analytic frameworks for analysing operating

environment

• PEST(EL) Analysis

• Porter’s Five Forces

• SWOT Analysis

• Company / Product Life Cycle

47
PEST(EL) Analysis

Look at broad external forces that might have an impact on

the company’s operations:

• Political
• Economic
• Social
• Technological
• Environmental
• Legislative or Legal

48
Porter’s Competitive Analysis Five Forces
New Entrants • Barriers to entry
• Internationalisation
Suppliers • Branding

• Concentration

• Switching costs
• Margins COMPANY Buyers
• Information • Concentration

• Product’s importance to cost • “Fickleness”

and quality • Switching costs
• Importance of Company as
• How significant is the
customer Substitutes purchase
• Substitutes? • How many?
• Margins
• How close
• What quality
Source: Porter (1981)
• Outlook
49
SWOT Analysis

• Strengths

• Weaknesses

• Opportunities

• Threats

50
Company/Product Lifecycle

51
Making Financial Projections:
Methodology

• Define the relevant components of FCF

• Develop an integrated historic perspective of the

company’s performance

• Develop financial forecasts and relevant scenarios

(sensitivity analysis)

• Step back and interpret the numbers: Do they seem to

make sense?

52
Company Growth Analysis
• Most challenging aspects of free cash flow forecasts
• Revenue growth
• Change in margins
• Sales forecasts
• External* factors
• Rate of economic growth – nominal gross domestic product
(GDP)
• Industry/sector growth rate
• Internal factors
• Change in market share
• Financial and operating leverage
• Margin forecasts
• Potential operating efficiencies
• Optimizing capital structure

53
Company Growth Analysis
• Free cash flow projections
• Sales forecasting
• By product line/industry sector
• Geographic region
• Margin changes
• Operating efficiencies
• Financial efficiencies

• Example
• Nominal GDP: +3%
• Industry growth rate: 1.5× GDP
• Increase market share: 20% (10% to 12%)
• Efficiency gain of 2%
• (1.045 × 1.2 × 1.02) -1 = .27908 ≈ 27.9%

54
 Working Capital Cycle
CASH

STEP 5
STEP 1
Accounts Receivable
Raw Materials Acquired
Collected
Accounts Payable Created

STEP 4 STEP 2
Finished Goods Sold Work in Progress

SG+A Expenses Incurred Value is Added and

Accounts Receivable Created Expenses Incurred

STEP 3
Finished Goods
Completed Expenses
Incurred

55
Working Capital Cycle and Cash Flows

• Managing working capital is a specialized section of

corporate finance because it can enhance cash flow if done
properly

• For example, inventory and accounts receivable

management can squeeze out extra cash, just by saving
costs on carrying inventory and having someone pay
sooner on their bills.

• We shall discuss some techniques.

56
Operating Environment Exercise
In groups, determine the current operating environment
for a few of the following companies which have been in
the news recently:

• Alphabet
• Anheuser-Busch Inbev
• Apple
• Amazon
• Facebook
• Intel
• Roche Holdings
• Royal Dutch Shell
• Wal-Mart
57
Calculating Free Cash Flow

EBITA (Earnings before Interest & Tax & Amortization)

- ‘Notional Taxes’ at marginal tax rate

= NOPAT (Net Operating Profit after Tax)

+ Depreciation, amortization & other non-cash charges

- Capital expenditures
-/+ Increase (decrease) in working capital

- Other non-operational uses of cash

= Free Cash Flow (FCF)

58
Free Cash Flow Projection Example

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

EBITA $22.70 $29.80 $37.10 $40.10 $42.10

Less: taxes (34%) 7.7 10.1 12.6 13.6 14.3
NOPAT 15.0 19.7 24.5 26.5 27.8

Plus: depreciation 21.5 13.5 11.5 12.1 12.7

Operating cash flow 36.5 33.2 36.0 38.6 40.5
Less:
Change in working capital 12.3 - 1.9 - 4.2 - 5.2 - 6.1
Capital expenditures -10.7 -10.1 -10.4 -11.5 -13.1

Free cash flow 38.1 21.2 21.4 21.9 21.3

59
Forecasting Free Cash Flows:
Key Areas
• Revenues

• Operating Costs

• Taxation

• Working Capital

• Capital Expenditure

60
Sources of Information

• Company’s own business plan

• Analysts’ research reports

• Industry reports

• Own estimates

61
Step Back from the Numbers

• “Sanity Check” on the main components of FCF

• Confront sales growth assumptions with underlying

market industry dynamics

• Check reasonableness of margins:

• Avoid “hockey sticks”

• Beware “spurious accuracy”

62
Calculate Free Cash Flow - Example

Base Case Cash Flows

Firm X's Income Statement

Amount ($MM)
Gross Profit 220
Depreciation -120
Amortization 0
EBIT 100
Tax -37
NOPAT or EBIT (1-t) 63

63
Free Cash Flow - Solution
Gross Profit 220
Depreciation -120
Amortization 0
EBIT 100
Tax -37
NOPAT or EBIT (1-t) 63

In Addition
Capital Expenditures 100
Increase in NWC 10

Free Cash Flow = NOPAT + Depreciation + Amortisation - Increase in NWC - CAPEX

FCF = $63 + $120 - $10 - $100 = $73MM

64
Free Cash Flow Exercise

Calculate the free cash flows for the class case company
over an appropriate forecast period

65
Apple Inc. Financial Data

66
Terminal Value
• Descriptor for value associated with cash flows beyond
period for which explicit forecasts are made
• Also called residual or continuing value
• Usually valued as a perpetuity running from the end of the forecast
horizon
• Will usually account for majority (70-90%) of estimated value

• Assumptions regarding terminal value calculation

• Free cash flow assumption
• Constant
• Growing at a constant rate (more typical)
• Risk assumptions
• Same level to infinity
• Must be greater than the assumed rate of cash flow growth

67
Terminal Value Determination

• Alternative methods or most common approaches (i.e.

constant perpetuity or growing perpetuity)

• Growth then no growth of FCF (i.e. combination)

• Comparable multiples
• Cash beyond forecast period valued via some multiple
• P/E, EV/EBITDA seemingly most commonly used

• Liquidation value as terminal value

• Sometimes used

• Not theoretically appropriate

68
Constant Perpetuity

• For companies in mature industries one can assume

‘steady state’ or no growth in FCFs

• Calculated as the value of a fixed perpetuity:

CFt
TV =
r
• Where, CFt is the FCF in the final year of the forecast

69
Constant Perpetuity
• Implicit assumptions
• Working capital requirements remain constant
• Capital expenditures = depreciation

• Assumes company is simply maintaining current level of

operating activity

• Final period cash flow may need to be adjusted to be

consistent with those assumptions

• Generally perceived as very conservative approach when

using a DCF valuation

70
Growing Perpetuity

• Continuous growth is more typical assumption

• Terminal value is calculated as a growing perpetuity

• For companies in developed economies growth should

be based on long run nominal GDP growth rate

CFt (1 + g)
TV =
r-g

71
Impact of Growth Rates
• Assume you are determining the terminal value.
Three different growth rates have been suggested:

• 3.0%
• 7.0
• 9.0%

• Assume the discount rate to be used is 8.5%

72
Impact of Different Growth Rates

• 3.0%
• 100 × 1.03 / (8.5% - 3.0%) = 103/0.055 = 1,873
• 7.0%
• 100 × 1.07 / (8.5% - 7.0%) = 107/0.015 = 6,294
• 9.0%
• 100 × 1.09 / (8.5% - 9.0%) = 109/-0.055 = -1,982

73
Forecast Periods for DCF Valuations
• DCF valuations usually use same approach as was
illustrated earlier in Variable Growth DDM
• Forecast FCF/FCFE and discount rate for over some time horizon
• Establish terminal value as just discussed

• Length of explicit forecast period

• Typically 3-5 years
• Very difficult to make long run projections (e.g. high-tech or low
entry barriers)
• May be a bit longer for some situations (e.g. regulated utilities or
service industries with high entry barriers)

• Related Considerations
• Industry lifecycle stage
• Economic and political outlook
• Technological considerations vis-à-vis life of operating assets
74
Liquidation Value
• May be appropriate in limited circumstances
• Small operators with a limited asset portfolio
• Projects with limited lives (e.g. mines / oil wells)

• Some liquidation values may be negative

• Extraction industries – land remediation (e.g. strip mining
required replacing the overburden, returning land to original state)
• Nuclear plants – nuclear waste disposal costs
• Such wind-down costs must be reflected to more accurately value
companies
• Legal costs must be estimated in industries for which court cost,
attorneys’ fees and awards of damages have become a regular
feature of the operating environment.

75
Liquidation Value
• Other factors complicating estimates of liquidation value
• Demand for used assets
• Changes in technology
• Effects of inflation

• Reasons liquidation value is usually not appropriate for

terminal value
• Valuing business as a going concern
• Value of saleable assets wouldn’t reflect ability to generate cash
• Developed supplier and/or distribution networks
• Human capital of existing workforce

76
Terminal Value Exercise

• Determine an appropriate continuing or terminal

value for the class case company

• Use your solution (revised as you think appropriate)

for the Free Cash Flow Exercise done previously

77
 Module 11

Discounted Cash Flow

Analyses

A FINANCIAL TIMES COMPANY 78

Discounted Cash Flow Valuation

• Discounted Cash Flow Valuation

• Potential problems with dividend discount models
• Discounting cash flows to company
• Do markets focus on dividends or earnings?
• Earnings versus cash flows
• Different cash flow measures
• Free cash flow
• Free cash flow available to equity holders
• Appropriate discount rate

79
Discounted Cash Flow

Investment Decisions Cash Flow from

Investments

Management Strategies
Shareholder Value
and Policies

Cost of
Financing Decisions
Financing

80
Rationale for DCF Valuation
• Ownership of business is claim on free cash flows
generated by assets of the business

• Free cash flows are discounted at the business’

opportunity cost of capital

• Only widely used valuation methodology that explicitly

attempts to incorporate all information

• Extremely strong correlation exists between the market

value of a company and its discounted cash flow

81
Characteristics of DCF

• Forward-looking and focuses on cash generation

• Recognises time value of money

• Allows operating strategy to be built into a model

• Reasonableness of values estimates depends on realistic

assumptions and projections

• Best used in the context of scenario analyses to produce a

range of values given different economic conditions

• More an art than a science!

82
Valuation Process
Analyze historical performance

Examine operating environment

and corporate strategy

Forecast free cash flows

Estimate a continuing (terminal) value

Determine and appropriate

discount rate

Calculate and interpret the results

(including sensitivity analysis)

83
Discounted Cash Flow Valuation

FCFE N × (1 + g c )
FCFE1 FCFE2 FCFE N k c - gc
Value = + +! + +
1 2 N
(1 + k 1 ) (1 + k 2 ) (1 + k N ) (1 + k c )N+1

FCFE = Free cash flow to equity holders

= Net income + non cash expenses - capital
expenditures - increases in working capital -
debt repayment + debt issuance

84
Discounted Cash Flow Valuation
Constant Growth Model
• Assumes k constant and FCFE growing at a constant
rate. FCFEN+1 = FCFE1 × (1 + g) where g is the constant
rate of dividend growth.
FCFE0 ×(1+ g) FCFE1
Value = =
k−g k−g
Example: $1,082 of FCFE (realized at year-end), growing at
a 6% rate, 10% annual discount rate
FCFE0 = $1082 g = .06 k = .10

$1082×1.06 $1146.92
Value = = = $28,673.00
.10 −.06 .04

85
Discounted Cash Flow Valuation
Variable Growth Model
• Assumes variable g and k over initial several periods
followed by constant g and k.
FCFN × (1 + g constant )
FCF1 FCF2 FCFN 1 + k constant
Value = + +! + +
1 2 N
(1 + k 1 ) (1 + k 2 ) (1 + k N ) (1 + k constant )N+1

Growth rates and discount factor - year one through year six and beyond
Growth rates Discount rates
Year One 30% 25%
Year Two 40% 20%
Year Three 25% 18%
Year Four 20% 16%
Year Five 15% 14%
Year Six 8% 12%
Year Seven+ 5% 9%

86
Discounted Cash Flow Valuation
Variable Growth Model (continued)
Given FCF0 = 120
FCF1 = FCF0 ×1 + g1 = 120 ×1.3 = 156.0
FCF2 = FCF1 ×1 + g2 = 156 ×1.4 = 218.4
FCF3 = FCF2 ×1 + g3 = 218.4 ×1.25 = 273.0
FCF4 = FCF3 ×1 + g 4 = 273×1.2 = 327.6
FCF5 = FCF4 ×1 + g5 = 327.6 ×1.15 = 376.74
FCF6 = FCF5 ×1 + g6 = 376.74 ×1.08 = 406.88
FCF7 = FCF6 ×1 + g7 = 406.88 ×1.05 = 427.22
427.22
156.0 218.4 273.0 327.6 376.74 406.88 .09 −.05
Value = 1
+ 2
+ 3
+ 4
+ 5
+ 6
+
(1.25) (1.20) (1.18) (1.16) (1.14) (1.12) (1.09)7

= 124.80 +151.67 +166.16 +180.93+195.67 + 230.94 + 5,842.60

= 6,892.77
87
Discounted Cash Flow Valuation
• Impact of terminal value on DCF valuations
• Sensitivity to growth and discount rates to infinity
• Consequence of even 1% change to either rate
• Terminal value and DCF valuation if growth rate was 4%
FCF7 = FCF6 ×1+ g7 = 406.88×1.04 = 423.07
423.07
156.0 218.4 273.0 327.6 376.74 406.88 .09−.04
Value = + + + + + +
(1.25)1 (1.20)2 (1.18)3 (1.16)4 (1.14)5 (1.12)6 (1.09)7
= 124.80 +151.67+166.16 +180.93+195.67+230.94 + 4628.70
= 5,678.87
• Terminal value and DCF valuation if discount rate was 10%
FCF7 = FCF6 ×1+ g7 = 406.88×1.05 = 427.22
427.22
156.0 218.4 273.0 327.6 376.74 406.88 .10 −.05
Value = + + + + + +
(1.25)1 (1.20)2 (1.18)3 (1.16)4 (1.14)5 (1.12)6 (1.10)7
= 124.80 +151.67+166.16 +180.93+195.67+230.94 + 4,384.63
= 5,434.80

88
 Module 12

Alternate Valuation
Methodologies:
Economic Profit and
Economic Value Added

A FINANCIAL TIMES COMPANY 89

Enterprise Value

Present Value of Free Cash Flow Forecast:

+ Present Value of Terminal Value

+ Value of ‘excess cash’
+ Value of non-operating assets
= Enterprise Value

90
Enterprise Value Jargon Alert
• Beware of alternate meanings given to Enterprise Value
• Enterprise Value is sometimes calculated by summing the
market value of a company’s equity and debt (this is a
different use of the terminology)
• DCF is a valuation methodology that assumes true value
should be based on a company’s ability to generate free
cash flows over long time horizons
• Basing a company’s Enterprise value on the market
capitalization of its equity potentially confuses pricing
with valuation
• Many market participants are playing a relative valuation
game (earnings multiples)
91
‘Excess Cash’

• Cash not needed for operations of the business or

growth in working capital requirements
• Deducted at this stage so that you don’t have to worry
about forecasting investment income (often taxed at a
different rate than operating income)
• Make sure that you don’t double count

92
Equity Value

Present Value of Free Cash Flow Forecast:

+ Present Value of Terminal Value

+ Value of ‘excess cash’
+ Value of non-operating assets
= Enterprise Value
- Market value of outstanding debt (incl CVs)
- Market value of preferred shares
= Equity Value

93
Enterprise Value and Equity Value
Exercise
• Calculate the class case company’s Enterprise
Value and Equity Value (most recent year)

94
Economic Profit
• Generic concept of economic profit developed over 100
years ago

• Updated variant used in corporate valuations:

• EVA – Economic Value Added (most popular)
• developed by Stern Stewart, a management consulting firm
• SVA, ShV – Shareholder Value Added

• Uses the same tools as DCF valuation

• Measures the performance of a project or a company over

one period

95
Economic Profit

Main uses:
• Identifying value created (or destroyed) in existing
projects (or company-wide)

• Resource allocation (which projects to support)

• Performance evaluation

• Management incentive plans

96
Characteristics of EVA

• Equivalent to the DCF procedure but makes clear

it is the quality of FCF that matters

• Increasingly used in management incentive

compensation packages

97
Economic Profit Model
Economic Profit Per
Usually WACC is used
Dollar Invested

EVA = ROIC % - Cost of capital % × Capital

‘profit-margin’ % per $ invested

This approach is called the “Spread Method”

98
Alternative Calculation

EVA = NOPAT Cost of capital % × Capital

-

Economic
Earnings - Cost of providing
generated capital

This approach is called the “Capital Charge Method”

99
EP: Example

Opening capital* 300

NOPAT 80
WACC 10%

* Can use opening invested capital (capital employed) or an

average of invested capital over the year

100
EP: Different Methods

Capital charge method:

Opening capital 300 NOPAT 80
WACC 10% Capital charge (30)
[Cap charge = 300 × 10% ] SVA 50

Spread method:
ROCE (NOPAT/Opening capital): 80/300 = 26.7%
Spread (ROCE - WACC): 26.7% - 10% = 16.7%
SVA (Spread × Opening capital): 16.7% × 300 = 50

101
Future Economic Profit

• Economic Profit may be earned in future periods

• The present value of future EP is defined as Market Value

Added (MVA)
⎡ EVA1 EVA2 ⎤
MVA = ⎢ 1
+ 2
+!⎥
⎣ (1 + c) (1 + c) ⎦

• Total Enterprise Value = MVA + Invested Capital

102
Value Using Free Cash Flows

Year 0 Year 1 Year 2 Year 3

Investment
-300
(300 × $1 shares)

NOPAT 80 80 80

Depreciation 100 100 100

Cash Flow 180 180 180

Present Value @ 10% 164 149 135

PV of Future Cash Flow 448

Warranted share price $1.49

103
Using EP Instead of FCF

Year 0 Year 1 Year 2 Year 3

Investment 300 200 100

NOPAT 80 80 80

Capital charge @ 10% -30 -20 -10

Economic Profit 50 60 70

PV of EP @ 10% 45 50 53

Market value added 148

Invested capital 300

Shareholder value 448

104
Issues with Economic Profit

• Economic profit looks at capital from the

manager’s perspective (i.e. book value or
embedded cost) rather than the investor’s
perspective (ie market value/opportunity cost)

105
 Module 13

Relative Valuation
Techniques

A FINANCIAL TIMES COMPANY 106

Relative Valuation Techniques

• Give a sense of the price at which an asset would trade in

the market

• Give a sense of the price an asset might be worth in a

takeover

• A check on DCF valuations

• If DCF valuation is out of line with relative valuation:
• Something is wrong with the DCF valuation, or
• The security is over/under priced in the market

107
Six Commonly Used Market Multiples

1. Price-Earnings (P/E) ratio

2. Price to Earnings growth (PEG) ratio
3. Price to Sales ratio
4. Price to Book ratio
5. Enterprise Value to EBITDA
6. Enterprise Value to Revenues

108
Valuation Ratios

Earnings multiple
Price/earnings = Price
or P/E ratio Earning per share

Cash flow multiple = Price

Cash flow per share
Price
Sales multiple =
Sales per share

109
Valuation Ratios

Price to book ratio = Price

Book value per share

Enterprise Value to EBITDA = EV

EBITDA

Enterprise Value to Revenue = EV

Revenue

110
Advantages

• Easy to Find
• Many investor services now provide the information

• Easy to Apply
• It is simple to put together a ‘comps table’ and come up
with a reasonable estimate of value

• Easy to Understand
• Both sophisticated and unsophisticated investors can
understand relative value

111
Steps in Relative Valuations
Select the comparable companies

Many any necessary adjustments

Calculate the multiples

Interpret the range

Apply to the target company

Interpret the results

112
Step 1: Selecting Comparable
Companies
Issues:
• Riskiness of business
• Scope of product offerings
• Variances in customer base
• Size of the company
• Geographic reach
• Distribution and sales force
• Future growth potential
• Current and future profitability

113
Step 2: Adjusting Comparables’
Financials
• Recurring versus non-recurring income / expenses
• Minority interests
• Impact of outstanding options
• Impact of outstanding convertible securities
• Capitalized versus operating leases
• Equity income from affiliates
• Off balance sheet items

114
Step 3: Calculate the Multiples

• Price Earnings Ratio (P/E)

• Price Earnings Growth Multiple (PEG)
• Price/Sales
• Price / Book Value
• Enterprise Value / EBITDA
• Enterprise Value / Revenues

115
Price Earnings Ratio
• Price/earnings ratios (earnings multiples)
• Calculation
• Current market price per share
• One year’s earnings per share

• Variants
• Historic or trailing P/E
• Forecast or forward P/E
• Coincident or concurrent P/E

116
Price-Earnings Ratios

P/E ratio = Current market price

Earnings per share
Which earning per share (EPS)?

Trailing or historic P/E ratio:

Current market price
Last 4 quarters actual EPS

Forward or forecast P/E ratio:

Current market price
Next 4 quarters estimated EPS

117
Price Earnings Ratio
• Application

• Estimating earnings multiple

• Historical relationships
• Estimating multiple from dividend discount model
• Market and industry relative P/E ratios

• Earnings estimates

• Factors influencing market/stock valuation

multiples

118
Price Earnings Ratio

Using P/E ratios to calculate target price and project

returns
Price T
P / ET =
EPS T-T+1 year

Target priceT = EPST-T+1 year × P/ET

That is, the target price (estimated value) at an identified date

in the future (T) equals the forecasted EPS over the
subsequent year times the projected forward P/E as of time T.

119
Price Earnings Ratio
Target prices and projected returns
Current price Trailing 4q Trailing FCST Forward P/E
(5/10/18) EPS P/E 2019 EPS (2019)
S&P 2885.57 141.31 20.42 172.07 15.52
AAPL 224.29 11.03 20.33 14.84 16.68

10/19 Target price = P/EFY20 × EPS2020

Best: 17.11 × 20 = 342.20 (high EPS estimate, current forward P/E +20%)
Likely: 14.84× 17 = 252.28 (average EPS estimate, ≈ current forward P/E)
Worst: 13.03 × 15 = 195.45 (low EPS estimate, current forward P/E -11%)
Target price - current price
Projected return =
Current price
342.20 – 224.29
Best case: = +52.57%
224.29
252.28 - 224.29
Likely case: = +12.48%
224.29
Worst case: 195.45 - 224.29 = -12.86%
224.29
120
Price Earnings Ratio

• Factors influencing market/stock valuation

multiples

• Relative P/E

• Company to industry (P/E I/M )

• Industry to market (P/E C/I)

• P = EPS × P/E I/M × P/E C/I

121
Price Earnings Ratio

Limitations:

• Does not explicitly define assumptions of risk or growth

• Heavily influenced by current market sentiment
• Not meaningful when earnings are negative
• Difficulties when used for cyclical industries or firms with
high volatility in earnings

122
Price Earnings Ratio

Assume the share price on Nov 1, 2018 is $10.00

Earnings
Year P/E multiple Term used
per share

2017
0.50 20.0× Historic
(past)

2018
0.62 16.1× Estimated
(current)

2019
0.75 13.3× Forecast
(future)

123
PEG Ratios

• More frequently employed when P/E ratios approach

historical highs – means of justifying lofty valuations

• PEG ratio takes account of differences in growth and

can determine ‘relative attractiveness’

124
Price Earnings Growth Multiple (PEG)

• Analyzes company’s P/E in relation to expected earning’s

growth

=
P/E
PEG
GROWTH RATE

P/E Growth PEG

Company A 29 16% 1.81

Company B 18 10% 1.80

125
S&P 500 P/E and PEG Ratios

126
Price / Sales

• Price per share divided by sales or net revenues per share

• Most common used for:

• Privately held companies

• Rapidly growing companies (tech/software, Salesforce.com/CRM)

• Companies with a lot of discretion regarding recognition of

earnings (Amazon/AMZN)

• Typically used in conjunction with other valuation

multiples, often as a sanity check

127
Price / Book Value

• Price per share divided by book value of shareholders’

equity per share

• Widely used in financial services and manufacturing

companies

• Many financial companies must mark-to-market a

substantial portion of their securities holdings

• Reasonable metric of relative value where firms use similar

accounting methods for recording asset values and
recognizing expenses

128
Price / Book Value
Limitations:
• Does not reflect the assets’ earning power and projected
cash flows
• For many assets book value reflects original cost less
accumulated depreciation or amortization
• Book values often diverge dramatically from market values
• Reflects decisions about useful life and method of depreciation
• Would need adjustments to common basis for company
comparisons

• Does not apply to service firms or firms without

significant fixed assets

129
Equity vs Enterprise Value Ratios

• P/E and MV/BV ratios are used in determining the equity

value or market capitalization of a business

• Enterprise Value ratios determine the value of debt +

equity

• To compare an ‘equity ratio’ to ‘enterprise value ratio’,

deduct the value of debt from the enterprise value ratio

130
Enterprise Value / EBITDA

• (Market Capitalization + Debt) / EBITDA

• More appropriate for industries that require a substantial

investment in infrastructure and long gestation periods

• For LBO transactions, EBITDA multiples capture the

ability of the firm to generate cash flows that may be used
to support debt repayments in the short run

131
Enterprise Value / EBITDA

• Allows for comparison of firms with differing financial

leverage

• May be computed even for firms with net losses

• Looks at cash flows prior to capital expenditures

132
Enterprise Value / Revenues

• Unlike earnings, sales multiples are available for even the

most financially troubled firms

133
Enterprise Value / Revenues

Limitations:

• Does not reflect differences in profitability (either gross or

net)

• Does not reflect differences in the ability to generate cash

flows

• Not all industries trade on similar revenue multiples

134
Step 4: Interpret the range

• Look at both the average and the median multiple

• Look at relative multiples

• Consider a company’s multiple versus:
• Its history
• The industry
• The market

135
Step 4: Interpret the range

• How to treat outliers?

• General factors affecting comparable multiples

• Expected revenue growth

• Capital intensity (fixed capital, working capital)
• Risk (event, beta (systematic), financial)
• Current industry trends (consolidation)
• Profitability

136
Step 5: Apply the multiples

Assume the following multiples were calculated using 6

companies in the industry. There were no outliers.

P/E 2017 P/E 2018 MV/BV EV/EBITDA

Average 21.3 19.2 4.5 7.0

Median 23.9 21.2 4.3 7.4

137
Step 5: Apply the Multiples

Exercise—assume the company has:

• Earnings of $45m in 2017, $59.6m in 2018
• Current book value of $250m
• EBITDA of $166.7m

138
Step 5: Apply the Multiples

P/E 2017 P/E 2018 MV/BV EV/EBITDA

Average 21.3 19.2 4.5 7.0

Median 23.9 21.2 4.3 7.4

Company
$45.0 $59.6 $250.0 $166.7
Figures ($m)

Value (avg)

Value (med)

139
Step 5: Apply the Multiples - Solution

P/E 2017 P/E 2018 MV/BV EV/EBITDA

Average 21.3 19.2 4.5 7.0

Median 23.9 21.2 4.3 7.4

Company
$45.0 $59.6 $250.0 $166.7
Figures ($m)

Value (avg) $959 $1144 $1125 $1167

Value (med) $1075 $1264 $1075 $1234

Note: Liabilities must be subtracted from enterprise value to derive equity value.

140
Step 5: Apply the Multiples - Solution

• Enables quick assessment as to whether a company appears

cheap or expensive
• For example, for 2018, valued at the industry median p/e of
21.2, the company would have a value of $1264. If at market
values the company is valued at $1000 and it is perceived
as an average or above average operator relative to its
competitors it seems attractively priced. The company
appears to be worth more than its current market value.
• The open question: which valuation is more accurate, the
market’s or the analyst’s?

141
Benchmarks Multiples
• Industry benchmarks obtained by computing various ratios
on comparable companies.

• Often entail adjusting for different accounting methods

• Cannot always find truly comparable companies

• Ratios deemed most insightful vary by industry and

company circumstances

• Banks and some other financials often judged on price/book

basis

• Rapidly growing privately held companies often valued by

price/sales
142