5/19/2021

SECURITY ANALYSIS & BUSINESS VALUATION

FIN306

Dr DUC HONG VO
The University of Western Australia
Australian Energy Regulator

Chapter 12

Valuation:
Cash –Flow- Based
Approaches

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Valuing the Firm

Economic theory teaches us that the value of an
investment is:
n
Projected Future Payoffs t
V0 = 
t =1 (1 + Discount Rate)t
Expected future payoffs can be measured in
terms of:
 Dividends
 Cash Flows
 Earnings
Chapter: 12 3

Approaches to firm valuation

Chapter: 12 4

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Cash-Flow-Based Valuation
 Focus is on the cash that flows into the firm.
 Measures the cash flows that are “free” to be
distributed to shareholders.
 Cash flows generated by the firm create
dividend-paying capacity.

Chapter: 12 5

Cash-Flow-Based Valuation (Contd.)

 Amount of cash flowing into firm differs from
dividends paid in a particular period.
 But over the lifetime of the firm, cash flows
into and cash flows out of the firm will be
equivalent.

Chapter: 12 6

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Rationale for Using Free-Cash-Flows

• Cash is the ultimate source of value. The
free cash flows approach measures value
based on the cash flows that the firm
generates that can be distributed to
investors.
 It is a measurable common denominator
for comparing the future benefits of
alternative investment instruments.
Chapter: 12 7

Cost of Common Equity Capital

CAPM Model:
E[R Ej ] = E[R F ] + ß j  {E[R M ]–E[RF ]}

Where :
E = expectatio n
REj = Required return on common equity in firm j
RF = Risk - free rate of return
ß j = Market beta for firm j
RM = Required return on marketwide portfolio
Chapter: 12 8

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Weighted Average Cost of Capital

RA = [wD  RD  ( 1–tax rate)] + [wP  RP ] + [wE  RE ]

Where :
wD + wP + wE = 1
R is cost of each type of capital
w is proportion of each type of capital
Tax rate is rate applicable to debt costs

Chapter: 12 9

Measuring Free Cash Flows

 Under U.S. GAAP and IFRS, Cash flow
statement categorize the activities as
operating, investing and financing.
 Some rearrangements are necessary to
compute free cash flows.

Chapter: 12 10

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Measuring Free Cash Flows (Contd.)

• Cash flow from operations from the
projected statement of cash flows is the most
direct starting point because it requires the
fewest adjustments.
• However, some analysts compute free cash
flows using alternative starting points.

Chapter: 12 11

Measuring Free Cash Flows

• Free Cash Flows for All Debt and Equity Stakeholders:
Operating Activities:
Cash Flow from Operations
+/- Net Interest after Tax
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for All Debt and Equity

Investing Activities:
+/- Net Capital Expenditures
= Free Cash Flows for All Debt and Equity Stakeholders

Chapter: 12 12

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Measuring Free Cash Flows

• Free Cash Flows for Common Equity Shareholders:
Operating Activities:
Cash Flow from Operations
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for Equity
Investing Activities:
+/- Net Capital Expenditures

Financing Activities:
+/- Debt Cash Flows
+/- Financial Asset Cash Flows
+/- Preferred Stock Cash Flows
= Free Cash Flows for Common Equity Stakeholders

Chapter: 12 13

Cash-Flows-Based Valuation Models

 To value common equity measure:
 Discount rate – RE .
 Expected future free cash flows – FCFEq for
periods 1 through T over forecast horizon.
 Continuing free cash flows, FCFEq(T+1), and long-
run growth rate, g.

Chapter: 12 14

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Free-Cash-Flows-Based Valuation Models

 For common equity shareholders:

T 
FCFE t 
V0 =   t
+ [FCFE T +1 ]  [ 1/(R E –g)]  [ 1/( 1 + RE )T ]
t =1  ( 1 + RE ) 

Where,
V0 = Present value of the common equity of a firm
FCFE = Free cash flows for common equity shareholde rs
RE = Required rate of return on equity capital
g = Growth rate
Chapter: 12 15

Free-Cash-Flows-Based Valuation Models

• For all debt and equity capital stakeholders:
T 
FCFAt 
VNOA0 =   t
+ [FCFAT +1 ]  [ 1/(R A –g)]  [ 1/( 1 + RA )T ]
t =1  ( 1 + RA ) 

Where,
VNOA0 = Present value of net operating assets of a firm
FCFA = Free cash flows for all debt and equity capital
stakeholde rs
RA = Expected future weighted average cost of capital
g = Growth rate
Chapter: 12 16

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Continuing Value
• Represented by last term of equation:
[FCFAT +1 ]  [ 1/(R A –g)]  [ 1/( 1 + RA )T ]

• Use expected long-term growth rate, g, to

project all items on Year T+1 income
statement and balance sheet.
 RA must be greater than g for this formula to
work.
Chapter: 12 17

What now?
Once valuation model is applied, then
 Conduct sensitivity analysis:
 Vary cost of equity capital rate (RE)
 Vary long-run growth rate (g)
 Discount rate assumptions
 Vary these parameters and assumptions
individually and jointly.

Chapter: 12 18

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Evaluation of the Free-Cash-Flows-Valuation

method
Advantages:
• Focuses on free cash flows, believed to
have more economic meaning than
earnings.
• Results from projections of future
operating, investing, and financing
decisions of a firm made by the analyst.

Chapter: 12 19

Evaluation of the Free-Cash-Flows-Valuation

method
Advantages: (Contd.)
• Focuses directly on net cash inflows
available to be distributed to capital
providers. This perspective is especially
pertinent to acquisition decisions.
• Widely used in practice.

Chapter: 12 20

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Evaluation of the Free-Cash-Flows-Valuation

method
Disadvantages:
• Can be time-consuming making it costly.
• Continuing value tends to dominate the total
value but is sensitive to assumptions growth
rates and discount rates.
• Free cash flow computations must be
internally consistent with long-run
assumptions regarding growth and payout.
And is affected by estimation errors.

Chapter: 12 21

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