FINANCIAL STATEMENT

ANALYSIS VALUATION
EASTON
&
McANALLY 5e SOMMERS ZHANG

MODULE 13
Cash-Flow-Based
Valuation

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 Learning Objective 1

Identify equity valuation models

and explain the information
required to value equity securities.

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 Dividend Discount Model

 Equity investments involve two types of payoffs:

1. Dividends received while the security is owned and
2. Capital gains when the security is sold.
 Since the future stock price is, itself, also assumed to be related
to the expected dividends that the new investor expects to
receive, the expected receipt of dividends is the sole driver of
stock price under the Dividend Discount Model.
 As a practical matter, however, the model is not always useful
because many companies that have a positive stock price have
never paid a dividend, and are not expected to pay a dividend in
the foreseeable future.
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 Discounted Cash Flow (DCF) Model

 The most widely used model to estimate the value of

common stock is the discounted cash flow (DCF) model.
 The DCF model takes as its fundamental input variable, the
expected free cash flows to the firm, which are defined as
operating cash flows net of the expected new investments
in net operating assets (such as property, plant and
equipment) that are required to support the business.
 The DCF model first estimates the value of the company
(the enterprise value) as the present value of the expected
free cash flows to the firm and, then, determines the
shareholders’ portion, or the equity value as the enterprise
value less the value of the company’s debt.
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 Residual Operating Income (ROPI) Model

 The residual operating income (ROPI) model uses both

net operating profits after tax (NOPAT) and the net
operating assets (NOA) to determine equity value.
 This approach highlights the importance of return on
net operating assets (RNOA), and the disaggregation of
RNOA into net operating profit margin and NOA
turnover.

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 Model Equivalency
 When the DDM was introduced in Module 12, it was
based on the following relation:
 Both the DCF and ROPI models derive from this basic
starting point and are, therefore, mathematically
equivalent.

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 Learning Objective 2

Describe and apply the

discounted free cash flow model
to value equity securities.

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 Discounted Cash Flow (DCF) Model

 The discounted cash flow (DCF) model defines firm

value as follows.

 The expected free cash flows to the firm include cash

flows arising from the firm’s operating activities.
 Importantly, free cash flows to the firm do not include
the cash flows from financing activities.

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 Free Cash Flows to the Firm (FCFF)

 A common definition of free cash flow is operating

cash flows less capital expenditures (CAPEX).
 In this definition, “operating cash flows” is not equal to
net cash flows from operating activities reported in the
statement of cash flows because the latter begins with
net income which includes both operating activities
and nonoperating income and expense (like interest).

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 Two Equivalent Definitions of FCFF

 The following table shows the definition of free cash flow

commonly found in finance textbooks.
 The table also shows that this definition is approximately
equivalent to:

where
 NOPAT = Net operating profit after tax
 NOA = Net operating assets

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 Steps in Applying the DCF Model

 Application of the DCF model to equity valuation involves

five steps:
1. Forecast and discount FCFF for the horizon period.
2. Forecast and discount FCFF for the post-horizon period, called
terminal period.
3. Sum the present values of the horizon and terminal periods to yield
firm (enterprise) value.
4. Subtract net nonoperating obligations (NNO), along with any
noncontrolling interest (NCI), from firm value to yield equity value.
 If NNO is positive, the usual case, we subtract it in Step 4;
 If NNO is negative, we add it. (For many, but not all, companies, NNO is positive
because nonoperating liabilities exceed nonoperating assets.)
5. Divide firm equity value by the number of shares outstanding to
yield stock value per share.
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 Illustrating the DCF Model
— Procter & Gamble —

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 P&G’s WACC

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 Extending the DCF Model

 The illustration makes several assumptions that can be refined

to derive more precise stock values.
 Horizon Period. The illustration uses a relatively short horizon period. It might
be more reasonable to anticipate growth for longer than four years before
the company settles into a long-term growth of 1%, as in our example.
 Growth Rate. The illustration assumes that growth rate increases from 1% to
2% after the first year of the horizon period. As an alternative, we can alter
these, even having different rates for each year.
 Financial Statement Forecasts. The illustration uses a parsimonious method
to multiyear forecasting to focus attention on the valuation process. As an
alternative, we can prepare detailed year-by-year forecasts of the income
statement and balance sheet to derive NOPAT and NOA, respectively.
 Terminal Growth Rate. This rate reflects all future FCFF beyond the forecast
horizon, which is captured in terminal value. and many valuations are
sensitive to variations in terminal growth rate.
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 Price Sensitivity to WACC and Growth

 WACC. The illustration uses only one set of

assumptions and derives only one stock price.
 To refine our valuation we can perform sensitivity
analyses.

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 Price Sensitivity to NOPM and NOAT

 By varying the NOAT and NOPM assumptions in the

same manner as for growth and WACC, we can gauge
the price sensitivity to these estimates.

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 Price Sensitivity to NOPM and NOAT

 Alternatively, we could vary assumptions in percentage

terms instead of percentage points.

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 Mid-Year Adjustment

 Payoffs in our valuation model are assumed to

occur at year-end and are discounted for the
entire year.
 An alternative is to assume that payoffs occur
evenly during the year.

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 Reverse Engineering

 One alternative to sensitivity analysis is to use

reverse engineering in an attempt to “unlock”
the market’s assumptions in determining price.
 The process of reverse engineering uses
observed price combined with valuation
assumptions to solve for one of the valuation
parameters such as WACC or terminal growth
rate.

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 Summary of DCF Model

 The DCF model is frequently used in valuation due to the appeal

of relying on actual cash flows; a readily understandable concept.
 However, it is not possible to forecast cash flows without also forecasting
accounting numbers because cash flows and accounting accruals are
simultaneously determined.
 A serious implementation issue with DCF is the choice of forecast
horizon and terminal growth rate.
 The farther out the forecast horizon, the less reliable forecasts tend to be.
 Still, we demand a long enough forecast horizon to reach steady state so
we can identify an appropriate terminal growth rate.
 This balance can make cash-flow-based valuation a difficult process to
implement as FCFF often requires a very long horizon.
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The End