Frameworks for Valuation Flashcards
What Valuation Models are appropriate if the capital structure is expected to stay the same? What discount rate do they use?
DCF and Discounted Economic Profit. WACC.
What Valuation Models are appropriate if the capital structure is expected to change?
adjusted present value (APV) model
List the Items on a typical accounting Income Statement
Revenue
less: Operating Cost
less: Depreciation
gives: Operating Profit (EBIT)
less:Interest Expense
gives:Earnings before Taxes
less:Income Taxes
gives:Net Income
List the Items on a typical statement of shareholders equity
Equity, beginning of year
add: Net Income
less: Dividends
less/add:Share issuance (repurchase)
gives: Equity, end of year
List the Typical items on the income statement that has been rearranged towards NOPAT - Economic Income Statement
Revenue
less: Operating Cost
less: Depreciation
gives: Operating Profit (EBIT)
less: Operating Tax
gives: NOPAT
List how we would reconcile Net Income and NOPAT
Net Income
add: Interest Expense
less: Interest Tax shield
gives: NOPAT
-> expenses are added and gains subtracted in reconciliations. Think of it as calculating backwards.
List the Usual Items on a Balance Sheet
Cash
Accounts Receivable
Investories
Current Assets
Property, Plant and Equipment
Goodwill and acquired intagibles
Total Assets
Liabilities and Equity
Short-Term Debt
Accounts Payable
Current Liabilites
Long term debt
Shareholders Equity
Total Liabilites and equity
ROIC_t1
= NOPAT_t1 / Invested Capital_t0
Why do we calculate the ROIC with and without goodwill?
We can compare both and see if even we are achieving returns over our cost of capital, even without acquisition premiums
List Items usually on the rearranged or Economic Balance Sheet
Working Capital
Property, Plant and Equipment
Invested Capital, excluding goodwill
Goodwill and acquired intagibles
Invested Capital, including goodwill
Non-Operating Assets
Total funds invested
+
Reconciliation of Total Funds
Show how to reconcile the total funds invested with the sources of capital
Short-Term Debt
Long Term Debt
Debt and debt equivalents
Shareholders Equity
Total Funds invested
Enterprise DCF of a Company - Big Picture
Why do we measure invested capital both with and without goodwill?
By analyzing invested capital with and without goodwill, we can assess the impact of acquisitions on past performance. A company with robust margins and lean operations can have low ROIC with goodwill because of the high prices it paid for acquisitions.
Whats the math behind Working Capital?
Working Capital = current assets - current liabilities (excluding fin. debt)
What do we look at when analysing the rearranged financial statements of a firm?
ROIC, NOPAT growth, FCF
How long do we usually make a line by line forecast, a key value driver forecast (operating margin, operating tax rate and capital efficiency) and continuing value?
Depends heavily on the type, predictability of the Firm. But good starting point:
0-5
5-15
15 onwards
Why can we more easily take Free operating cash flow from the rearranged statements? Why not just from the accounting cash flow statement?
FCF is derived directly from NOPAT and the change in invested capital. Unlike the accounting statement of free cash flows, FCF or better free operating cash flow is independent of non-operating items and capital structure.
What is the Value of operations split into?
Explicit forecast period + Period after explicit forecasting
What method do we use for continuing value?
There are various models for evaluating the continuing value, but the Key Value Driver Formula is superior as it is based on cash flow and it links cash flow directly to growth and ROIC.
What is the Key Value driver Formula? What is it used for?
Estimating continuing value in perpetuity.
Continuing Value_t = (NOPAT_t+1(1-(growth/RONIC)))/(WACC - growth)
*growth is the long run growth in NOPAT
Why do we use the weighted average cost of capital?
Its because the free cash flows are available to all investors. The risk investors carry on these cash flows is therefore the weighted average cost of capital - WACC.
Formula for WACC
Are we using market or Book value of Equity/ Debt for the WACC? Why?
MARKET!! This is extremely important as using book could undervalue the cost of capital immensely. Think of cost of capital as the opportunity cost that Investors face when investing into a firm.
What is the Tax shield?
Debt carries a tax shield on the interest a firm has to pay. In other words, interest is tax deductible.
Why is the Debt Tax shield not just included FCF?
It allows us to assess performance as if the entire Firm was equity financed. Not looking at capital structure in this step makes it much easier to compare performance across companies and over time.
Give an example for non-operating Assets? How do we handle them in a Enterprise DCF?
For example, when a company owns a minority stake in another company, it will not record the company’s revenue or costs as part of its own. Instead, the company will record only its proportion of the other company’s net income as a separate line item. Including net income from non-consolidated subsidiaries as part of the parent’s operating profit will distort margins, since only the subsidiaries’ profit is recognized and not the corresponding revenues. Consequently, non-consolidated subsidiaries are best analyzed and valued separately.
How do we convert Enterprise Value into Equity Value? Why do we want to do that?
We subtract the value of debt and other non equity claims.
Our goal is ultimately to find the intrinsic value per share and compare that to the share price on the market.
Non Equity claims are hard to spot. Give me a list of the most typical ones.
*this list is non exhaustive
Debt - use market value for fixed and floating
Leases - lease payments recorded as interest expense and not rental expense
Unfunded retirement liabilities - unfunded obligations should be treated like debt
Preferred Stock
Employee options
non controlling interest - important to realize that the minority interest holder does not have a claim on the company’s assets, but rather a claim on the subsidiary’s assets
We know why DCF is so good, it cuts accounting bullshit and values when cash changes hands. What is are some weaknesses of DCF? What model could cover that weakness?
each year’s cash flow provides little insight into the company’s competitive position and economic performance. Declining free cash flow can signal either poor performance or investment for the future. The economic-profit model highlights how and when the company creates value, yet properly implemented, it leads to a valuation that is identical to that of enterprise DCF. This makes them a strong duo when used together.
Formula for Economic Profit
= Invested Capital * (ROIC - WACC)
or
= NOPAT - (Invested Capital * WACC)
If debt is always cheaper than equity (which it is) why cant we just increase debt to lower our WACC?
When adding debt, we adjusted the weights, but we failed to properly increase the cost of equity. Since debt payments have priority over cash flows to equity, adding leverage increases the risk to equity holders. When leverage rises, they demand a higher return. Modigliani and Miller postulated that this increase would perfectly offset the change in weights.
*This thought experiment is in a world without tax
What is unlevered cost of equity?
The cost of equity would be, if the company had no debt
How does APV work?
DCF as if all equity financed + add all debt benefits -> this will give you the value of its operations
*remember to use the unlevered cost of equity to discount
Modigliani & Miller? What does it assume?
- Cost of Capital (or financing) depends on the risk of the capital employed
- The WACC is fundamentally independent from the capital structure.
- Shareholders are not sensitive to dividend policy
Assumes no Tax benefits
Discuss the Cost of Equity and the unlevered cost of equity.
As this equation indicates, the cost of equity depends on the unlevered cost of equity, or the cost of equity when the company has no debt, plus a premium for leverage, less a reduction for the tax deductibility of debt. Note that when a company has no debt (D = 0) and subsequently no tax shields (Vtxa = 0), ke equals ku. This is why ku is referred to as the unlevered cost of equity.
What happens to cost of equity if we assume the firm manages the debt to value ratio to a target?
then the value of the tax shields will track the value of the operating assets. Thus, the risk of tax shields will mirror the risk of operating assets (k_txa = k_u). This leaves out the reduction term for the tax deductibility of debt. The unlevered cost of equity can now be reverse engineered using the observed cost of equity, the cost of debt, and the market debt-to-equity ratio.
How to value tax shields?
We take net debt * interest rate to get our expected interest payment. We then apply the marginal tax rate to find our interest tax shield.
What could happen to the interest tax shield with firms that are extremely highly leveraged?
A company with significant leverage may not be able to fully use the tax shields (it may not have enough profits to shield). If there is a significant probability of default, you must model expected tax shields, rather than the calculated tax shields based on promised interest payments.
What did Richard Ruback of the Harvard Business School argue?
there is no need to separate free cash flow from tax shields when both flows are discounted by the same cost of capital.15 He combined the two flows and named the resulting cash flow (i.e., FCF plus interest tax shields) capital cash flow (CCF)
What are the 3 distinct but identical methods created solely around how they treat tax shields? evaluate them?
WACC (tax shield valued in the cost of capital), APV (tax shield valued separately), and CCF (tax shield valued in the cash flow).
Although FCF and CCF lead to the same result when debt is proportional to value, we believe FCF models are superior to CCF models. By keeping NOPAT and FCF independent of leverage, it is easier to evaluate the company’s operating performance over time and against competitors. A clean measure of historical operating performance leads to better forecasts.
Capital Cash Flow Formula
What differentiates the Cash flow to equity valuation model form the DCF, APV and CCF?
Each of the preceding valuation models determined the value of equity indirectly by subtracting debt and other nonequity claims from enterprise value. The equity cash flow model values equity directly by discounting cash flows to equity (CFE) at the cost of equity, rather than at the weighted average cost of capital.
How to value with the cash flow to equity valuation model?
To value using cash flow to equity holders, discount projected equity cash flows at the cost of equity. Unlike enterprise-based models, this method makes no adjustments to the DCF value for nonoperating assets or debt. Rather, they are embedded as part of the equity cash flow.
Is the cash flow to equity valuation good?
Most of the times, capital structure changes are too complex, and you will make mistakes. It is not commonly used.
One situation where the equity cash flow model leads to the simplest implementation is the analysis and valuation of financial institutions. Since capital structure is a critical part of operations in a financial institution, using enterprise DCF to separate operations and capital structure requires unnecessary assumptions.
What are alternatives to discounted cash flows? What are the Benefits? What are the pitfalls?
Multiples. They are low effort and a great sanity check. Easy to communicate.
It is hard to choose good comparables. It is hard to choose the correct multiple. It is easy to misinterpret.
What is important when choosing comparable companies for multiples?
The comparable companies not only should be in the same industry, but also should have similar performance, as measured by ROIC and growth
Suppose the value estimated by multiples is $1.3 billion, but your DCF value is $2.7 billion. What might this indicate?
This might be a clue that there is something wrong with your DCF valuation model. Alternatively, it could be that the company you are valuing is expected to perform differently than the comparable companies. Finally, it could be that investors have a different outlook for the entire industry than you do (in which case the multiples of all the comparable companies would be out of line with their DCF value).
What are real options?
If a portfolio exists of traded securities whose future cash flows perfectly mimic the security you are attempting to value, the portfolio and security must have the same price.
*powerful for stock options, hard for corporate valuation
