Frameworks for Valuation

Question 1

What Valuation Models are appropriate if the capital structure is expected to stay the same? What discount rate do they use?

Answer 1

DCF and Discounted Economic Profit. WACC.

Question 2

What Valuation Models are appropriate if the capital structure is expected to change?

Answer 2

adjusted present value (APV) model

Question 3

List the Items on a typical accounting Income Statement

Answer 3

Revenue
less: Operating Cost
less: Depreciation
gives: Operating Profit (EBIT)

less:Interest Expense
gives:Earnings before Taxes

less:Income Taxes
gives:Net Income

Question 4

List the Items on a typical statement of shareholders equity

Answer 4

Equity, beginning of year
add: Net Income
less: Dividends
less/add:Share issuance (repurchase)
gives: Equity, end of year

Question 5

List the Typical items on the income statement that has been rearranged towards NOPAT - Economic Income Statement

Answer 5

Revenue
less: Operating Cost
less: Depreciation
gives: Operating Profit (EBIT)

less: Operating Tax
gives: NOPAT

Question 6

List how we would reconcile Net Income and NOPAT

Answer 6

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.

Question 7

List the Usual Items on a Balance Sheet

Answer 7

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

Question 8

ROIC_t1

Answer 8

= NOPAT_t1 / Invested Capital_t0

Question 9

Why do we calculate the ROIC with and without goodwill?

Answer 9

We can compare both and see if even we are achieving returns over our cost of capital, even without acquisition premiums

Question 10

List Items usually on the rearranged or Economic Balance Sheet

Answer 10

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

Question 11

Show how to reconcile the total funds invested with the sources of capital

Answer 11

Short-Term Debt
Long Term Debt
Debt and debt equivalents

Shareholders Equity
Total Funds invested

Question 12

Enterprise DCF of a Company - Big Picture

Answer 12

Question 13

Why do we measure invested capital both with and without goodwill?

Answer 13

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.

Question 14

Whats the math behind Working Capital?

Answer 14

Working Capital = current assets - current liabilities (excluding fin. debt)

Question 15

What do we look at when analysing the rearranged financial statements of a firm?

Answer 15

ROIC, NOPAT growth, FCF

Question 16

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?

Answer 16

Depends heavily on the type, predictability of the Firm. But good starting point:

0-5
5-15
15 onwards

Question 17

Why can we more easily take Free operating cash flow from the rearranged statements? Why not just from the accounting cash flow statement?

Answer 17

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.

Question 18

What is the Value of operations split into?

Answer 18

Explicit forecast period + Period after explicit forecasting

Question 19

What method do we use for continuing value?

Answer 19

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.

Question 20

What is the Key Value driver Formula? What is it used for?

Answer 20

Estimating continuing value in perpetuity.

Continuing Value_t = (NOPAT_t+1(1-(growth/RONIC)))/(WACC - growth)

*growth is the long run growth in NOPAT

Question 21

Why do we use the weighted average cost of capital?

Answer 21

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.

Question 22

Formula for WACC

Answer 22

Question 23

Are we using market or Book value of Equity/ Debt for the WACC? Why?

Answer 23

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.

Question 24

What is the Tax shield?

Answer 24

Debt carries a tax shield on the interest a firm has to pay. In other words, interest is tax deductible.

Question 25

Why is the Debt Tax shield not just included FCF?

Answer 25

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.

Question 26

Give an example for non-operating Assets? How do we handle them in a Enterprise DCF?

Answer 26

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.

Question 27

How do we convert Enterprise Value into Equity Value? Why do we want to do that?

Answer 27

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.

Question 28

Non Equity claims are hard to spot. Give me a list of the most typical ones.

*this list is non exhaustive

Answer 28

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

Question 29

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?

Answer 29

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.

Question 30

Formula for Economic Profit

Answer 30

= Invested Capital * (ROIC - WACC)

or

= NOPAT - (Invested Capital * WACC)

Question 31

If debt is always cheaper than equity (which it is) why cant we just increase debt to lower our WACC?

Answer 31

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

Question 32

What is unlevered cost of equity?

Answer 32

The cost of equity would be, if the company had no debt

Question 33

How does APV work?

Answer 33

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

Question 34

Modigliani & Miller? What does it assume?

Answer 34

1. Cost of Capital (or financing) depends on the risk of the capital employed
2. The WACC is fundamentally independent from the capital structure.
3. Shareholders are not sensitive to dividend policy

Assumes no Tax benefits

Question 35

Discuss the Cost of Equity and the unlevered cost of equity.

Answer 35

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.

Question 36

What happens to cost of equity if we assume the firm manages the debt to value ratio to a target?

Answer 36

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.

Question 37

How to value tax shields?

Answer 37

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.

Question 38

What could happen to the interest tax shield with firms that are extremely highly leveraged?

Answer 38

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.

Question 39

What did Richard Ruback of the Harvard Business School argue?

Answer 39

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)

Question 40

What are the 3 distinct but identical methods created solely around how they treat tax shields? evaluate them?

Answer 40

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.

Question 41

Capital Cash Flow Formula

Answer 41

Question 42

What differentiates the Cash flow to equity valuation model form the DCF, APV and CCF?

Answer 42

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.

Question 43

How to value with the cash flow to equity valuation model?

Answer 43

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.

Question 44

Is the cash flow to equity valuation good?

Answer 44

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.

Question 45

What are alternatives to discounted cash flows? What are the Benefits? What are the pitfalls?

Answer 45

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.

Question 46

What is important when choosing comparable companies for multiples?

Answer 46

The comparable companies not only should be in the same industry, but also should have similar performance, as measured by ROIC and growth

Question 47

Suppose the value estimated by multiples is $1.3 billion, but your DCF value is $2.7 billion. What might this indicate?

Answer 47

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).

Question 48

What are real options?

Answer 48

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