Lecture 7 - Valuation (Free cash flow) Flashcards
What is free cash flow?
Cash available to shareholders after cost of operations and investment.
- Does not apply accrual principal.
Free cash flows to firm (unlevered) = operating cash flows – capital outlays (investment)
Unlevered vs levered FCF :
Unlevered FCF = FCF to the firm and thus to both equity and debt holders
- Estimate the value of the firm before finance cost
- Take out debt holders Net equity.
Levered FCF = FCF to equity holders and thus after net payments to debt holders.
- Determine levered FCF
- Discount to determine value of equity.
Steps for a discounted free cash flow valuation:
For a unlevered valuation:
1. Forecast free cash flow to a horizon;
• Remove Financing from Reported Operating Cash Flow
• Remove Financing from Reported Investment Cash Flow
2. Discount the free cash flow to present value;
3. Calculate a continuing value at the horizon with an estimated growth rate;
4. Discount the continuing value (VCT)to the present;
5. Add 2 and 4;
6. Subtract net debt (debt liability-debt asset)
CF from operations
Reported cash flow from operations + After-tax net interest payments
CF from investment
Reported cashflow from investment activities + after tax net interest payments
e.g. investment in long term deposits or withdrawal of long term deposits.
Net interest
After tax net interest
= interest payments – interest receipts
= net interest * (1-tax rate)
Weighted Average Cost of Capital
- The value of the firm as a whole.
- There are two claimants to the firms assets (debt and equity).
- Therefore WACC is identifying the relative percentage.
- Be careful, must be AFTER TAX rate of debt.
How to calculate cost of debt:
- Interest expense/average total debt
- Then find after tax * (1-tax rate)
2 Advantages of FCF
Less subject to manipulation and estimation Less opportunistic earnings management and random error. By passes HC accounting biases May not accurately reflect matching (e.g. old stock)
3 Disadvantages of FCF
- Any advantage of accrual accounting
a. Timing problems alleviation
b. Matching problems
i. Benefits of investment are ‘lumpy’ - E.g. purchase of PPE will have flow on, but in the period of purchase will result in lower cash flows.
- Better representation of underlying economic value added
a. Assuming accruals are alleviating timing and matching problems, associated with cash flows. - Analysts typically measure earnings.
Valuation using multiples:
Select a measure of performance or value
e.g. earnings, sales, cash flows, book equity, book assets.
Estimate price multiple for comparable firms
Multiple is share price against performance
e.g. P/E=Shareprice/EPS
Apply comparable firm multiple
Estaimated value=P/E*Firm^’ s earnings per share.
3 main precautions or limitations of using multiples
- Comparable firms must match on risk and growth.
o In addition, have a similar business model
o Could use industry average instead - Assume market is perfectly efficient
o i.e. market impounds all information immediately and is correct in its movements. - Cannot be used for negative fundamental earnings.
2 P/E Ratio Measurement issues:
Firm measures itself on transitory earnings
Market values firm on expected future ‘permanent’ earnings.
Solution: adjust post earnings for non-recurring items.
Bias Dividends
Release of dividends will decrease price in year t, but not earnings
P/E could be understated
Solution: add back dividends
PE Ratio: (P_t+D_t)/E_t
Trailing vs forward p/e ratio:
- Depends on what time period earnings number you use?
- Training: we use current share price divided by historical eps
- Forward: current share price divided by forecast of future eps
3 ways that P/E ratios can differ.
- Risk and the cost of capital
- Riskier firm lower price – EPS ratio - Growth
- Higher growth expectation, relative to current EPS
i. Market is expecting firm earnings to grow ↑P/E - Accounting difference
- Upward bias in earnings lower PE Ratio
i. Efficient market SP should reflect value accurately.
