week 5 Flashcards
Free cash flow (FCF)
■ Cash flows available for distribution to providers of capital
Economic profit (EP)
returns profits or cash flows excess of that required to meet cost of capital
shareholder value analysis (SVA) profit
Also known by other terms such as:
‐ economic value added (EVA®) ‐
‐ excess return on capital / excess
Steps in Enterprise DCF
Step 1
Value the company’s operations/NPV by discounting free cash flow at the weighted average cost of capital.
a) Free cash flow generated over forecast horizon
b) Continuing value
NPV analysis of companies
Estimate cash flow available to providers of capital, and discount at the return required by those providers
NPV valuation models
Enterprise DCF vs economic profit
Works best for projects, business units, and companies that manage their capital structure to a target level
Explicitly highlights when a company creates value
Methods of calculating continuing value
NPV‐based valuation formula:
NPV‐based formulas facilitate clear focus on relation of CV with growth rates, WACC & marginal ROIC beyond forecast horizon
KGW preferred method is one of many, and has its own issues. (Use it for FINM 3005; but always question if appropriate before adopting.)
Sensitivity to assumptions
Methods of calculating continuing value
Multiple based
PE, EVM, or Price/Asset Backing
Use multiples as they should be in future, not now: This may require resorting to NPV‐based formulas for guidance.
Advantage of simplicity; anchored to plausible levels
Methods of calculating continuing value
Asset valuation
Invested capital – may be valid if ROIC ≈ WACC
Forecast liquidation value – only if ‘liquidation’ meaningful
continuing value
estimate of the value of operations, as at the end of the explicit forecast period.
the value of the company’s expected cash flow beyond the explicit forecast period.
continuing value
calculations should be based on?
Calculations should be founded on “steady state” estimates:
– Margins, asset turn, ROIC, etc should all be at sustainable levels
– NOPLAT, FCF and growth rates at maintainable or trend levels
– Target capital structure
– Note: If CV = 50% of DCF value, then ±10% cash flow => ±5% value
continuing value
Start from presumption of
Start from presumption of no excess returns beyond the period of analysis (i.e. marginal ROIC or “RONIC” = WACC) . . . . . . unless there is a good reason to assume otherwise
continuing value
Link explicit forecast horizon to
duration of competitive advantage
CVt
KGW formula for CV
‘g’ is best viewed as reflecting
g’ is best viewed as reflecting inflation plus any additional growth arising from discretionary reinvestment
The term ‘g/RONIC’ plays the role as
a retention rate, scaling down the numerator towards what is distributed out of NOPLAT after allowing for reinvestment of FCF to support ‘g’
Understanding the KGW formula for CV
Under inflation,
NOPLAT > FCF because Depreciation < Capex. The formula implicitly adjusts for this if baseline g = inflation
KGW formula for CV
The difficult part is
estimating how much to top up ‘g’ for additional reinvestment. Recommended formula below. (Note: This adjusts for fact that
KGW formula erroneously compounds inflation with any excess RONIC)
g = Inflation + % of FCF Retained * Real RONIC
Timing adjustments
Timing issues are tricky:
As cash flow accrues, the value of all claims will vary. For instance, as you progress through the year:
– Cash flow may be applied to reduce debt
– Value of enterprise and equity rise as cash accrues and future cash flows get nearer, hence increasing NPV
Timing adjustments
KGW scales up present value of operations by
‘mid‐year’ adjustment factor. This will only be correct if you are valuing company at beginning of the year.
valuing non operating assets
Methods to value these other assets:
- Market value–if this provides the best estimate ofvalue
- Do your own valuation–e.g.NPV, multiple‐based
- Book value–usually a last resort
Other non‐equity claims include:
– Debt
– Debt‐equivalents – leases, pension liabilities, selected provisions
– Preference shares
– Hybrids – employee options, warrants, convertibles
– Minority interest
value to equity holders is
Value attributable to equity holders is residual remaining after the value of such claims is accounted for
value of non equity claims
best measure
An underlying concept is that the best measure of the value of such claims is their market value (where available)
Value of non equity claims
consistency issues
What if your valuation differs from the basis of market pricing? e.g.
company priced for distress; but you value for recovery
– Market value of claims tied to enterprise value may then be inconsistent with your valuation, so . . .
– You might consider alternative valuations / scenario analysis
– Relevant areas: High‐yield debt, any options, preference shares
value of non equity claims
Debt value
– Market value, in theory
– Book value is often acceptable; but consider whether you should be finding or estimating an appropriate ‘market value’
– Don’t forget leases
Non equity claims
Other provisions & claims
Do any other liabilities or similar items of ‘real value’ exist that could diminish what is left over for equity holders?
Economic Profit based valuation
economic profit
= Invested Capital x (ROIC‐WACC)
= NOPLAT‐ Invested Capital x WACC
Economic profit based valuation
a stream of growing cash flows valued using the growing-perpetuity formula:
value0
Value0 = Invested Capital0 + Economic Profit/(WACC‐g)
Economic profit valuation
Value =
invested capital at the beginning of the Forecast
+ PV of Forecast Economic Profit during the explicit forecast period
+ PV of Economic Profit at the explicit Forecast (C V)
Economic Profit Valuation
Formula for continuing valuation
CVt
Economic Profit Valuation
PV(Economic Profitt+2 )
Company’s value
Value = Present Value of Cash Flow + Present Value of Cash Flow during Explicit Forecast Period after Explicit Forecast Period
The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period.
How do you estimate continuing value
Making simplifying assumptions about the company’s performance during this period (e.g., as- suming a constant rate of growth and return on capital
continuing value accounts for 56 percent to 125 percent of total value. These large percentages do not necessarily mean that most of a com- pany’s value will be created in the continuing-value period. Often continuing value is large because
profits and other inflows in the early years are offset by outflows for capital spending and working-capital investment—investments that should generate higher cash flow in later years.
RONIC =
The rate of return on net new investment is 12 percent, calculated as the increase in NOPLAT from one year to the next, divided by the net investment in the prior year.
Estimate enterprise value with growing-perpetuity formula
since cash flows are growing at a constant rate,
Key driver formula
G =
Roic x investment rate
Net investment
Net Investment = Invested Capitalt+1 − Invested Capitalt
If growth in the continuing-value period is forecast to be less than the growth in the explicit forecast period
then the proportion of NOPLAT that must be invested to generate growth also is likely to be less.
Because perpetuity-based formulas rely on parameters that never change, use a continuing-value formula only when
he company has reached a steady state, with low revenue growth and stable operating margins
Continuing Value
considerations
NOPLAT
NOPLAT should be based on a normalized level of revenues and sustainable margin and return on invested capital (ROIC). The normalized level of revenues should reflect the midpoint of the company’s business cycle and cycle average profit margins.
Continuing value considerations
RONIC:
should be consistent with expected competitive conditions.
Continuing value considerations
Economic theory suggests that
Competition will eventually eliminate abnormal returns, so for many companies, set RONIC equal to WACC.
However, for companies with sustainable competitive advantages (e.g., brands and patents), you might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period
Continuing value considerations
Growth rate
Few companies can be expected to grow faster than the economy for long periods. The best estimate is probably the expected long-term rate of consumption growth for the industry’s products, plus inflation.
Continuing value considerations
WACC considerations
should incorporate a sus- tainable capital structure and an underlying estimate of business risk consistent with expected industry conditions
Economic profit valuation
The economic-profit continuing value is the last term in the preceding equation.
The economic-profit formula for continuing value is:
SUBTLETIES OF CONTINUING VALUE
While the length of the explicit forecast period you choose is important,
While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it only affects the distribution of the company’s value between the explicit forecast period and the years that follow.
As the explicit forecast horizon grows longer, value shifts from the continuing value to the explicit forecast period, but the total value always remains the same
SUBTLETIES OF CONTINUING VALUE
While the length of the explicit forecast period you choose is important,
While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it only affects the distribution of the company’s value between the explicit forecast period and the years that follow.
As the explicit forecast horizon grows longer, value shifts from the continuing value to the explicit forecast period, but the total value always remains the same
Subtleties of continuing value
By extending the explicit forecast period, you also implicitly extend
you also implicitly extend the time period during which returns on new capital are expected to exceed the cost of capital. Therefore, extending the forecast period indirectly raises the value.
Subltleties of continuing value
competitive adv period
This is the notion that companies will earn returns above the cost of capital for a period of time, followed by a decline to the cost of capital
the company’s competitive-advantage period has not come to an end once the continuing-value period is reached
For many companies in competitive industries, we expect that the return on net new investment will
will eventually converge to the cost of capital as all the excess profits are competed away.
Assume RONIC = WACC
any growth will
probably require additional working capital and fixed assets.
Steps in Enterprise DCF
Step 1
EstimateNPVofcashflowsfromoperations,discountingatWACC:
a) Free cash flow generated over forecast horizon
b) Continuing value
Steps in Enterprise DCF
Step 2
Identify and value nonoperating assets, such as marketable securities, excess cash, nonconsolidated subsidiaries, and other equity investments.
Steps in Enterprise DCF
Step 3
Enterprise value = value of operations/NPV + nonoperating assets
Value of operations = Present Value of Free Cash Flow during Explicit Forecast Period + Present Value of Free Cash Flow after Explicit Forecast Period
Steps in Enterprise DCF
Step 4
Identify and value all debt and other nonequity claims against the en- terprise value. Debt and other nonequity claims include (among others)
debt, unfunded retirement liabilities, capitalized operating leases, employee options, and preferred stock.
Steps in Enterprise DCF
Step 5
Equityvalue = enterprise value– value of non‐equity claims
Steps in Enterprise DCF
Step 6
Valuation of shares/price per share = equity value /number of shares outstanding
Valuing operations quals the discounted value of future free cash flow.
Free cash flow equals
the cash flow generated by the company’s operations - any reinvestment back into the business.
FCF= cash flow available to all investors—equity holders, debt holders, and any other nonequity investors—so it is independent of capital structure.
FCP must be discounted using the WACC b/c it represents rates of return required by the company’s debt and equity holders blended together
NOPLAT represents
he total after-tax operating income generated by the company’s invested capital, available to all financial investors.
Timing adjustments
Midyear adjustment factor
(1 + WACC)^((6)/12)
The economic-profit model highlights
yet leads to a valuation that is identical to that of enterprise DCF.
