Company valuation

Why discount future Cash Flows?

Consider an investor seeking to purchase company shares.

Primary goal? Return on Investment

Cash Flow

Dividends

Investment Divestment
Investment horizon
Investment
Future Cash Flows of the investment

The Investor buys the shares at a given price based on their expectations for future cash flows
deriving from the investment

Dividends are a function of Divestment price is a function

future Cash Flows of future Cash Flows
What drives company value?

Given that a company’s value is a function of its future cash flows we need to
determine what drives future cash flows.
Two functions drive a firm’s
value in the future:

Growth
Cash
conversion
ratio % Profitability
Revenues Expenditures Investments Operating cash
flow

1 2
Why growth? Why profitability?

• Bigger size • Same size

• Same conversion • Stronger
ratio conversion ratio

Higher future cash flows, higher valuation

Calculating Cash Flow: NOPAT

1 NOPAT (Net Operating Profit After Taxes) :

$ in million Year 1 Year 2 Year 3

Net Sales 17,022 18,341 18,549
Cost of goods sold (9,483) (9,822) (9,857)

Gross Margin 7,539 8,519 8,692

Operating expenses (3,492) (4,394) (4,123)

D&A (487) (511) (693)
EBIT 3,560 3,614 3,876

Tax rate 35% 35% 35%

Operating taxes (1,246) (1,265) (1,356)

NOPAT 1 2,314 2,349 2,520

NOPAT is a measure of operating profitability. It does not take into consideration the financial structure of
a firm.
Note: Interest expense not included in the calculation.
Calculating Cash Flow: Working Capital & Capex

2 Working Capital
$ in million Year 1 Year 2 Year 3 DeltaY1-Y2 Calculate cash effect
Account receivables 3,621 4,174 3,492 -553 -(Receivables Y2-Receivables Y1)

Inventories 2,311 1,813 2,104 -498 -(InventoriesY2-InventoriesY1)

Trade payables* (3,383) (4,207) (3,212) 824 -(PayablesY2-PayablesY1)

Working Capital 2 2,549 1,780 2,384 -227

*Please note that Trade Payables are with a negative sign because they are a liability

3 Capital Expenditures
Costs incurred to replace or acquire Property, Plant and Equipment (PP&E).
Growing businesses require additional PP&E Investments (a reasonable assumption)

4 Other assets and liabilities

Used for the generation of Operating Cash Flows;
Operating
Could be modeled as a % of revenues
vs.
Excluded from Operating Cash Flow Generation, Value (positive or
Non-operating negative) should be accounted for in Enterprise Value calculation.
Calculating Cash Flow

$ in million
NOPAT Net Operating Profit After Taxes is a measure of operating profitability
NOPAT
Add-back D&A
Add-back D&A D&A is added back as it is not a Cash expense
Working capital
Net other assets, liabilities Delta Growing a business requires investments in Receivables and Inventory
Working Capital and generates more Payables
Capex
Delta Net Other
Unlevered Free Cash Flow Like working capital, operating assets increase as a business expands
Operating assets
!Free Cash Flows are available Expenditure for PP&E used to replace old PP&E or acquire new PP&E in
to both debt and equity Capex
order to support the growth of the business
investors!

3 n
(1+Discount factor) (1+Discount factor)
2
(1+Discount factor)

1
(1+Discount factor)

UFCF 2 UFCF 3 UFCF “n”

UFCF 1

T T T T T
0 1 2 3 n
Finding a proper discount factor: WACC

Debt investors WACC

There are two types Free cash flow is (Weighted average cost of capital)

of financial available to both

debt and equity Takes into consideration
investors in a firm Equity investors investors both debt and equity
investors

WACC (Weighted Average Cost of Capital) represents the opportunity cost

investors sustain for investing their funds in the firm

𝑫 𝑬
𝑾𝑨𝑪𝑪 = ∗ 𝒌𝒅 ∗ (𝟏 − 𝒕) + ∗ 𝒌𝒆
𝑫+𝑬 𝑫+𝑬
D = Amount of debt financing E = Amount of equity financing

𝑘𝑑 = Cost of debt 𝑘𝑒 = Cost of equity

t = Tax rate
Finding cost of equity and cost of debt

Practical
Methodology Needed data implementation

▪ Market value ▪ Bond current Use the bond’s Yield to Maturity

of debt pricing
Cost of
debt ▪ Book value ▪ Book value of Financial Divide Interest expense to the
of debt debt in BS amount of Financial debt
▪ Interest expense in P&L

▪ CAPM ▪ Risk-free rate Use a 10-year government bond

(Capital Asset
Pricing Model)
𝒌𝒆 = 𝒓𝒇 + 𝜷 ∗ 𝑴𝒂𝒓𝒌𝒆𝒕 𝒓𝒊𝒔𝒌 𝑷𝒓𝒆𝒎𝒊𝒖𝒎 ▪ Market Risk Premium Studies show it is between
4.5% and 5.5%
Cost of
equity
▪ Company beta A measure of a company’s stock
price volatility in relation to the
market. Available in financial
platforms such as Bloomberg,
Thomson Reuters etc.
Two stages of DCF

Stage 1 Stage 2

Present Value of Cash Flows in the

Free Cash Flows Forecast period + Continuing value
5-10 years After forecast

Description Needed data Math formula

𝐹𝐶𝐹1 𝐹𝐶𝐹2
Explicit forecast period sufficient ▪ Free Cash Flow 1 + +
to reach steady state in business Forecast (5 or 10 years (1+𝑊𝐴𝐶𝐶) (1+𝑊𝐴𝐶𝐶)2
Forecast 𝐹𝐶𝐹3 𝐹𝐶𝐹4
period development + +
▪ WACC (1+𝑊𝐴𝐶𝐶)3 (1+𝑊𝐴𝐶𝐶)4
(Stage 1) 𝐹𝐶𝐹5
(1+𝑊𝐴𝐶𝐶)5

The timeframe beyond the ▪ Free Cash Flow 𝐹𝐶𝐹5 ∗ (1 + 𝑔)

explicit forecast period. Forecast for 5th year
Continuing
Often accounts for a
(𝑊𝐴𝐶𝐶 − 𝑔)1
Value (1 + 𝑊𝐴𝐶𝐶)5
significant portion of a ▪ WACC
(Stage 2)
company’s valuation
(typically over 50%) ▪ Perpetuity growth rate (g)
From Enterprise Value to Equity Value

1
Non-operating Assets: Assets that are
not integral to a company's day-to-day
operations

Non-operating real estate, personal cars,

Present Value of Free Cash Flows financial subsidiaries etc.
+
Non-operating Assets 1 2
Net debt: Interest-bearing financial debt
Enterprise Value
minus cash
- Net debt 2
Debt to banks, Bond issues, Leases etc.
- Debt-like items 3

Equity Value 3
Debt-like items: Non-interest-bearing
liabilities excluded from Free Cash Flow

Provisions, Unfunded Pension liabilities,

Liabilities from litigation, etc.