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Chapter 2 Valuation Concepts Methods Part 2

The document discusses several core valuation techniques: 1. The economic profit model values a company based on its economic profit, which is the net operating profit less a charge for invested capital. 2. The discounted cash flow method values a company by forecasting its future free cash flows and discounting them back to the present using the weighted average cost of capital. 3. Valuation models can value either a company's enterprise value (including debt) or its equity value (excluding debt claims).

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118 views28 pages

Chapter 2 Valuation Concepts Methods Part 2

The document discusses several core valuation techniques: 1. The economic profit model values a company based on its economic profit, which is the net operating profit less a charge for invested capital. 2. The discounted cash flow method values a company by forecasting its future free cash flows and discounting them back to the present using the weighted average cost of capital. 3. Valuation models can value either a company's enterprise value (including debt) or its equity value (excluding debt claims).

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Daisy Tañote
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CORE

VALUATION
TECHNIQUES
Economic Profit-based Valuation Model

Economic profit measures the value created by the


company in a single period.

Economic Profit = Invested Capital × (ROIC −WACC)

Economic Profit = NOPLAT − (Invested Capital ×WACC)

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Discounted Cash
Flows Method

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Defining Enterprise Value
vs. Equity Value
Enterprise Value – equals the
value of operations (core
businesses) and non-operating
assets such as excess cash.
Equity Value – can be
computed indirectly by
calculating enterprise value
first and then subtracting any
non-equity claims such as
debt.
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ENTERPRISE VALUE

Refers to the theoretical value of its core


business activities as reflected by its net
cash flows.
This is the basic premise of most
valuation methodologies.

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FREE CASH FLOW (FCF)
Free cash flow (FCF) is the cash a company
generates after taking into consideration cash
outflows that support its operations and maintain its
capital assets.
It refers to the cash flow available to the parties
who supplied capital (i.e. lenders and shareholders)
after paying operating expenses, including taxes, and
investing in capital expenditures and working capital
as required by business needs.
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Net Cash Flows to the Firm (Indirect)

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Net Cash Flows to the Firm (Direct)

Cash Flows from Operating Activities


Add: Interest Expense (net of tax, if
deducted from operations)
Less: Cash Flows from Investing Activities
Equals Net Cash Flows to the Firm

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ENTERPRISE DISCOUNTED
CASH FLOW MODEL
Discounts free cash flow (meaning the cash flow available to
all investors—equity holders, debt holders, and any other non-
equity investors) at the weighted average cost of capital.
The claims on cash flow of debt holders and other non-equity
investors are subtracted from enterprise value to determine
equity holders’ value.
Especially useful when applied to a multi-business company
where individual projects, business units, and even the entire
company can be valued with a consistent methodology.

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Understanding Terminal/Continuing Value
Forecasting gets murkier as the time horizon grows
longer. This holds true in finance as well, especially
when it comes to estimating a company's cash flows
well into the future. At the same time, businesses
need to be valued.
To "solve" this, analysts use financial models, such
as discounted cash flow (DCF), along with certain
assumptions to derive the total value of a business
or project.
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What are Non-Operating Assets?
Non-operating assets are assets that are not
required in the normal operations of a business but
that can generate income nonetheless.
The assets are recorded in the balance sheet. Non-
operating assets do not help in the day-to-day
operations of the business, but they may be
investments or assets that can be disposed of to
generate income to finance the operations of the
business.
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DISCOUNTED ECONOMIC PROFIT
MODEL
Discounts economic profit at the weighted
average cost of capital.
The claims on cash flow of debt holders and
other non-equity investors are subtracted
from enterprise value to determine equity
holders’ value.
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Model Measure Discount factor Assessment

Adjusted Free cash Unlevered cost Highlights changing capital structure


present value flow of equity more easily than WACC-based models.
Capital cash Capital Unlevered cost Compresses free cash flow and the
flow cash flow of equity interest tax shield in one number, making
it difficult to compare operating
performance among companies and over
time.
Equity cash Cash flow Levered cost of Difficult to implement correctly because
flow to equity equity capital structure is embedded within the
cash flow. Best used when valuing
financial institutions.

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Unlevered/Levered Cost of Equity
The unlevered cost of capital represents the cost
of a company financing the project itself without
incurring debt.
The levered cost of equity represents the risk
components of the financial structure of a firm. To
finance the projects of a firm, companies often
need to resort to debt that is collected from the
market.
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Adjusted Present Value Model
The adjusted present value model separates the value of
operations into two components:
the value of operations as if the company were all-equity
financed and
the value of tax shields that arise from debt financing
The APV valuation model follows directly from the teachings of
economists Franco Modigliani and Merton Miller, who proposed
that in a market with no taxes (among other things), a
company’s choice of financial structure will not affect the
value of its economic assets. Only market imperfections, such as
taxes and distress costs, affect enterprise value.
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Adjusted Present Value Model

Example: Assume a multi-year projection calculation


finds that the present value of Company ABC’s free cash
flow (FCF) plus terminal value is 100,000. Its debt
amounts to 50,000. The tax rate for the company is 30%
and the interest rate is 7%. The APV is?
APV = 100,000 + ((50,000 x 7% x 30% )/7%) = 115,000
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Capital Cash Flow Model
When a company actively manages its capital structure
to a target debt-to-value level, both free cash flow (FCF)
and the interest tax shield (ITS) are discounted at the
unlevered cost of equity.
In 2000, Richard Ruback of the Harvard Business School
argued that there is no need to separate free cash flow
from tax shields when both flows are discounted by the
same cost of capital. He combined the two flows and
named the resulting cash flow (FCF plus interest tax
shields) capital cash flow (CCF).
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Cash-Flow-To-Equity Valuation Model
The equity cash flow model values
equity directly by discounting cash
flows to equity at the cost of equity,
rather than at the weighted average cost
of capital.

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Cash-Flow-To-Equity Valuation Model
Cash flow to equity starts with net income.
Next, add back noncash expenses, and subtract
investments in working capital, fixed assets, and
nonoperating assets.
Finally, add any increases in debt and other nonequity
claims, and subtract decreases in debt and other nonequity
claims.
Alternatively, you can compute cash flow to equity as
dividends plus share repurchases minus new equity issues.
The two methods generate identical results.
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Thanks!
Any questions?

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