Class 2 - Valuation continued Flashcards
What is Arzac’s free cash flow method?
- First, you need to calculate your NOPAT : it stands for Net Operating Profit After Tax
NOPAT
Net Income 6,947
(+) Net Interest After Tax 4,121
= Unlevered Net Income 11,068
+ Change in Deferred taxes 403
NOPAT 11,470
We add back the tax payed, on calcule comme sil y avait pas de dette dans la companie
Change in deffered taxes is a minor detail, on fait cet ajustement mais cest un detail pas tres important
- Then, with the NOPAT previously calculated, you calculate your free cash flow :
NOPAT 11,470
(+) Depreciation 10,775
- Change in Net Working Capital (1,330)
- Capital Expenditures (11,380)
= Free Cash Flow 9,537
Add back depreciaiton because non cash item
Substract change in net working capital, its an investment in the company, on investie quand la compagnie grow. Capex, necessary for the business to keep going. Part of the most important assumptions
We need to make investment for the company to keep growing on a perpetual basis, donc CAPEX cest ce qui est necessaire pour que ca soit un going concern
Name the concepts of the cost of capital
- Opportunity cost
- Average cost of capital
- The cost of equity
- Risk-free rate
- Market risk premium
Describe what is the opportunity cost
The cost of capital to the issuer corresponds to the opportunity cost for the investor
When a VC is making an investment in a company, he will foresee is exit from that invesmtnet. You can realize the return with and IPO or selling it to a company
It is rare that a vc company willbe sold to another vc investor. There is a small secondary market for VC but it is VERY limited and its not very efficient. Usually they want to sell their stake in the stock market. Thats where you find the investors willing to pay the highest price. VC will not prefer to sell to another vc funds.
The value of the company is maximised in the stock market because of liquidity and rapidity, arbitrage etc
When comes the tie to sell, you wonder what price am i gonna get. So then you are interested in the valuation of companies in the stock market.
The other option is selling to another company (in a consolidation plays for example. Selling the company to a bigger one)
When you select and investment, the cost of capital is the opportunity cost pcq aurait pu faire linvestissement ailleurs
3rd way : reselling it to owners, not a good option because you dont get the max return.
The vc fund will want to know what will be the valuation once they get out of it.
Describe what is the average cost of capital
The cost of capital to the firm is the weighted average cost of capital (WACC)
We use this when the company is leveraged, uses debt to finance itself
Describe what is the cost of equity
Cost = discount rate
The discount rate required for present value of future cash flows to equal the market price
The cost of capital corresponds to the expected return for the investor
We will typically use the cost of equity to discount the free cash flows
Its the rate necessary to justify the price of a certain stock/company
Name some problems linked to the cost of equity (i.e the discount rate)
The discount rate is an expected returns of future cash flows
The discount rate can vary over time
We are forecasting so there is an uncertainty
The comapny can go through different stages so it needs to be adjusted,
What is the equation for the cost of equity
CAPM :
k = rf + B*market risk premium
B : A measure of the systematic risk of a security or portfolio compared to the market as a whole
What are the three challenges in setting the cost of equity?
Set the risk-free rate
Set the bêta
Set the market-risk premium
How can we set the risk-free rate?
Which is the best way to set the risk-free rate?
T-bills?
Long-term (30-year) bonds? Because the maturity of the company is not defined et vient techniquement pas a maturité mais on voit pas ca souvent
10-year bonds (10-year Canadas)
There is a debate. usually its the 10-year bonds. The 10 year bonds have a certain risk
But we could also set it with other
t-bills are basically the real risk free rate
We can see that the rates are consistently going down
At the begininng of the year the rates were flat, maening that the three rates were very close to one another
What is the debate on how to set the risk premium?
Debate on the best way to calculate the market risk premium :
Historical data? Assuming that the history is a good basis to predict the future, which is not necessarily the case
Prospective data? (Gordon model and analysts’ forecasts) pcq on calcule la valeur based on futur cash flows donc ca ferait du sens pour calculer le risk premium based on future values
How do we calculate the risk premium with historical data and what are some problems associated with that method?
With historical data :
Spread between the Market return and Risk free rate
Problem :
1. What is the correct period over which to calculate the average market return?
Longest period possible?
Should we take historical data? Or project what would be the market risk premium? Whats the period over which we calculate the risk premium?
You need to understand that there has been a full cycle. If you calculate over a year, the year will not be representative of the next 5 years
2. The market represent the surviving companies. The companies going bankrupt are taken out of the indices
1-3% are taken out of the market sauf que les compagnies dans lindice vont moins bankrupt donc represente pas completement
3. Changes in the market risk premium :
Factors
Availability of capital
Investors’ preferences
Market risk : more transparency
Real risk-free rate : comes down
Market efficiency : investors are more comfortable investing because the market is more efficient
The preimum changes over time! It went down over time
Some can argue that the risk premium is rather 3% than 5%. Historical data shows tho that the preimum is higher than that.
On peut argue que le premium goes down over time pcq capital invested is higher, population vieillit donc plus investi, changes in habits
there
How do we calculate the risk premium with prospective data and what are some problems associated with that method?
With the Gordon Growth Model :
1st approach : one company at a time
P0 = D1/k-g
ou
K = (D1/P0) + g
- Try and forecast what would be the return for investors to then set the cost
K would be calculated based on the growth of the dividend of the company
Problem : It is difficult to predict the long-term dividend growth rate of a single firm
2nd approach : with the entire market
k = (P1/PE1) + g
Where
P1 = D1/EPS : Expected payout
EPS1 : Earnings per Share in year 1
PE1 : Expected price/earnings ratio
Note : the variables depend on market forecasts
So we would take an indices. We would set the dividend of the SP500
K would in this case be the expected returns for the entire market
Adjustments :
The growth rate of earnings and dividends varies from short term to long term
Dividends adjust relatively slowly to the change in earnings : over short period its a problem pcq ca sajuste pas immediatement
Over time tho, payout and earnings growth converge towards the long-term average
Caveat :
Forecast market data may be overly optimistic
Sell side analysts are naturally optimistic!
The only ppl that do forecasts of the market are analysts and they are usually very optimistic
The data available for earnings growth is there
But sell side analysts are naturally too optimistic, they forecast higher growth than the reality
What is the usual market risk premium? What is a big warning associated with that?
The answer is: between 3% and 5%…!
(But let’s keep a critical mind!)
There is a big subjectivity in valuation. It depends on the perspective of the person using it
Often, the person valuing at 3% are often sellers of securities, they want it to be as high as posisble. Cest tres subjectif. Its a matter of whos the client. Depending on the purpose of the valuation you will take a different number. A buyer would value it with 5%
Warning :
There must be a correspondence between the basis for calculating the risk premium and the risk-free rate used
(Spread over what exactly?)
When we calcultae the risk premium, we calculate the spread. Donc si on a pas le meme rf rate, the historical data of the spread has to be sur la meme period que notre risk free
Ex : si on prend le 10-year bond, on doit prendre le spread sur 10 ans
How do we adjust for leverage?
The data with which the ß is calculated are market data that includes the impact of firms’ financial leverage
Systematic risk increases with financial leverage
You dont have the same market access with a private company so there is a risk. You also have more systematic risk
In a way, VC investments are the least investments you have, hence, we justify using a high premium on the discount rate.
On doit ajusté pour isoler le cost of equity pcq on se base sur des compagnies qui sont leveragées sauf que des compagnies de VC sont pas levererd
Impact of leverage
Be = (1 + D/E)Ba
Be : equity beta
D/E : debt/equity ratio
Ba : firms beta
On peut calculer le beta de la unlevered firm en enlevant la strucutre de dette
Be = (1 + (1-t)D/e))Bu
t : tax rate βU : Unlevered firm Bêta If: D/E: Constant debt/equity ratio Cost of debt (and « tax shield ») are at risk free rate
What are two factors to consider that may justify a premium
The returns are higher for firms with a smaller market capitalization (linked to liquidity?)
Returns are higher for firms with a higher ratio of book value to stock price
Linked to liquidity, amongst other things.
Smaller companies represent a higher risk profile all else being equal.
On se base souvent sur le fait que la compagnie est aprt of the average
Par contre des petites entreprises normalement sont plus risquées, thus higher return
