Enterprise value and free cash flow Flashcards
(13 cards)
Explain why an analyst, facing a choice of using a valuation model that values equity directly
or a model that first calculates enterprise value, would choose the enterprise value option.
EV is a better valuation estimate to use in comparisons with other companies as it is
capital structure neutral.
This allows better quality comparisons between companies with different capital
structures.
Explain the treatment of non-controlling interests (NCI) in the EV bridge.
Deducted as NCI represents a source of financing for the operations.
How should lease debt be treated in an EV bridge? Explain you answer.
Deducted along with other forms of debt finance
What is the difference between “total enterprise value” (TEV) and “operating enterprise
value” (OEV)?
TEV = OEV + value of non-operating assets
An analyst at a conference suggests that enterprise value represents the market value of debt
and the market value of equity. But during your university programme you understood that
enterprise value represents the market value of the operations of a firm. How would you
reconcile these two positions?
These can be thought of as the two different ways of looking at EV. The financing ‘lens’
represents all of the funding that supports the value of the operations. Therefore:
Value of net operating assets = market value of debt + market value of equity
What is the meaning of the term ‘free’ in Free cashflow?
That the cashflow is after deducting the CAPEX required to support the growth
assumption in the model.
Explain with reasons whether we should use the effective or marginal rates of tax when
calculating FCFF.
Marginal tax rates are normally the tax rates in the country of listing of the firm. Effective
tax rates are blended rates based on where the business operates. As FCFF relates to
operations, effective tax rates should be used. Marginal tax rates become more important
when analysing financing issues. For example, the tax shield on the cost of debt , if all the
debt is issued in country X, should be based on that country’s tax rate rather than the
“average” effective rate.
What are the differences between ‘free cashflow to equity’ (FCFE) and ‘free cashflow to the
firm’ (FCFF)?
FCFE = Post tax, post interest, post debt flows
FCFF = Pre-tax, pre-interest and pre-debt flows
Capital expenditure (CAPEX) is a key figure in a free cashflow calculation. Explain how
analysts might forecast CAPEX.
CAPEX is often forecast based on a % of revenues.
It can also be triangulated with growth and ROIC calculations to ensure the CAPEX
forecasted is adequate.
You read in a popular textbook that Discounted cash flow (DCF) analysis is the most accurate
method of equity valuation. Do you agree?
Disagree. DCF analysis is a powerful tool, but its accuracy depends on the quality of the assumptions
made, such as growth rates, discount rates, and cash flow projections. Small changes in these
inputs can lead to significant variations in the valuation. Other methods, like relative valuation,
may be more practical in some situations. There is no evidence to suggest DCF is the most
accurate valuation too
The Enterprise Value (EV) of a company is always higher than its market capitalisation. Is this
true?
Enterprise value includes market capitalization, debt, and preferred equity, minus cash and cash
equivalents. While EV is typically higher than market capitalisation due to the inclusion of
debt, it can be lower if the company has significant cash reserves and a lower amount of debt.
For example, a company with $100m of gross debt, $150m of cash and a market capitalisation
of $500m would have an EV of $500m + $100m - $150m - $450m, lower than the equity value.
It is often said that a free cash flow to equity (FCFE) model is more appropriate for valuing
companies with stable capital structures. Suggest with reasons whether this is true.
Agree. The FCFE model calculates the cash flows available to equity holders after accounting for
capital expenditures, debt repayments, and other obligations. It is most suitable for companies
with stable capital structures, as significant changes in debt levels can complicate the model
9eg requiting time varying discount rates)
Can Enterprise value (EV) be used in all industries?
EV is not suitable for any industry where there is a lack of distinction between the operations
of a company and the associated sources of finance. An obvious example of this would be a
bank. Banks operations ‘are’ financing. So, a fixed income liability cannot clearly be labelled
as operating or financing.
