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

CV_{t }

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:

1. Market value–if this provides the best estimate ofvalue

2. Do your own valuation–e.g.NPV, multiple‐based

3. 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

Value_{0} = Invested Capital_{0} + Economic Profit/(WACC‐g)