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)

Economic profit valuation

Value =

invested capital at the beginning of the Forecast

+ PV of Forecast Economic Profit during the explicit forecast period

+ PV of Economic Profit at the explicit Forecast (C V)

Economic Profit Valuation

Formula for continuing valuation

CV_{t}

Economic Profit Valuation

PV(Economic Profitt+2 )

Company's value

Value = Present Value of Cash Flow + Present Value of Cash Flow during Explicit Forecast Period after Explicit Forecast Period

The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period.

How do you estimate continuing value

Making simplifying assumptions about the company’s performance during this period (e.g., as- suming a constant rate of growth and return on capital

continuing value accounts for 56 percent to 125 percent of total value. These large percentages do not necessarily mean that most of a com- pany’s value will be created in the continuing-value period. Often continuing value is large because

profits and other inflows in the early years are offset by outflows for capital spending and working-capital investment—investments that should generate higher cash flow in later years.

RONIC =

The rate of return on net new investment is 12 percent, calculated as the increase in NOPLAT from one year to the next, divided by the net investment in the prior year.

Estimate enterprise value with growing-perpetuity formula

since cash flows are growing at a constant rate,

Key driver formula

G =

Roic x investment rate

Net investment

Net Investment = Invested Capital_{t+1} − Invested Capital_{t}

If growth in the continuing-value period is forecast to be less than the growth in the explicit forecast period

then the proportion of NOPLAT that must be invested to generate growth also is likely to be less.

Because perpetuity-based formulas rely on parameters that never change, use a continuing-value formula only when

he company has reached a steady state, with low revenue growth and stable operating margins

Continuing Value

considerations

NOPLAT

NOPLAT should be based on a normalized level of revenues and sustainable margin and return on invested capital (ROIC). The normalized level of revenues should reflect the midpoint of the company’s business cycle and cycle average profit margins.

Continuing value considerations

RONIC:

should be consistent with expected competitive conditions.

Continuing value considerations

Economic theory suggests that

Competition will eventually eliminate abnormal returns, so for many companies, set RONIC equal to WACC.

However, for companies with sustainable competitive advantages (e.g., brands and patents), you might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period

Continuing value considerations

Growth rate

Few companies can be expected to grow faster than the economy for long periods. The best estimate is probably the expected long-term rate of consumption growth for the industry’s products, plus inflation.

Continuing value considerations

WACC considerations

should incorporate a sus- tainable capital structure and an underlying estimate of business risk consistent with expected industry conditions

Economic profit valuation

The economic-profit continuing value is the last term in the preceding equation.

The economic-profit formula for continuing value is:

SUBTLETIES OF CONTINUING VALUE

While the length of the explicit forecast period you choose is important,

While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it only affects the distribution of the company’s value between the explicit forecast period and the years that follow.

As the explicit forecast horizon grows longer, value shifts from the continuing value to the explicit forecast period, but the total value always remains the same

SUBTLETIES OF CONTINUING VALUE

While the length of the explicit forecast period you choose is important,

While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it only affects the distribution of the company’s value between the explicit forecast period and the years that follow.

As the explicit forecast horizon grows longer, value shifts from the continuing value to the explicit forecast period, but the total value always remains the same

Subtleties of continuing value

By extending the explicit forecast period, you also implicitly extend

you also implicitly extend the time period during which returns on new capital are expected to exceed the cost of capital. Therefore, extending the forecast period indirectly raises the value.

Subltleties of continuing value

competitive adv period

This is the notion that companies will earn returns above the cost of capital for a period of time, followed by a decline to the cost of capital

the company’s competitive-advantage period has not come to an end once the continuing-value period is reached

For many companies in competitive industries, we expect that the return on net new investment will

will eventually converge to the cost of capital as all the excess profits are competed away.

Assume RONIC = WACC

any growth will

probably require additional working capital and fixed assets.

Steps in Enterprise DCF

Step 1

EstimateNPVofcashflowsfromoperations,discountingatWACC:

a) Free cash flow generated over forecast horizon

b) Continuing value

Steps in Enterprise DCF

Step 2

Identify and value nonoperating assets, such as marketable securities, excess cash, nonconsolidated subsidiaries, and other equity investments.

Steps in Enterprise DCF

Step 3

Enterprise value = value of operations/NPV + nonoperating assets

Value of operations = Present Value of Free Cash Flow during Explicit Forecast Period + Present Value of Free Cash Flow after Explicit Forecast Period

Steps in Enterprise DCF

Step 4

Identify and value all debt and other nonequity claims against the en- terprise value. Debt and other nonequity claims include (among others)

debt, unfunded retirement liabilities, capitalized operating leases, employee options, and preferred stock.

Steps in Enterprise DCF

Step 5

Equityvalue = enterprise value– value of non‐equity claims

Steps in Enterprise DCF

Step 6

Valuation of shares/price per share = equity value /number of shares outstanding

Valuing operations quals the discounted value of future free cash flow.

Free cash flow equals

the cash flow generated by the company’s operations - any reinvestment back into the business.

FCF= cash flow available to all investors—equity holders, debt holders, and any other nonequity investors—so it is independent of capital structure.

FCP must be discounted using the WACC b/c it represents rates of return required by the company’s debt and equity holders blended together

NOPLAT represents

he total after-tax operating income generated by the company’s invested capital, available to all financial investors.

Timing adjustments

Midyear adjustment factor

(1 + WACC)^((6)/12)

The economic-profit model highlights

yet leads to a valuation that is identical to that of enterprise DCF.