Cash Flow Approach of Corporate Valuation

FCFE & FCFF Models

STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST PERIOD

1. Selection of explicit forecast period Ideally should be such that the business reaches a steady state at the end of this period. This is required because continuing value formula is based on the following assumption Firm earns a fixed profit margin, achieves constant asset turnover and hence earns constant rate of return on the invested capital Re-investment rate (proportion of gross cash invested annually) and the growth rate remain constant Theoretically, length of explicit forecast period has no bearing on total value; it merely influences distribution of the total value between its two components viz. the value of cash flows during explicit forecast period and the continuing value In practice, choice of the forecast horizon may have an indirect impact on value as it may subtly influence the underlying economic assumptions

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STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST PERIOD

2. Define free cash flow to the firm Sum of the cash flows to all investors (lenders and shareholders) of the firm Free Cash Flow to the Firm (FCFF)

Operating Free Cash Flow (FCF)

Non-operating Free Cash Flow

NOPLAT

Net Investment

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STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST PERIOD

Operating FCF : refers to post-tax cash flow generated from operations of the firm after providing for investments in fixed assets + NWC requirements FCF = NOPLAT (net operating profit less adjusted taxes) Net Investment = (NOPLAT + Depreciation) (net investment +depreciation) FCF = gross cash flow gross investment NOPLAT = EBIT Taxes on EBIT (considering only operating income) Taxes on EBIT = tax after adjusting income tax provision for tax attributable to interest income and expense and other income/ loss. Net Investment = Gross Investment (incremental capex + NWC) Depreciation In case gross investment information not available, then

Net Investment = (NFA + NWC) at end of year - (NFA + NWC) at beginning of year Non- Operating FCF : to be considered after adjusting for taxes

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STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST PERIOD

3. Drivers of FCF FCF = NOPLAT Net Investment = Invested Capital (NOPLAT/ Invested Capital)(1 [(Net Investment/ Invested Capital)/ (NOPLAT/ Invested Capital )] Invested Capital = NFA + NWC NOPLAT/ Invested Capital = Return on Invested Capital (ROIC) Net Investment/ Invested Capital = growth rate Invested capital, ROIC and growth rate are basic drivers of FCF ROIC = NOPLAT/ Invested Capital = NOPLAT/ Turnover * Turnover / Capital

Post tax operating margin

Capital turnover

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STEP 1. CASH FLOW FORECAST DURING EXPLICIT FORECAST PERIOD

4. Develop the FCF forecast Develop credible sales forecast Complete projections including income statement and balance sheet Treat inflation consistently Look at multiple scenarios : scenario building based on different industry structures and company capabilities

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STEP 2. ESTABLISH COST OF CAPITAL

Providers of capital want to be suitable rewarded / compensated for invested funds in the firm. Cost of capital is the discount rate used for converting expected FCF into its present values WACC = rE (S/V) + rP (P/V) + rD (1-T)(B/V) rE = cost of equity capital rP = cost of preference capital S/V = market value of equity/ market value of firm B = Market value of interest bearing debt

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STEP 3. CONTINUING VALUE

Company Value = PV of cash flow during forecast period + PV of cash flow after explicit forecast period

Continuing/ Terminal value Typically, terminal value is the dominant component in a companys value. Hence it should be estimated carefully and realistically. 2 steps in estimating continuing value Choose appropriate method Estimate evaluation parameters and calculate continuing value

Choose appropriate method : Cash Flow Methods : Growing free cash flow perpetuity method; Value driver method Non-cash flow methods Replacement cost method, Price PBIT method, Market to book ratio method

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STEP 3. CONTINUING VALUE

Growing free cash flow perpetuity method : assumes that the free cash flow would grow at a constant rate for ever, after the explicit period T. Hence the continuing value of such a stream can be established by applying the constant growth valuation model CVT = FCFT+1 / (WACC g) CVT = continuing value at the end of year T FCFT+1 = expected free cash flow for the first year after the explicit forecast period g = expected growth rate of free cash flow for ever

Value Driver method : uses the growing free cash flow perpetuity formula but expresses it in terms of value drivers as follows CVT = NOPLAT
T+1

(1-g/r) / (WACC g)

NOPLATT+1 = expected NOPLAT for the first year after the explicit forecast period WACC = constant growth rate of NOPLAT after the explicit forecast period r = expected rate of return on net new investment
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STEP 3. CONTINUING VALUE

Replacement cost method : continuing value equated with replacement cost of fixed assets of the company. Two major drawbacks a) considers only tangible assets; could lead to understatement of the value of the firm. b) at times may be uneconomical for the firm to replace the asset Price to PBIT ratio method : expected PBIT in the first year after the explicit period is multiplied by a suitable price to PBIT ratio. Drawbacks a) no reliable method available for forecasting the price to PBIT ratio b) assumption that PBIT drives prices is flawed Market to book ratio method : continuing value assumed to be a multiple of the book value Hence, on an overall basis cash flow methods superior to non-cash flow methods for estimating continuing value

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STEP 4. FIRM VALUE

The value of the firm is equal to the sum of the following three components PV of the free cash flow during the explicit forecast period PV of the continuing value Value of non-operating assets (like excess marketable securities, which were ignored in the free cash flow analysis

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FREE CASH FLOW TO EQUITY (FCFE) VALUATION

Equity value of the firm can be determined as follows Equity Value = Firm value Debt value Alternatively the FCFE which is the cash flow lest for equity shareholders after the firm has covered its capital expenditure and working capital needs and met all its obligations towards lenders and preference shareholders FCFE = PAT Pref. Div (Capex Dep) Change in NWC + (new debt issues debt repayment)+ (new preference issue pref repayment)-change in investment in marketable securities

Equity value = t=1 FCFE/ (1+ re)t

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FREE CASH FLOW TO EQUITY (FCFE) VALUATION

The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashflows for the next five years. Year 1 2 3 4 5 CF to Equity $50 $ 60 $ 68 $ 76.2 $ 83.49 $ 40 $ 40 $ 40 Int Exp (1-t) $40 $ 40 $ 108 $ 116.2 $ 123.49 $ 2363.008 CF to Firm $90 $ 100

Terminal Value $ 1603.008

Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.)

The current market value of equity is $1,073 and the value of debt outstanding is $800.
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FREE CASH FLOW TO EQUITY (FCFE) VALUATION

Equity versus Firm Valuation Method 1: Discount CF to Equity at Cost of Equity to get value of equity Cost of Equity = 13.625% PV of Equity = 50/1.13625 + 60/1.13625^2 + 68/1.13625^3 + 76.2/ 1.13625^4 + (83.49+1603)/1.13625^5 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = $1873 PV of Equity = PV of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073

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FREE CASH FLOW TO EQUITY (FCFE) VALUATION

First Principle of Valuation Never mix and match cash flows and discount rates. The key error to avoid is mismatching cashflows and discount rates, since discounting cashflows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cashflows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm. The Effects of Mismatching Cash Flows and Discount Rates Error 1: Discount CF to Equity at Cost of Capital to get equity value PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 + (83.49+1603)/1.09945 = $1248 Value of equity is overstated by $175. Error 2: Discount CF to Firm at Cost of Equity to get firm value l PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 + (123.49+2363)/1.136255 = $1613 PV of Equity = $1612.86 - $800 = $813 Value of Equity is understated by $ 260. Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity Value of Equity = $ 1613 Value of Equity is overstated by $ 540
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GUIDELINES FOR CORPORATE VALUATION

Discounted Cash Flow Valuation: The Steps Estimate the discount rate or rates to use in the valuation Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm) Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real Discount rate can vary across time.

Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm) Estimate the future earnings and cash flows on the asset being valued, generally by estimating an expected growth rate in earnings. Estimate when the firm will reach stable growth and what characteristics (risk & cash flow) it will have when it does. Choose the right DCF model for this asset and value it.

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GUIDELINES FOR CORPORATE VALUATION

Understand how the various approaches compare Use at least two different approaches Work with a value range Go behind numbers Value flexibility Blend theory with judgment Avoid reverse financial engineering Beware of common pitfalls Control premia & non-marketability factor for partial interest and control add 20-60% as premium to pro-rata value of the firm and deduct non-marketability discount for minority stake without control rights

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