The cost of capital
To value a company using enterprise DCF, we discount free cash flow by the weighted average cost ofcapital (WACC). the WACC represents the oportunity cost that investors face for investing their funds in one particular business instead of others with similar risk.
What are the steps in a DCF analysis? (7 steps)
DCF Step #1 – Projections of the Financial Statements
DCF Step #2 – Calculating the Free Cash Flow to Firms
DCF Step #3 – Calculating the Discount Rate
DCF Step #4 – Calculating the Terminal Value
DCF Step #5 – Present Value Calculations
DCF Step #6 – Adjustments
DCF Step #7 – Sensitivity Analysis
What determines value?
CF and Cost of Capital
CF being dependent on ROIC & Revenue Growth
What is value?
- A company is a collection of assets
- The value of an assets is equal to the net sum of the present values of future expected cashflows
- Or the difference between cash flows and the cost of investment made, adjusted for time value of money and risk
• Cash flows are a function of return on
invested capital and revenue growth
Is pushing for growth always value enhancing?
The effect of growth depends on cost of capital (9%) and ROIC
Higher ROIC is always value increasing
5 determinants of competitive pressure (Porter):
- Threat of new entry
- Pressure from substitute products
- Bargining power of buyers
- Bargaining power of suppliers
- Rivalry among competitors
Sources of competitive advantage for firms:
Two sources:
Price premium:
- Innovative products
- Quality of products
- Brand (customers willing to pay more base on the brand)
- Customer lock-in
- Rational price descipline: Lower bound on prices established by large industry leaders through price signaling or capacity mangement
Cost of capital efficiency:
- Innovative business method
- Unique resources
- Economies of scale
- Scalable product/process
When does Growth add value to a company?
What does growth depend on?
Growth adds value only when ROIC > cost of capital
Growth depends on:
- Portfolio momentum (organic growth)
- Market share performance (organic growth)
- M&A (inorganic growth)
Enterprise Value VS Equity Value
Enterprise value equals the value of operations (core businesses) and nonoperating assets, such as excess cash.
Equity value can be computed indirectly by calculating Enterprise Value first and then subtracting any nonequity claims, such as debt.
Equity value = Enterprise value - Debt
The valuation process using enterprise DCF
Valuation is an iterative process:
1. Analyze Historical Performance By thoroughly analyzing the past, we can document whether the company has created value, whether it has grown, and how it compares with its competitors.
- Forecast Financials and Cash Flows
Project financials over the short and medium term. Short-term forecasts should be consistent with announced operating plans. Medium-term forecasts should focus on operating drivers, such as margins, and on capital turnover. - Estimate a Continuing Value
To forecast cash flows in the long-term future, use a perpetuity that focuses on the company’s key value drivers, specifically ROIC and growth. - Compute the cost of capital
To value the enterprise, free cash flow is discounted by the weighted average cost of capital. The cost of capital is the blended rate of return for all sources of capital, specifically debt and equity. - Enterprise Value to Equity Value
To convert enterprise value into equity
value, subtract any nonequity claims, such as debt, unfunded retirement liabilities,
capitalized operating leases, and outstanding employee options. - Calculate and Interpret Results
Once the model is complete, examine
valuation results to ensure your findings
are technically correct, your assumptions
are realistic, and your interpretations are
plausible.
Equity is a residual claimant, receiving cash flows only after the company
has fulfilled its other contractual claims. In today’s increasingly complex
financial markets, many claimants have rights to a company’s cash flow
before equity holders—and they are not always easy to spot.
name 7 of these claims:
- Debt. If available, use the market value of all outstanding debt.
- Unfunded retirement liabilities. Although total shortfall is not reported on the balance
sheet (only a smoothed amount is transferred to the balance sheet), the stock market
values unfunded retirement liabilities as an offset against enterprise value. - Operating leases. The most common form of off-balance-sheet debt is that of
operating leases. Under certain conditions, companies can avoid capitalizing leases as
debt on their balance sheets (required payments must be disclosed in the footnotes). - Contingent liabilities. Most cases, operating leases represent the largest off-balancesheet
obligation. Any other material off-balance-sheet contingencies, such as lawsuits
and loan guarantees, will be reported in the footnotes. - Minority interest. When a company controls a subsidiary but does not
own 100 percent, the investment must be consolidated, and the funding
provided by other investors is recognized on the company’s balance
sheet as minority interest. - Preferred stock. Although the name denotes equity, preferred stock in
well-established companies more closely resembles unsecured debt. - Employee options. Each year, many companies offer their employees
compensation in the form of options. Since options give the employee
the right to buy company stock at a potentially discounted price, they
can have great value.
High ROIC companies should focus on growth, while, low-ROIC companies should focus on improving returns before growing.
True/False?
True!
The length and detail of the forecast:
The explicit forecast period must be long enough for the company to reach
a steady state, defined by the following characteristics:
• The company grows at a constant rate and reinvests a constant proportion
of its operating profits into the business each year.
- The company earns a constant rate of return on new capital invested.
- The company earns a constant return on its base level of invested capital.
• In general, we recommend using an explicit forecast period of 10 to 15 years—
perhaps longer for cyclical companies or those experiencing very rapid growth.
7 Components of a good forecasting model:
• Many spreadsheet designs are possible. In the valuation example from the
preceding slide, the workbook contains seven worksheets:
- Raw historical data from company financials.
- Integrated financials based on raw data.
- Historical analysis and forecast ratios.
- Market data and WACC analysis.
- Reorganized financial statements (into NOPLAT and invested capital).
- ROIC and free cash flow (FCF) using reorganized financials.
- Valuation summary, including enterprise discounted cash flow (DCF),
economic profit, and equity valuation computations.
Approaches to calculate Continuing Value
Recommended Approaches:
- Key value driver (KVD) formula.
The key value driver formula is superior to alternative methodologies
because it is cash flow based and links cash flow to growth and ROIC. - Economic-profit model.
The economic-profit model leads to results consistent with the KVD formula,
but explicitly highlights expected value creation in the continuing-value (CV) period.
Other Methods:
• Liquidation value and replacement cost.
Liquidation values and replacement costs are usually far
different from the value of the company as a going concern. In a growing, profitable industry, a
company’s liquidation value is probably well below the going-concern value.
• Exit multiples (such as P/E and EV/EBITA).
A multiples approach assumes that a company will be worth
some multiple of future earnings or book value in the continuing period. But multiples from today’s
industry can be misleading. Industry economics will change over time and so will their multiples!
Closing thoughts on Continuing Value
• Continuing value can drive a large portion of the enterprise value and should
therefore be evaluated carefully.
• Several estimation approaches are available, but recommended models (such as the key value driver and economic-profit models) explicitly consider four components:
- Profits at the end of the explicit forecast period—NOPLATt+1
- The rate of return for new investment projects—RONIC
- Expected long-run growth—g
- Cost of capital—WACC
• A large continuing value does not necessarily imply a noisy valuation. Other methods, such as business components and economic profit, can provide meaningful perspective on your continuing-value forecasts.
The estimated beta used in CAPM has some issues:
Three problems:
- High standard error
- It reflects the firm’s business mix over the period of the regression, not the current mix
- It reflects the firm’s average financial leverage over the periodrather than the current leverage.
Main findings of “Best practices in estimating the cost of capital”
- DCF is the dominant form to estimate value
- WACC is the dominant discount factor for DCF valuation
- Weights are based on market not book value mixes of debt and equity
- The CAPM is the dominant model for estimating the cost of equity
“the WACC FALLACY”
a Explain why firms might overinvest in projects that are riskier than their core operations
The intuition:
- If the risk of a project is > than the WACC => NPV will be inflated > overinvestment in risky projects
- If the risk of a project < than the WACC => NPV will be deflated > underinvestment in risky projects
- Over-investment destroy value because of negative NPV, underinvestment destroy value as they are missed opportunities
For Exam: Using your WACC for a different industry will lead to under or over-investment in risky projects in that industry.
Why can it be easier to use multiples when valuing a company that operates in multiple industries?
Because then you don’t have to compute the WACC for every single industry.
When building multiples, the denominator should use a forecast of profits, rather than historical profits, why?
– Unlike backward‐looking multiples, forward‐looking multiples are consistent with the principles of valuation-particular, that a company’s value equals the present value of future cash flows, not sunk costs.
– Second, forward‐looking earnings are typically normalized, meaning
they better reflect long‐term cash flows by avoiding one‐time past
charges.
Trading vs Transaction multiples:
Trading multiples: • Focus on publicly traded firms • Provides up‐to‐date measure of market value • Focus on larger (possibly more complex) firms • Ignores synergies • Liquid stocks! • Give and indication of VALUE
Transaction multiples:
• Focus on previous transaction prices (M&As)
• Include acquisition premiums
• Gives information about frequency of transactions and market conditions
• Deal characteristics are noisy and will depend on both firm characteristics and timing
• Synergies might not apply to different transactions
• Given an indication of PRICE
Why are M&As important and necessary?
- Improve allocation of resources
- Discipline managers
- Value created by M&As is asymmetrically distributed
- Target shareholders usually gain from a merger
Explain how shareholder value theory views corporate social responsibility
Shareholder value sees CSR as an extra expense that will reduce the value transferred to shareholders
