RSM433 - Advanced Corporate Finance

Session 7
MODULE 2: VALUATION
CHAPTER 2: FUNDAMENTALS OF
VALUATION
1
Where We Are?
• Make good investment decisions

 Module 2: Valuation

o Session 6: What Creates Value?

o Session 7: Fundamentals of Valuation
o Session 8: M&A 1
o Session 9: M&A 2
RECAP OF LAST SESSION

3
How to Measure Value? The DCF Model
• The DCF model discounts free cash flows, meaning
the cash flow available to all investors – equity
holders and debt holders - at the weighted average
cost of capital (WACC)

Σ
Free Cash Flow t
Value
(1 + WACC)t

• The DCF model hence computes the Net Present

Value (NPV) using the WACC

4
Free Cash Flow: Cash is King!!
• Definition: Free cash flow is the after-tax cash flow
available to all investors: debt holders and equity
holders.
 Unlike « cash flows from operations » reported in a
company’s annual report, free cash flow is independent
of financing or non operating items
 It can be thought as after tax cash flows as if the company
held only core operating assets and financed the business
entirely with equity

5
Free Cash Flow: Cash is King!!

NOPAT1

Gross cash flows

Depreciation

Free cash
flows
Change in Net operating
working capital
Gross
investment in
Invested Capital
Capital expenditures (fixed
assets and intangible assets)

1 Also known as Unlevered Net Income or After Tax Operating Profit

6
Plan for this Session
1. The DCF Step 1/2: Cost of Capital/Forecasting Cash
flows
2. The DCF Step 3: The Terminal Value
3. Measuring the Value per Share
4. Valuation Using Multiples
Plan for Today: Objectives
• Objective #1: Step-by-step guide for analyzing and
valuing a company in practice using the DCF Model
• Objective #2: Apply the tools we have developed
thus far to build a valuation model of a firm
• Objective #3: Understand the stakes when valuing a
company
1. DCF STEP 1/2: WACC AND
FORECASTING CASH FLOWS

9
Estimating the Cost of Capital for levered firms
STEP 1 Compute the Cost of Equity

STEP 1.a Find a set of comparable firms

STEP 1.b Compute Asset or Unlevered Betas

STEP 1.c Relever the beta using the target capital structure

STEP 1.d Estimate the Cost of Equity using the CAPM

STEP 2 Estimate the cost of debt

STEP 3 Estimate the WACC using debt and equity market values
and the target capital structure
Free Cash Flows: Length and Details of the Forecast

• Develop an explicit forecast for a number of

years
• Value the remaining years with a perpetuity
formula
• The explicit forecast period should be long If not, the
enough that the company’s growth rate is company
explodes
less than or equal to that of the economy
• In general: the explicit forecast period is 5 to
15 years
Too short: Extrapolating FCF is problematic for growing firms

Too long: excess of details will make you miss the drivers of growth over the
long run
Mechanics of Forecasting: 5 steps
 Prepare and analyze historical financials: Identify ROIC and
STEP 1 growth

 Build the Revenue Forecast:

STEP 2 Almost every line item will rely directly or indirectly on revenues

 Forecast the Gross Cash Flows

STEP 3

 Forecast the Gross Investment

STEP 4

 Calculate Free Cash flows

STEP 5
Step 1: Analyze Historical Data
• Use raw data from the financial statements
• Collect raw data from the financial statements on
revenues and ROIC components
• Analyze historical:
 Revenue Growth: Company revenues, market growth,
market share
 ROIC:
o Operating margins
o PPE Turnover
o Working capital turnover
Step 2: Build the Revenue Forecast
• Top-down approach:
1. Size the total market
2. Determine market share
3. Forecast prices
Step 2: Build the Revenue Forecast
• In mature industries:
 The aggregate market grows slowly
 What matters is the change in market share: does the
company have the required products and services to
capture share? Can competitors displace the company’s
market position?
 Use announced capabilities for growth:
o Retail: new stores
o Pharmacy: patents, drugs in clinical trials
o Oil: reserves and refining capacity
Step 2: Build the Revenue Forecast
• In new-product markets:
 More work is required!
 For example, how to evaluate the potential size and speed
of penetration of the Microsoft Surface, a laptop-tablet
hybrid computer?
Step 2: Build the Revenue Forecast
• Use what you observe!: comparable markets
 Market Size: Size the tablet market of Apple or Samsung.
Will hybrids be adopted by even more users given their
greater functionality, or fewer, because of the higher
price?
 Penetration speed: Look at the speed of migrations for
other electronics going through transition (for example
from the voice-only cell phone to the smart phone). What
characteristics drive penetration speed?
 Prices: How competitive will the market be..
• There are more questions than answers!
Step 2: Build the Revenue Forecast
• The key is:
 Structuring the analysis
 Applying historical evidence

• If you lack confidence: use multiple scenarios, and

sensitivity analysis
Step 3: Forecast the Gross Cash Flows

 Decide what economic relationship drives the line item

STEP 1 (which is the economic driver?) and build the corresponding ratio
 For example: operating margin for EBIT

 Estimate the forecast ratio

STEP 2  A good start is to set the forecast ratio equal to the previous
year’s value

 Multiply the forecast ratio by its driver

STEP 3  For example: revenues for cost of goods sold
 Step 3: Forecast the Gross Cash Flows
• Most items are driven by Revenues!!!

Item Economic Ratio Driver

EBIT Operating Margins Revenues
Depreciation Depreciation Rate PP&E
Shortcut:
Revenues!

• Estimate the effective tax rate using historical data

to get NOPAT
 Problem 7.1 Alpha Inc.
$ million $ million
Historical Income Statement Historical Balance Sheet
2016 2015 2016
Revenues 240 Assets
Cost of goods sold (90) Operating Cash 5 5
Selling and general expenses (45) Excess Cash 100 60
Depreciation (19) Inventories 35 45
EBITA 86 Current assets 140 110

Interest expenses (23) Net PP&E 200 250

Interest income 5 Equity investments 100 100
Nonoperating income 4 Total assets 440 460
Earnings before taxes 72
Liabilities and equity
Taxes (24) Accounts payables 15 20
Net income 48 Short-term debt 224 213
Current Liabilities 239 233

Long-term debt 80 80
Common stock 65 65
Retained earnings 56 82
Total liabilities and equity 440 460

Could you give the forecast income statement based on a revenue growth of 20%
and non operating income growth of 33.3%?
Problem 7.1 Alpha Inc. - Solution
Step 4: Forecast Gross Investment
• Forecast:
 Operating working capital
 Long term capital

• Same methodology as for the income statement:

1. Determine the Economic Driver
2. Compute the Ratio
3. Use the ratio to obtain the forecast value
Step 4: Forecast Gross Investment

Operating Operating Operating Current

Working Capital Current Assets Liabilities

• Operating working capital excludes:

 any non operating assets such as excess cash, income tax
receivables
 any financing items such as short term debt and dividends
payable
Line Items Driver Ratio
Accounts Receivable Revenues Receivable/Revenues
Accounts Payable Cost
Inventories Revenues

• Short cut: % of Revenues!!

Problem 7.2 Alpha Company
$ million $ million
Historical Income Statement Historical Balance Sheet
2016 2015 2016
Revenues 240 Assets
Cost of goods sold (90) Operating Cash 5 5
Selling and general expenses (45) Excess Cash 100 60
Depreciation (19) Inventories 35 45
EBITA 86 Current assets 140 110

Interest expenses (23) Net PP&E 200 250

Interest income 5 Equity investments 100 100
Nonoperating income 4 Total assets 440 460
Earnings before taxes 72
Liabilities and equity
Taxes (24) Accounts payables 15 20
Net income 48 Short-term debt 224 213
Current Liabilities 239 233

Long-term debt 80 80
Common stock 65 65
Retained earnings 56 82
Total liabilities and equity 440 460

Could you give the forecast operating working capital?

Problem 7.2 Alpha Company - Solution
 Step 4: Forecast the Gross Investment

Net PP&E2017 Net PP&E2016 Depreciation2017 Capex2017

• Net PP&E is usually forecast as a percentage of

revenues
• Steps:
 Forecast net PP&E
 Forecast depreciation as a percentage of net PP&E the
year before
 Calculate Capex (to get free cash flows)
• Shortcut: Forecast Capex as % of revenues
Calculate Free Cash Flows!

NOPAT1

Gross cash flows

Depreciation

Free cash
flows
Change in Net operating
working capital
Gross
investment in
Invested Capital
Capital expenditures (fixed
assets and intangible assets)

1 Also known as Unlevered Net Income or After Tax Operating Profit

28
Problem 7.3 Alpha Company
• What is the forecast free cash flow of Alpha
Company in 2017?
Problem 7.3 Alpha Company - Solution
• What is the forecast free cash flow of Alpha
Company in 2017?
Problem 7.3 Alpha Company - Solution
• What is the forecast free cash flow of Alpha
Company in 2017?

Could you give the forecast operating working capital?

2. DCF STEP 3: THE TERMINAL
VALUE

32
Terminal Value
• Def: The value of the company’s expected cash
flows beyond the explicit forecast period.
Present Value of FCF Present Value of FCF
Value during Explicit Forecast after Explicit Forecast
Period Period

• Be careful: Terminal value is often a significant

fraction of firm’s value!
• Sensitivity analysis to assumptions about TV growth
rate
Terminal Value

• Terminal value is a large share of company’s total

value when capital spending is large in the first
years.
Terminal Value
• You apply the perpetuity formula to free cash flows:

Free Cash Flowst+1

Terminal Valuet
WACC - g
Total Firm Value

Σ
t=T
FCFt FCFT+1
Firm Value
(1+WACC)t (1+WACC)T (WACC – g)
t=1
Technical Rules
• Use a TV only when the company has reached a
steady state, usually after 10 years:
 The company grows at a constant rate by reinvesting a
constant proportion of its operating profits into the
business each year.
 The company earns a constant rate of return on both
existing capital and new capital invested.

• FCF should be based on sustainable revenues,

margins and return on invested capital => they
should reflect the midpoint of the company’s
business cycle, not a peak.
Technical Rules
• Growth: The best estimate for growth is probably
the long-term rate of consumption growth for the
industry’s product, plus inflation, or average
nominal GDP growth rate (4.2% 30 yrs average in
Canada). Sensitivity analyses are useful.
• WACC: Sustainable capital structure
• Depreciation: should converge to Capex
 Capex > Depreciation => company is expanding into
infinity because your assets are growing faster than you
are depreciating them.
 Capex < Depreciation => company's asset base will go to
nothing since you are depreciating more than you are
Problem 7.4 Terminal Value
• What is the terminal value of this firm? The Wacc is
11%

Year 1 Year 2 Year 3 Year 4 Year 5

Earnings 100.0 106.0 112.4 119.1 126.2
Net investment (50.0) (53.0) (56.2) (59.6) (63.1)
Free Cash flow 50.0 53.0 56.2 59.6 63.1
Problem 7.4 Terminal Value - Solution

• g = 6%
• Wacc = 11%
𝐹𝐶𝐹 ×(1+𝑔)
• Terminal Value in Year 5 -
𝑤𝑎𝑐𝑐 −𝑔

63.1 ×(1+ .06)

• Terminal Value in Year 5 = = 1337.72
.11−.06
1337.72
• Present Value of TV = = 793.87
1.115
3. MEASURING THE VALUE PER
SHARE

41
Valuing a Company’s Equity using DCF
 Value the company’s operations with a DCF approach
STEP 1

 Identify and value non operating assets such as excess

STEP 2 cash and marketable securities, non consolidated
subsidiaries to get gross enterprise value

 Identify all debt and non equity claim (pension liabilities

etc.)
STEP 3

 Subtract the value of debt and non equity claim to the gross
enterprise value
STEP 4

 Divide by the number of share to get value per share

STEP 5
4. VALUATION USING MULTIPLES

43
Valuation using Multiples
Concept: Assess value based on that of other
(publicly-traded) firms

Methodology: To use multiples properly, you need

to:
 Dig into the accounting statements to make sure that
you are comparing apples to apples

 Find a good set of comparables

44
Enterprise Value Multiples
• Numerator of the multiple is typically the
enterprise value of the firm (EV=D+E)

• Denominator of the multiple is

 A proxy for cash flows such as
o EBITDA
o FCF
o NOPAT
 OR an industry specific driver of the cash flows:
o Clicks or subscribers for a web site
o Number of PhDs for a laboratory
o Number of patents for a high-tech firm

45
Price Multiples
• Numerator of the multiple is the price per share

• Denominator of the multiple is earnings or proxy

for cash flows/driver of cash flows

46
Methodology of Valuation with Multiples
Step 1. Identify comparable firms in the same business as
the firm (or the project) you want to value: make sure
comparables are truly similar!
Step 2. Calculate multiple for comparable firms.

Step 3. Calculate average (mean or median) multiple for

the set of comparable firms.
Step 4. Multiply the average multiple by the actual value
for the denominator (the cash flow proxy or driver) of
the firm you want to value.

47
Valuation with multiples: Strengths
• Incorporates lots of information from other
valuations in a simple way, which can ease
communication

• Embodies market’s view about discount rate,

growth rate, returns on invested capital

• Can provide discipline (benchmark) by ensuring

valuation is consistent with that of other firms

48
 What is behind Value Multiples?
Suppose FCFs are a perpetuity…
Enterprise Value = FCF/(WACC-g)
which gives valuation ratio…
EV/FCF = 1/(WACC-g)
• So, comparable firms will have similar EV/FCF multiples
only if they have:
 The same WACC (requires similar D/(D+E)!)
 The same growth rate, g

49
 If we introduce ROIC..
EV = NOPAT*(1-g/ROIC)/(WACC-g)
which gives valuation ratio…
EV/NOPAT = (1-g/ROIC)/(WACC-g)

If same capital structure, the multiple depends on g and

ROIC!

50
 What is behind Price Multiples?
P/E=(1-Leverage)*EV/Earnings
• Leverage affects both the numerator and denominator!!

51
Be Careful with Price Multiples!!
• Better to use enterprise value multiples
 EV/EBITA, EV/FCF or EV/Nopat

• Price multiples (Price/Earnings) are problematic:

 When comparable firms have different leverage ratios!!

o When firms have a low leverage, P/E decreases with leverage

o For firms with a high leverage, P/E increases with leverage

 When you have non-operating income and expenses

52
Example

53
 Valuation with multiples: Limitations
Limitations:

• Difficult to find true comparables: implicitly assumes that all

comparables are alike in growth rates, cost of capital, leverage,
etc. (capital intensive versus capital light/online distribution
versus bricks and mortar…)

• Cannot incorporate firm-specific information

• Differences in accounting practices can affect earnings and

equity-based multiples: Better to use FCF and EBITA than earnings!!

• If everyone uses multiples, who does the actual fundamental

analysis?

• If market is overpaying, you will too!

54
Conclusion
• Never rely on valuation based only on multiples.

• Best to use multiples only as a check for valuation

based on discounted cash flows.

• Because of accounting differences, be careful in using

multiples to compare firms across industries, and
especially across countries.

• Ratios based on total firm value are better when

comparables have different capital structure.

55