DES Chapter 2 1

Chapter 2

A Complete Corporate Valuation for a Simple

Company

DES Chapter 2 2

Three types of value

Book value: the company’s historical value as shown on its financial statements.

Market value: the current price at which an asset can be bought or sold.

Intrinsic value: estimate of the value an individual buyer places on an asset.

DES Chapter 2 3

Objective:

Objective is to provide a sound basis for estimating the intrinsic value of a stock.This intrinsic value is also called its fundamental value.The process is known as fundamental valuation—Warren Buffet is very successful at identifying a company’s fundamental value!

DES Chapter 2 4

The three basic concepts of valuation

Investors can only spend cash so "Cash is good and more cash is better."Cash today is worth more than cash tomorrow.Risky cash flows are worth less than safe cash flows.These three imply the value of a company depends on the size, timing, and riskiness of its cash flows.

DES Chapter 2 5

Valuation of a Simple Company: Mayberry Personal

Receivers, Inc. (MPR)Investors are:DebtholdersStockholders

DES Chapter 2 6

Debtholders and the value of debt

Consider a bond that pays $90 per year for 10 years, and $1,000 at the end of 10th year.

$90 is the coupon payment

$1,000 is the face value, or maturity value.

$90/$1000 = 9% is the coupon rate

DES Chapter 2 7

What do investors require?

MPR’s bonds compete in the market with other bonds. If investors can earn 9% on similar investments, then MPR has to offer at least 9% on its bonds to attract investors. The required rate of return is 9%.

rD = 9%

DES Chapter 2 8

More investors…

MPR’s shares of stock also compete in the market for investors.

Stockholders are the owners of the firm, and the value of ownership is the value of the asset, less any debt that is owed.

For example: Suppose MPR is worth $501 million. It owes $150 million to debtholders. So MPR’s equity is worth $501 – 150 = $351 million.

DES Chapter 2 9

Cash flows that equity holders receive

Dividends:Not fixed—usually growNo maturity dateRiskier than bond payments The required return on equity, rS,

compensates investors for this risk. MPR’s rS is 12%.

DES Chapter 2 10

Discounted dividend valuation

MPR’s last dividend, D0,was $2.34 per share, and is expected to grow at 5% per year.

The present value of these at 12% is:

10.35$....12.1

)05.1(34.2$

12.1

)05.1(34.2$

12.1

)05.1(34.2$3

3

2

2

=+++

Of course, this method becomes difficult to apply if the company doesn’t pay dividends!

DES Chapter 2 11

The Corporate Valuation Model

PV of cash flows available to all investors—called free cash flows (FCFs).

Discount free cash flows at the average rate of return required by all investors—called the weighted average cost of capital (WACC)

DES Chapter 2 12

Steps in the corporate value model

Determine weighted average cost of capital

Estimate expected future free cash flows

Find value of company

DES Chapter 2 13

Estimating the Weighted Average Cost of Capital (WACC)

Company has two types of investorsDebtholdersStockholders

Each type of investor expects to receive a return for their investmentThe return an investor receives is a “cost of capital” from company’s viewpoint.

DES Chapter 2 14

Cost of Debt

MPR’s cost of debt: rD = 9%.

But MPR can deduct interest, so cost to MPR is after-tax rate on debt.

If tax rate is 40%, then after-tax cost of debt is:After-tax rD = 9%(1-0.4) = 5.4%.

DES Chapter 2 15

Cost of Equity

Cost of equity, rs, is higher than cost of

debt because stock is riskier.MPR: rs = 12%

DES Chapter 2 16

Weighted Average Cost of Capital

WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type.

For MPR, target percent financed by equity: wS = 70%

For MPR, target percent financed by debt: wD = 30%

(More….)

DES Chapter 2 17

WACC (Continued)

WACC = wD rD (1-T) + wS rS

= 0.3(9%)(1 - 0.4) + 0.7(12%)

= 10.02%

DES Chapter 2 18

Free Cash Flow (FCF)

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

A company’s value depends upon the amount of FCF it can generate.

DES Chapter 2 19

Calculating FCF

FCF = net operating profit after taxes minus investment in operating capital

DES Chapter 2 20

Financial Statements

Balance sheetAssets (all of MPR’s assets are used in

operations)Operating assets

Operating current assets Property, plant, and equipment (PPE)

DES Chapter 2 21

Operating Current Assets

Operating current assets are the CA needed to support operations.Op CA include: cash, inventory,

receivables.Op CA exclude: short-term investments,

because these are not a part of operations.

DES Chapter 2 22

Operating Current Liabilities

Operating current liabilities are the CL resulting as a normal part of operations.Op CL include: accounts payable and

accruals.Op CA exclude: notes payable, because

this is a source of financing, not a part of operations.

DES Chapter 2 23

Balance Sheet: Assets

2001 2002 2003

Op. CA 162,000.0 168,000.0 176,400.0

Total CA162,000.0 168,000.0 176,400.0

Net PPE 199,000.0 210,042.0 220,500.0

Tot. Assets 361,000.0 378,042.0 396,900.0

DES Chapter 2 24

Balance Sheet: Claims

2001 2002 2003

Op. CL 57,911.5 62,999.7 66,150.0

Total CL 57,911.5 62,999.7 66,150.0

L-T Debt 136,253.0 143,061.0 150,223.0

Total Liab.194,164.5 206,060.7 216,373.0

Equity 166,835.5 171,981.3 180,527.0

TL & Eq. 361,000.0 378,042.0 396,900.0

DES Chapter 2 25

Income Statement2001 2002 2003

Sales 400,000.0 420,000.0 441,000.0Costs 344,000.0 361,994.2 374,881.6 Op. prof. 56,000.0 58,005.8 66,118.4Interest 11,678.7 12,262.8 12,875.5 EBT 44,321.3 45,743.0 53,242.9Taxes (40%) 17,728.4 18,297.2 21,297.2 NI 26,592.7 27,445.8 31,945.7Dividends 21,200.0 22,300.0 23,400.0Add. RE 5,392.7 5,145.8 8,545.7

DES Chapter 2 26

NOPAT (Net Operating Profit After Taxes)

NOPAT is the amount of after-tax profit generated by operations.NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have.

NOPAT = (Operating profit) (1-T)

= EBIT (1-T)

DES Chapter 2 27

Calculating NOPAT

NOPAT = (Operating profit) (1-T)

= EBIT (1-T)

NOPAT03 = 66.1184 (1-0.4) = 39.67104

million.

DES Chapter 2 28

Calculating Operating Capital

Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations. The short-term component is net operating

working capital (NOWC). The long-term component is factories,

land, equipment.

DES Chapter 2 29

Net Operating Working Capital

NOWC = Operating current assets

– Operating current liabilities

This is the net amount tied up in the

“things” needed to run the company on a

day-to-day basis.

DES Chapter 2 30

Net Operating Working Capital

NOWC = Operating CA – Operating CL

NOWC03 = $176.4 – $66.15

= $110.25 million

DES Chapter 2 31

Operating Capital

Operating capital = Net operating working capital

(NOWC) plusLong-term capital, such as factories,

land, equipment.

DES Chapter 2 32

Operating Capital = NOWC + LT Op. Capital

Capital03 = $110.25 + $220.50

= $330.75 million

This means in 2003 MPR had $330.75

million tied up in capital needed to support

its operations. Investors supplied this

money. It isn’t available for distribution.

DES Chapter 2 33

Investment in operating capital

Operating capital in 2002 was $315.0423 million

Operating capital in 2003 was $330.75 million

MPR had to make a net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2003.

DES Chapter 2 34

Calculating FCF

FCF = NOPAT – Investment in operating

capital

FCF03 = $39.67104 – (330.75 – 315.0423)

= $39.67104 – $15.7077

= $23.96334 million

DES Chapter 2 35

There are five ways for a company to use FCF

1. Pay interest on debt.

2. Pay back principal on debt.

3. Pay dividends.

4. Buy back stock.

5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

DES Chapter 2 36ReinvestmentBucket

Free Cash FlowBucket

DES Chapter 2 37

How Did MPR use its FCF?

Paid dividends: $23.4 millionPaid after-tax interest of: $12,875.5 (1-0.4) = $7.7253 millionFor a total of $31.1253 million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from?

MPR increased its borrowing by $150.223 – $143.061) = $7.162 million to make up the difference.

DES Chapter 2 38

Corporate Valuation

Forecast financial statements and use them to project FCF.

Discount the FCFs at the WACC

This gives the value of operations

DES Chapter 2 39

Value of Operations:

( )∑∞

= +=

1 1tt

tOp

WACC

FCFV

Of course, this requires projecting free cash flows out forever.

DES Chapter 2 40

Constant growth

If free cash flows are expected to grow at a constant rate of 5%, then this is easy:

2003 2004 2005 2006 2007 2008

FCF 23.963 25.161 26.419 27.740 29.12730.584

There is an easy formula for the present value of free cash flows that grow forever at a constant rate…

DES Chapter 2 41

Constant Growth Formula

The summation can be replaced by a single formula:

( )

( )gWACC

)g1(FCF

gWACC

FCFV

0

1Op

−

+=

−=

DES Chapter 2 42

The value of operations

( )

( )million 225.501$

05.01002.0

)05.01(96334.23$

)1(0

=

−

+=

−

+=

Op

Op

V

gWACC

gFCFV

DES Chapter 2 43

Value of EquitySources of Corporate ValueValue of operations = $501.225 millionValue of non-operating assets = $0 (in this

case)

Claims on Corporate ValueValue of Debt = $150.223 million

Value of Equity = ? Value of Equity = $501.225 - $150.223 = $351.002 million, or just $351 million.

DES Chapter 2 44

Value of EquityPrice per share

= Equity / # of shares

= $351 million / 10 million shares

= $35.10 per share

DES Chapter 2 45

A picture of the breakdown of MPR’s value

Equity

Debt

DES Chapter 2 46

Return on Invested Capital (ROIC)

ROIC can be used to evaluate MPR’s performance:

ROIC = NOPAT / Total operating capital in place at the beginning of the year

DES Chapter 2 47

ROIC calculation

ROIC03 = NOPAT03 / Capital02

ROIC03 = 39.67104 / 315.0423 = 12.6%.

This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So MPR added value during 2003.

DES Chapter 2 48

Economic Value Added (EVATM) (also called Economic Profit)

EVA is another key measure of operating performance.EVA is trademarked by Stern Stewart, Inc.It measures the amount of profit the company earned, over and above the amount of profit that investors required.

EP = NOPATt – WACC(Capitalt-1)

DES Chapter 2 49

Calculating EVA

EVA = NOPAT- (WACC)(Begng. Capital)

EVA03 = NOPAT03 – (0.1002)(Capital02)

EVA03 = $39.67104 – (0.1002)(315.0423)

= $39.67104 – $31.56742

= $8.1038 million

(More…)

DES Chapter 2 50

Economic profit…

This shows that in 2003 MPR earned about $8 million more than its investors required.

Another way to calculate EP is

EPt = (ROIC – WACC)Capitalt-1

= (0.125923 – 0.1002)$315.0423

= $8.1038 million

DES Chapter 2 51

Intuition behind EP

If the ROIC – WACC spread is positive, then the firm is generating more than enough “profit,” and is increasing value. But, if the ROIC – WACC spread is negative, then the firm is destroying value, in the sense that investors would be better off taking their money and investing it elsewhere.

DES Chapter 2 52

Applications of the corporate valuation model

Mergers and acquisitions Evaluate how much a target is worth under various

operating scenarios

Value-based management Make decisions with the goal of increasing the

company’s value

Fundamental investing Identify firms that are worth more than the current

stock price