Frameworks for Valuation Chapter 8 Summary Paula Heathcoat April 9, 2003.
-
Upload
randolf-joseph -
Category
Documents
-
view
221 -
download
2
Transcript of Frameworks for Valuation Chapter 8 Summary Paula Heathcoat April 9, 2003.
Frameworks for ValuationFrameworks for Valuation
Chapter 8 SummaryChapter 8 SummaryPaula HeathcoatPaula Heathcoat
April 9, 2003April 9, 2003
Valuing a company using the Valuing a company using the discounted cash flow approachdiscounted cash flow approach
4 models4 models
Enterprise DCF modelEnterprise DCF modelEconomic Profit ModelEconomic Profit ModelAdjusted Present Value (APV) ModelAdjusted Present Value (APV) ModelEquity DCF ModelEquity DCF Model
All models provide the same resultsAll models provide the same results(demonstrated later in this presentation)(demonstrated later in this presentation)
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Formula: Single-Business CompanyFormula: Single-Business CompanyEquity Value = Operating Value - Debt ValueEquity Value = Operating Value - Debt Value
Free cash flow from operations
Cash flow to debtholders
Cash flow to equity owners
Year 1 2 3 4 5
Discounted by WACC
Op
era
tin
g V
alu
e De
bt
Va
lue
Eq
uit
y V
alu
e
+
=
5064
6787 90
5043
332620
7090
100130
140
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Formula: Multi-business CompanyFormula: Multi-business CompanyEquity value = Equity value =
Sum of the values of the individual Sum of the values of the individual operating unitsoperating units
+ Marketable securities+ Marketable securities
- Corporate overhead- Corporate overhead
- Value of company debt and preferred stock- Value of company debt and preferred stock
1,750150 250
Unit D 2001,500
Unit C 300 300
P/ S 100
Unit B 400
1,100Unit A 700
Marketable securities
Value distribution
Value of operating units
Deb
tCom
mon
Equ
ity
Val
ue
Corporate Overhead
Enterprise Value
Reasons for recommending the Reasons for recommending the enterprise DCF model:enterprise DCF model:
The model values the components of the The model values the components of the business (each operating unit) that add up to business (each operating unit) that add up to the enterprise value the enterprise value The approach helps to identify key leverage The approach helps to identify key leverage areasareasIt can be applied consistently to the company It can be applied consistently to the company as a whole or to individual business unitsas a whole or to individual business unitsIt is sophisticated enough to deal with the It is sophisticated enough to deal with the complexity of most situations, yet easy to complexity of most situations, yet easy to carry out with personal computer toolscarry out with personal computer tools
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Value of operationsValue of operationsEquals the discounted value of expected future Equals the discounted value of expected future free cash flowfree cash flow
Free cash flowFree cash flow = = after tax operating earningsafter tax operating earnings
+ non-cash charges+ non-cash charges- investments in operating working - investments in operating working
capital, capital, property, plant, property, plant, and equipment, and equipment, and other and other assetsassets
Free cash flow = Free cash flow = sum of the cash flows paid to or sum of the cash flows paid to or
received received from all the capital providersfrom all the capital providers
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Value of operationsValue of operations
The The discount ratediscount rate applied to the free cash applied to the free cash flow should reflect the flow should reflect the opportunity costopportunity cost to to all the capital providers weighted by their all the capital providers weighted by their relative contribution to the company’s total relative contribution to the company’s total capital, or capital, or WACCWACC
opportunity costopportunity cost is the rate of return the is the rate of return the investors could expect to earn on other investors could expect to earn on other investments of equivalent riskinvestments of equivalent risk
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Value of operationsValue of operations
Indefinite life of a businessIndefinite life of a businessSeparate the value of the business into two periodsSeparate the value of the business into two periods
duringduring a precise forecast period a precise forecast periodafterafter a precise forecast period a precise forecast period
Value = present value of cash flow Value = present value of cash flow during during precise precise forecastforecast period + present value of cash flow period + present value of cash flow afterafter precise forecast period precise forecast period
The value after the precise forecast period is the The value after the precise forecast period is the continuing valuecontinuing value
Continuing value = NOPLAT (1-g/ROICContinuing value = NOPLAT (1-g/ROICii))
WACC-g WACC-g
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Value of debtValue of debtEquals the present value of the cash flow to Equals the present value of the cash flow to debt holders discounted at a rate that debt holders discounted at a rate that reflects the riskiness of that flowreflects the riskiness of that flow
Value of equityValue of equityEquals the value of the operations plus non-Equals the value of the operations plus non-operating assets, less the value of its debt operating assets, less the value of its debt and any non-operating liabilitiesand any non-operating liabilities
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
WACC Summary WACC Summary Hershey FoodsHershey Foods
Tax rate
Debt 12.1% 5.5% 39.0% 3.4% 0.4%Equity 87.9% 8.1% 8.1% 7.1%
WACC 7.5%
Contribution to weighted
average
Proportion of total capital
Source of
Opportunity cost
After-tax cost
Free Cash Flow Free Cash Flow Valuation SummaryValuation Summary
Year DiscountFactor
($ million) (7.5%) ($ million)
1999 331 0.930 3082000 349 0.865 302
2008 485 0.485 235Continuing value 14,710 0.485 7,138
9,855Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385Equity value per share 62.78
Free cash flow
Present Value Of FCF
Drivers of Free Cash Flow and ValueDrivers of Free Cash Flow and Value
The rate at which the company is growingThe rate at which the company is growingGrowth Rate = ROIC x Investment rateGrowth Rate = ROIC x Investment rate
Return on invested capital (relative to the Return on invested capital (relative to the cost of capital, or WACC)cost of capital, or WACC)
ROIC = NOPLAT / Invested capitalROIC = NOPLAT / Invested capital
If ROIC > WACC , then value is greater If ROIC > WACC , then value is greater If ROIC = WACC, then value is neutralIf ROIC = WACC, then value is neutralIf ROIC <WACC, then value is destroyedIf ROIC <WACC, then value is destroyed
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
DriversDriversTo increase value, a company must do one To increase value, a company must do one or more of the followingor more of the following
Earn a higher return on invested capital Earn a higher return on invested capital on legacy assetson legacy assets
Ensure that ROIC(new) exceeds WACCEnsure that ROIC(new) exceeds WACC
Increase the growth rate (keeping ROIC Increase the growth rate (keeping ROIC above WACC)above WACC)
Reduce WACCReduce WACC
Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model
Growth Rate & Free Cash Growth Rate & Free Cash FlowFlow
5% Growth rate ($ millions)
Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 105 110 116 122 128 134 141 148 155 163 171Net Investment 25 26 27 29 31 32 33 35 37 39 41 43Free cash flow 75 79 83 87 91 96 101 106 111 116 122 128
8% Growth rate ($ millions)
Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 108 117 126 136 147 159 171 185 200 216 233Net Investment 40 43 47 50 54 59 64 68 74 80 86 93Free cash flow 60 65 70 76 82 88 95 103 111 120 130 140
How ROCI and Growth Drive How ROCI and Growth Drive ValueValue
DCF Value
Operating profit ROIC(annual growth) 7.50% 10.00% 12.50% 15.00% 12.00%
3% $887 $1,000 $1,058 $1,113 $1,1706% $708 $1,000 $1,117 $1,295 $1,4429% $410 $1,000 $1,354 $1,591 $1,886
Value Value Value Destruction neutral creation
Assumes starting NOP LAT = 100, WACC = 10%, and a 25-year horizon after which ROIC = WACC
Economic Profit ModelEconomic Profit Model
Useful measure for understanding a Useful measure for understanding a company’s performance in any single yearcompany’s performance in any single yearEconomic Profit equals the spread Economic Profit equals the spread between the return on invested capital between the return on invested capital and the cost of capital times the amount and the cost of capital times the amount of invested capitalof invested capitalEconomic profit = Economic profit =
Invested capital x (ROIC - WACC)Invested capital x (ROIC - WACC)Translates the two value drivers (growth Translates the two value drivers (growth and ROIC) into a single dollar figureand ROIC) into a single dollar figure
Economic Profit ModelEconomic Profit Model
Economic Profit is the after-tax operating profits Economic Profit is the after-tax operating profits less a charge for the capital used by the less a charge for the capital used by the companycompanyEconomic Profit = NOPLAT - Capital chargeEconomic Profit = NOPLAT - Capital charge
= NOPLAT - (invested capital x WACC)= NOPLAT - (invested capital x WACC)
The approach says that the value of a company The approach says that the value of a company equals the amount of capital invested plus a equals the amount of capital invested plus a premium or discount equal to the present value premium or discount equal to the present value of its projected economic profitof its projected economic profitValue = Invested capital + present value of projected Value = Invested capital + present value of projected economic economic profitprofit
Economic Profit CalculationEconomic Profit Calculation
Forecast Forecast Forecast$ million 1997 1998 1999 2000 2001Return on invested capital 24.30% 23.0$ 23.00% 22.70% 22.60%WACC 8.30% 7.50% 7.50% 7.50% 7.50%Spread 16.00% 15.50% 15.50% 15.20% 15.10%Invested capital (beginning of year) 1,815 1,885 1,830 1,919 2,005Economic profit 291 293 283 292 304NOPLAT 442 434 420 436 454Capital charge (151) (141) (137) (144) (150)Economic profit 291 293 283 292 304
YearEconomic Profit
Discount Factor
Present Value of Economic Profit
($ million) (7.5%) ($ million)
1999 283 0.930 2632000 292 0.865 252
2008 403 0.485 196Continuing value 11,858 0.485 5,754Present value of economic profit 8,024Invested capital (beginning of year) 1,830
9,857Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385
Economic Profit Economic Profit Valuation SummaryValuation Summary
Free Cash Flow Valuation Free Cash Flow Valuation SummarySummary
Equity Value 9,385
Economic Profit Valuation Economic Profit Valuation SummarySummary
Equity Value 9,385
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
The APV model discounts free cash flows The APV model discounts free cash flows to estimate the value of operations, and to estimate the value of operations, and ultimately the enterprise value, where the ultimately the enterprise value, where the value of debt is then deducted to arrive at value of debt is then deducted to arrive at an equity value. an equity value. This is very similar to the enterprise DCF This is very similar to the enterprise DCF model, except:model, except:
APV model separates the value of operations APV model separates the value of operations into two componentsinto two components
The value of operations as if the company were The value of operations as if the company were entirely equity-financedentirely equity-financedThe value of the tax benefit arising from debt The value of the tax benefit arising from debt financingfinancing
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
The APV model reflects the The APV model reflects the findings from the findings from the Modigliani-MillerModigliani-Miller propositions on capital structurepropositions on capital structure
In a In a world with no taxesworld with no taxes, the enterprise , the enterprise value of a company (the sum of debt plus value of a company (the sum of debt plus equity) is independent of capital structure equity) is independent of capital structure (or the amount of debt relative to equity)(or the amount of debt relative to equity)
The value of a company should not be The value of a company should not be affected by how you slice it upaffected by how you slice it up
Remember these guys from Finance 602?
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
““Mr. Berra, would you like your pizza cut into six Mr. Berra, would you like your pizza cut into six or eight pieces?”or eight pieces?”
““Six please, I am not hungry enough to eat Six please, I am not hungry enough to eat eight.”eight.”
The pizza is the same size no matter how many The pizza is the same size no matter how many pieces you cut into it!pieces you cut into it!
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
The implications of The implications of MMMM for valuation in for valuation in a world without taxes area world without taxes are
the the WACC must be constantWACC must be constant regardless of regardless of the company’s capital structurethe company’s capital structure
Capital structure can only affect value Capital structure can only affect value through through taxes and other market taxes and other market imperfections and distortionsimperfections and distortions
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
The APV model The APV model
1)1) values a company at the cost of values a company at the cost of capital as if the company had no capital as if the company had no debt in its capital structure (the debt in its capital structure (the unlevered cost of equity)unlevered cost of equity)
2)2) adds the impact of taxes from adds the impact of taxes from leverage.leverage.
APV Free Cash Flow APV Free Cash Flow Valuation SummaryValuation Summary
Year Unlevered DiscountCost of Factor
($ million) Equity ($ million)
1999 331 7.80% 0.928 3072000 349 7.80% 0.860 301
2008 485 7.80% 0.472 229Continuing value13,526 7.80% 0.472 6,380
9,056Mid-year adjustment factor 1.037APV value of FCF 9,390
Free cash flow (FCF)
Present Value
APV Free Cash Flow Valuation APV Free Cash Flow Valuation Summary with Tax ImpactSummary with Tax Impact
APV value of FCF 9,390
Value of debt tax shield 642
Non-operating assets 450
Total enterprise value 10,482
Less: value of debt 1,282
Equity Value 9,200
APV Free Cash Flow APV Free Cash Flow Valuation SummaryValuation Summary
Equity Value 9,200
Free Cash Flow Valuation Free Cash Flow Valuation SummarySummary
Equity Value 9,385
Why is there a difference in the equity values?
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
Comparison…Comparison…
In the In the enterprise DCF modelenterprise DCF model, this , this tax benefittax benefit is is taken into consideration in the calculations of taken into consideration in the calculations of the the WACCWACC by adjusting the cost of debt by its by adjusting the cost of debt by its tax benefittax benefit
In the In the APV modelAPV model, the , the tax benefittax benefit from the from the company’s interest payments is estimated by company’s interest payments is estimated by discounting the projected tax savingsdiscounting the projected tax savings
The The keykey to reconciling the two approaches is the to reconciling the two approaches is the calculation of the calculation of the WACCWACC
Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel
Relating WACC to the unlevered cost of Relating WACC to the unlevered cost of equity assuming that the tax benefit of equity assuming that the tax benefit of debt is discounted at the unlevered cost debt is discounted at the unlevered cost of equityof equity
WACC = kWACC = kuu - k - kbb (B/(B+S)) T (B/(B+S)) T
WhereWhere kkuu = unlevered cost of equity = unlevered cost of equitykkbb = Cost of debt = Cost of debtT = Marginal tax rate on T = Marginal tax rate on
interest interest expensesexpensesB = Market value of debtB = Market value of debtS = Market value of equityS = Market value of equity
Enterprise DCF Adjusted for Enterprise DCF Adjusted for Changing Capital StructureChanging Capital Structure
The enterprise DCF The enterprise DCF model assumes that model assumes that the capital structure the capital structure and WACC would be and WACC would be constant every constant every periodperiod However, the capital However, the capital structure structure does does changechange every year every year
A separate capital A separate capital structure and WACC structure and WACC can be estimated for can be estimated for every yearevery year
Year WACC Discount(percent) Factor
($ million) (percent (7.5%) ($ million)1999 331 13.3 7.52 0.930 3082000 349 12.3 7.54 0.865 302
2008 485 13.1 7.52 0.483 234Continuing value 14,710 13.1 7.52 0.483 6,965
9,675Mid-year adjustment factor 1.037Value of operations 10,032Value of non-operating investments 450Total enterprise value 10,482Less: Value of debt 1,282WACC Equity Value 9,200
Free cash flow (FCF)
Debt/Total value
Present Value
APV Free Cash Flow APV Free Cash Flow Valuation SummaryValuation Summary
Equity Value 9,200
Enterprise DCF Adjusted Enterprise DCF Adjusted for Changing Capital for Changing Capital
StructureStructureEquity Value 9,200
The Equity DCF ModelThe Equity DCF Model
The equity DCF model The equity DCF model discounts the discounts the cash flowscash flows to the equity owners of the to the equity owners of the company at the company at the cost of equitycost of equity
Equity DCF Equity DCF Valuation SummaryValuation Summary
Year DiscountFactor
($ million) ($ million)
1999 245 0.925 2272000 137 0.856 118
2008 193 0.460 89Continuing value 12,895 0.460 5,934Discounted equity cash flows 8,454Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,261
Equity cash flow
Present Value
The Equity DCF ModelThe Equity DCF Model
This model also needs to be adjusted for This model also needs to be adjusted for the changing capital structure. It is the changing capital structure. It is necessary to recalculate the cost of equity necessary to recalculate the cost of equity every period using the following formulaevery period using the following formula
kkss = k = kuu + (k + (kuu - k - kbb)(B/S))(B/S)
WhereWhere k kss = levered cost of equity = levered cost of equity
Once the adjustment is made, the value Once the adjustment is made, the value using the equity DCF approach is the same using the equity DCF approach is the same as the APV approach and the enterprise as the APV approach and the enterprise DCF model with WACC adjusted every DCF model with WACC adjusted every periodperiod
Equity DCF Equity DCF Valuation SummaryValuation Summary
Year Levered Discountks Factor
($ million) (percent (percent) ($ million)
1999 245 13.3 8.16 0.925 2272000 137 12.3 8.13 0.855 117
2008 193 13.1 8.15 0.458 88Continuing value 12,838 13.1 8.15 0.458 5,880Discounted equity cash flows 8,393Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,200
Equity cash flow
Debt/Total value
Present Value
The Equity DCF ModelThe Equity DCF Model
Once the adjustment is made, the Once the adjustment is made, the value using the equity DCF approach is value using the equity DCF approach is the same as the APV approach and the the same as the APV approach and the enterprise DCF model with WACC enterprise DCF model with WACC adjusted every period.adjusted every period.
APV Free Cash Flow APV Free Cash Flow Valuation SummaryValuation Summary
Equity Value 9,200
Adjusted Enterprise DCF Adjusted Enterprise DCF Valuation SummaryValuation Summary
Equity Value 9,200
Adjusted Equity DCF Adjusted Equity DCF Valuation SummaryValuation Summary
Equity Value 9,200
The Equity DCF ModelThe Equity DCF Model
The equity DCF approach is not as useful The equity DCF approach is not as useful as the enterprise model as the enterprise model (except for (except for financial institutions)financial institutions) because because
Discounting cash flow provides less Discounting cash flow provides less information about the sources of value creationinformation about the sources of value creationIt us not as useful for identifying value-creation It us not as useful for identifying value-creation opportunitiesopportunitiesIt requires careful adjustments to ensure that It requires careful adjustments to ensure that changes in projected financing do not changes in projected financing do not incorrectly affect the company’s valueincorrectly affect the company’s valueIt requires allocating debt and interest expense It requires allocating debt and interest expense to each business unit, which creates extra to each business unit, which creates extra work, yet provides no additional information.work, yet provides no additional information.
Additional Models and Additional Models and ApproachesApproaches
Option Valuation ModelsOption Valuation ModelsModels which adjust for management’s Models which adjust for management’s ability to modify decisions as more ability to modify decisions as more information is made available.information is made available.
DCF ApproachesDCF ApproachesUsing real instead of nominal cash Using real instead of nominal cash flows and discount ratesflows and discount ratesDiscounting pretax cash flow instead Discounting pretax cash flow instead of after-tax cash flowof after-tax cash flowFormula-based DCF approachesFormula-based DCF approaches
Summary of ModelsSummary of Models
Enterprise DCF
Economic Profit
APV
Equity DCF
Adjus
tmen
t Adjustment
Economic Profit Model
Advantage over DCF Model:
EP is a useful measure for understanding a
company’s performance in any single year, while
cash flow is notAPV ModelAdvantage over
Enterprise DCF Model:
APV is easier to use when the capital
structure is changing significantly over the
projection period
Equity DCF ModelAdvantage:
Simple and Straightfoward
Disadvantage:Provides less information
Requires careful adjustments
Enterprise DCF ModelAdvantage:
Values the componentsPinpoints key leverage
areasConsistent
Can handle complex situations
Easy to carry out
Frameworks for ValuationFrameworks for Valuation
Questions?Questions?