Microsoft Power Point - 12 Cash Flow Based Valuation

8/4/2019 Microsoft Power Point - 12 Cash Flow Based Valuation

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12. Cash Flow based valuation

1. Dividend Growth Model

2. Earnings Growth Model

3. Free Cash Flow based Model

These use publicly

available figures

and very simpleassumptions such

as no growth or

constant growth


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Valuation

Present Value = Discounted Value of FutureExpected Free Cash Flows

For simplicity, we will say

+=

n

0 i

i

r)(1

FCFValuePresent We will study how

this is used


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1 Dividend Growth Model

PV of a perpetuity of C per period: PV= C/r

If the same dividend is expected inperpetuity: PV = D/r

This means that the Dividend is notgrowing

This is called the constant dividend

model

g-R

DP

e

10=

But dividend may be growing at rate g.

Present Value of constant dividend growth

company

e

10

R

DP =


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2 Earnings Growth Model

All the Earnings belong to the shareholders

The shareholders may decide to distributethem as dividends (no growth) or not

(maximum growth).

R

EP

e

10 =

g-R

EP

e

10 =

Present Value of constant earningsfirm

Present value of growing earningsfirm


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Comment on the Earnings

methodThe Earnings method assume that Earnings =

Cash Flow

This could be true if, for example, earnings wereconstant and the company was not growingbeyond that level

So depreciation = capital expenditure forreplacement

No capital expenditure for expansion

No increase in working capital


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From Earnings to Cash Flow

Earnings can be manipulated by

accounting entries. This would mean that two firms with

identical businesses but with different

reported earnings would have differentvalues

Therefore, people prefer to use freecash flows instead of earnings

The following model brings in more

realistic observations


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3 Free Cash Flow based

valuation

1. Projecting future cash flows

2. Horizon

3. Terminal Value

4. Discount rate

5. Applying this discount rate to the futurecash flows and terminal value.


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3.1 Projecting future cash flows

Usually Free Cash Flows are used

Based on non-financial flows

So start with NOPAT

Add depreciation

Adjust for operating working capital

Less Capital expenditure


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Reminder NOPAT and FCF

Below is a recent income statement for ABC Company.

Net sales $1,000

Cost of sales (including depreciation of $100) 600

Gross profit 400

Selling and admin. Exp (including interest of $60) 200

Income before tax 200Tax 68

Income after tax $132

Calculate ABC's free cash flow in this year assuming it spent$80 on new capital equipment and increased working capital$40.


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3.2 Horizon

This is the period over which cash flows

can be predicted with some certainty For risky businesses (high discount rate)

the horizon is short (e.g. high tech)

For stable businesses (lower discount

rate) the horizon is longer (e.g. Water supply)


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3.3 Terminal Value

Terminal value is often calculated bydetermining cash flow in the period beyond

the last projected period. Assume no salvage value; or

Assume perpetuity; or

Assume constant growth This predicted future cash flow is thencapitalized by a percentage k or (k-g)

This is terminal value in , say, end of year 5

NB: This capitalized figure has still to be

discounted back to the present using thediscount rate.


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Terminal Value

A company has FCF of 100, 120, 140,

160, 180 in the first five years It grows 3% thereafter

Its cost of capital is 13%

Calculate the terminal value of the growth

Calculate the present value of the terminal

value Calculate the present value of the

company


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Cumulated Present Value of

Firm

Total Present Value

Present Value

Discount by

Terminal value year 5 = FCF 6/ (k-g)

Present Value

Discount by 13%

Real Cash Flow

6 onwards543210Year

Answer: Terminal Value


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3.4 Discount rate

The discount rate for the free cash flows

would be

WACC


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3.5 Discounting future cashflows and terminal value.

The Free cash flows for the horizon period

And the Terminal Value

Are discounted at the appropriate rate (WACC)

This gives the value of the net assets

From this the value of the Debt is to be reducedto get the value of the equity.


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Question DCF:Grubb

Free cash flow next year will be $100 million

It is expected to grow at a 4 % annual rate indefinitely.

The company's WACC is 10 %

Market value of its liabilities is $1 billion,

20 million shares outstanding.

a. Estimate the price per share of Grubb's common stock.

b. Pickens believes that by selling the company DC 10,increasing the work day to eight hours, and institutingother cost savings, he can increase Grubb's free cash flownext year to $110 billion and can add a full percentagepoint to Grubb's growth rate without affecting its cost ofcapital. What is the maximum price Pickens can afford tobid for control of Grubb?


17/19


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Shapiro 11-5

What is the general stock price reactionto news that a company is increasing itsspending on research anddevelopment? What implications does

this reaction have for investmentdecision making?

Answer.


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Shapiro 11-10

On May 19, 1988, Citicorp's chairman, John Reed,announced that Citicorp was adding a staggering $3

billion to its reserves against losses on Third Worldloans. Reed's decision created a $2.5 billion loss forthe quarter and resulted in a loss for the year.

Nonetheless, Citicorp's stock rose from $50.625 to$55.375 in the week following the announcement.Why did the market respond so positively to this

disastrous earnings report?

Answer.

Microsoft Power Point - 12 Cash Flow Based Valuation

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