Firm Valuation: A Summary

Class Notes for Corporate Valuation

Discounted Cashflow Valuation

t = n CF t Value = t t =1 (1 + r)

where,

n = life of the asset CFt = cashflow in period t r = discount rate reflecting the riskiness of the estimated cashflows

Two Measures of Discount Rates

Cost of Equity: This is the rate of return required by equity investors on an investment. It will incorporate a premium for equity risk -the greater the risk, the greater the premium. This is used to value equity. Reqd. ROR = Riskfree rate + b (Risk Premium) Cost of capital: This is a composite cost of all of the capital invested in an asset or business. It will be a weighted average of the cost of equity and the after-tax cost of borrowing. This is used to value the entire firm.

Equity Valuation
Figure 5.5: Equity Valuation Assets
Cash flows considered are cashflows from assets, after debt payments and after making reinvestments needed for future growth Assets in Place Debt

Liabilities

Growth Assets

Equity

Discount rate reflects only the cost of raising equity financing

Present value is value of just the equity claims on the firm

Free Cash Flow to Equity = Net Income Net Reinvestment (capex as well as change in working capital) Net Debt Paid (or + Net Debt Issued)

Firm Valuation
Figure 5.6: Firm Valuation Assets
Cash flows considered are cashflows from assets, prior to any debt payments but after firm has reinvested to create growth assets Assets in Place Debt Discount rate reflects the cost of raising both debt and equity financing, in proportion to their use

Liabilities

Growth Assets

Equity

Present value is value of the entire firm, and reflects the value of all claims on the firm.

Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) Net Reinvestment
Net Reinvestment is defined as actual expenditures on short-term and long-term assets less depreciation. The tax benefits of debt are not included in FCFF because they are taken into account in the firms cost of capital.

Valuation with Infinite Life

DISCOUNTED CASHFLOW VALUATION

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Expe cte d Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Firm is in stable growth: Grows at con stant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Fore ver

Le ngth of Pe riod of High Growth

Disc ount Rate Firm:Cost of Capital Equity: Cost of Equity

Getting Closure in Valuation

A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash t = CFt Value = flows forever. t t = 1 (1+ r) Since we cannot estimate cash flows forever, we estimate cash flows for a growth period and then estimate a terminal value, to capture the value at the end of the period: Value = t =N CFt t Terminal Value
t = 1 (1 + r) (1 + r)N

Stable Growth and Terminal Value

When a firms cash flows grow at a constant rate forever, the present value of those cash flows can be written as:
Value = (Expected Cash Flow Next Period) / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate

This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. While companies can maintain high growth rates for extended periods, they will all approach stable growth at some point in time. When they do approach stable growth, the valuation formula above can be used to estimate the terminal value of all cash flows beyond.

Valuing the Home Depots Equity

Assume that we expect the free cash flows to equity at Home Depot to grow for the next 10 years at rates much higher than the growth rate for the economy. To estimate the free cash flows to equity for the next 10 years, we make the following assumptions: The net income of $1,614 million will grow 15% a year each year for the next 10 years. The firm will reinvest 75% of the net income back into new investments each year, and its net debt issued each year will be 10% of the reinvestment. To estimate the terminal price, we assume that net income will grow 6% a year forever after year 10. Since lower growth will require less reinvestment, we will assume that the reinvestment rate after year 10 will be 40% of net income; net debt issued will remain 10% of reinvestment. Cost of equity 9.78%

Estimating cash flows to equity: The Home Depot

Year
1 2 3 4 5 6 7 8 9 10

Net Income
$ $ $ $ $ $ $ $ $ $ 1,856 2,135 2,455 2,823 3,246 3,733 4,293 4,937 5,678 6,530

Reinvestment Needs Net Debt Paid

$ 1,392 $ $ 1,601 $ $ 1,841 $ $ 2,117 $ $ 2,435 $ $ 2,800 $ $ 3,220 $ $ 3,703 $ $ 4,258 $ $ 4,897 $ Sum of PV of FCFE = (139) (160) (184) (212) (243) (280) (322) (370) (426) (490) $ $ $ $ $ $ $ $ $ $

FCFE
603 694 798 917 1,055 1,213 1,395 1,605 1,845 2,122

PV of FCFE
$ $ $ $ $ $ $ $ $ $ 549 576 603 632 662 693 726 761 797 835 $6,833

Terminal Value and Value of Equity today

FCFE11 = Net Income11 Reinvestment11 Net Debt Paid (Issued)11
= $6,530 (1.06) $6,530 (1.06) (0.40) (-277) = $ 4,430 million

Terminal Price10 = FCFE11/(ke g)

= $ 4,430 / (.0978 - .06) = $117,196million

The value per share today can be computed as the sum of the present values of the free cash flows to equity during the next 10 years and the present value of the terminal value at the end of the 10th year. Value of the Stock today = $ 6,833 million + $ 117,196/(1.0978)10 = $52,930 million

Valuing Boeing as a firm

Assume that you are valuing Boeing as a firm, and that Boeing has cash flows before debt payments but after reinvestment needs and taxes of $ 850 million in the current year. Assume that these cash flows will grow at 15% a year for the next 5 years and at 5% thereafter. Boeing has a cost of capital of 9.17%.

Expected Cash Flows and Firm Value

Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,057mn Year 1 Cash Flow $978 Terminal Value Present Value $896

2 3 4 5

$943 $994 $1,047 $1103 $ 43,057 $27767 Value of Boeing as a firm = $32,750

$1,124 $1,293 $1,487 $1,710

What discount rate to use?

Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A simple representation of the hurdle rate is as follows: Hurdle rate = Return for postponing consumption + Return for bearing risk Hurdle rate = Riskless Rate + Risk Premium The two basic questions that every risk and return model in finance tries to answer are:

How do you measure risk? How do you translate this risk measure into a risk premium?

The Capital Asset Pricing Model

Uses variance as a measure of risk Specifies that a portion of variance can be diversified away, and that is only the non-diversifiable portion that is rewarded. Measures the non-diversifiable risk with beta, which is standardized around one. Relates beta to hurdle rate or the required rate of return: Reqd. ROR = Riskfree rate + b (Risk Premium) Works as well as the next best alternative in most cases.

From Cost of Equity to Cost of Capital

The cost of capital is a composite cost to the firm of raising financing to fund its projects. In addition to equity, firms can raise capital from debt

Estimating the Cost of Debt

If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate. If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated,

and it has recently borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt

The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

Estimating Cost of Capital: Boeing

Equity

Cost of Equity = 5% + 1.01 (5.5%) = 10.58% Market Value of Equity = $32.60 Billion Equity/(Debt+Equity ) = 82%

Debt

After-tax Cost of debt = Market Value of Debt = Debt/(Debt +Equity) =

5.50% (1-.35) = 3.58% $ 8.2 Billion 18%

Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%

Estimating the Expected Growth Rate

Expected Growth

Net Income

Operating Income

Rete ntion Ra tio= 1 - Dividends/Net Income

Retu rn on Equity Net Income/Book Value of Equity

Reinvestment Rate = (Net Ca p Ex + Chg in WC/EBIT(1-t)

Retu rn on Capital = EBIT(1-t)/Book Value of Capital

Expected Growth in EPS

gEPS = (Retained Earningst-1/ NIt-1) * ROE = Retention Ratio * ROE = b * ROE ROE = (Net Income)/ (BV: Common Equity) This is the right growth rate for FCFE Proposition: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

Expected Growth in EBIT And Fundamentals

Reinvestment Rate and Return on Capital gEBIT = (Net Capex + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Return on Capital = (EBIT(1-tax rate)) / (BV: Debt + BV: Equity) This is the right growth rate for FCFF Proposition: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital.

Relative Valuation
In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include - Price/Earnings (P/E) ratios

and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) and variants (Tobin's Q)

Price/Book (P/BV) ratios

Price/Sales ratios

Multiples and DCF Valuation

Gordon Growth Model: P rDPS g Dividing both sides by the earnings,
0 1 n

P0 Payout Ratio* (1 g n ) PE = EPS0 r-gn

Dividing both sides by the book value of equity,

P0 ROE * Payout Ratio* (1 g n ) PBV = BV 0 r-g

If the return on equity is written in terms of the retention ratio and the expected growth rate
P0 ROE - gn PBV = BV 0 r-gn

Dividing by the Sales per share,

P0 Profit Margin* Payout Ratio* (1 g n ) PS = Sales 0 r-g
n