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1. Most of the spreadsheet involves calculating the value of the equity (the stockholders value) using the Discounted Free Cashflow Method (DFCF). a. He finds the total value of the firm (Amazon).
b. Then he subtracts the pieces of value that get paid to others, such as bondholders and managers (through their options).
2. Part of the spreadsheet involves calculating the value of the equity using the relative valuation method of Price-to-Sales. Basic Steps for DFCF Firm Value
3.
4. Main Results a. The large negative cash flows in the early years dont impact the value that much because they last for a limited number of years.
Topic: How to value young, high-growth firms when they have no earnings, no financial history or comparable firms. Basic Solution: Value the firm 10 years in the future assuming some rough convergence to comparable industry free cash flow to the firm (FCFF) using FCFF/(k-g). Calculating the Valuation Inputs for Firms With Financial Data 1. FCFF - is the cash available to the firm after taxes and reinvestment needs required to sustain growth. FCFF = EBIT(1-T) - (CE - D) - (NCWC) Where EBIT = earnings before interest and taxes - also called operating income. T = marginal tax rate CE = Capital Expenditure D = depreciation NCWC = Change in non-cash working capital NOTE: EBIT(1-T) is used instead of EBT(1-T) because the cost of capital (debt) used to discount FCFF is after-tax.
2. g = RR * ROC Where g = Expected Growth in EBIT RR = Reinvestment Rate = (CE - D + NCWC) ROC = Return on Capital = EBIT(1-T)/capital invested 3. Cost of capital = k = ke[E/(D+E)] + kd[D/(D+E)]
Where
ke = cost of equity kd = after-tax cost of debt E = market value of equity D = market value of debt 4. Terminal Valuen = FCFFn+1 / (kn - gn) This value is discounted back n years at the appropriate k that covers the first n years, usually 10 years. Although first ten years FCFF is estimated and discounted, value comes largely from value after 10 years for the young firms of interest here. All inputs should be sustainable rates.
5. For the total firm value add the value of cash (C), marketable securities (MS) and other assets whose income is not consolidated in operating income (NOA).
FCFF (1 k ) k
n t t 1 t t
n 1
FCFF g (1 k )
t 1 n n t t 1
8. Equity Value Per Share = [Equity Value - Options Value]/ Shares Outstanding
9. Options value comes from management options, warrants and convertible debt or preferred.
Typically, the farther away current figures are from normal figures, the longer it is assumed to take until convergence to normal figures. If large growth is expected, then convergence may be quicker.
3. To handle tax effects of net operating losses (NOL), get PV of NOL = NOL(T)/(1+r)n where n is the year into which the losses are carried.
4. When should normal earnings be used? - when losses are transient - or cyclical. - use profitability and current revenues or capital to estimate normal earnings when scale of firm is changing. - long-term operational/structural problems - require adjusting margins to sustainable levels - industry average of stable firms. If problems seem insurmountable - consider bankruptcy so no value (or perhaps option value).
2. Expected Revenue Growth alternatives - use most recent 12 months growth for firm - growth for market the firm serves - sustainability depends on barriers to entry or competitive advantages
3. Sustainable Operating Margin - examine true competitors - Amazon - Specialty retailers - adjust firms own negative margins by removing research, development and advertising that are unusually high but must be expensed rather than capitalized by GAAP.
4. Reinvestment Needs - steady state - RR = g/ROC - all figures for steady state (see earlier) - assume RR growth = revenue growth
A. Then get $reinvestment = RR*current $Capital B. Or use $reinvestment = $Revenues/ (S/C) where S/C = Revenues/ Capital 5. Risk - estimate beta from financial characteristics - use industry average (internet firms) or assume convergence to industry average (specialty retail) in future.
Final Value
1. Firm Value = C + MS + NOA +
FCFF (1 k ) k
n t t 1 t t
n 1
FCFF g (1 k )
t 1 n n t t 1
Adjusted Equity Value Per Share = (Equity Value Per Share) * (1-default probability) 5. The most important value drivers are - sustainable margins - revenue growth - important but less - convergence time, reinvestment needs
Other Considerations
1. To deal with the uncertainty in pricing young firms consider investing in a portfolio of those you find undervalued rather than the most undervalued -you could be mistaken on the one- I.e. diversify.
2. Valuation shows what type of assumptions are required to justify market price - assumptions may seem reasonable or not.
3. Earnings growth obtained by cutting investment below that required to remain competitive and sustain future earnings may be misleading.
4. Comparables methods are popular because they are often easier to apply but actually implicitly rely on the same assumptions as the FCFF method. The FCFF method makes the assumptions easier to see and judge for reasonability.
For young firms, many get comparable ratio out 5-10 years and discount price back.
Main problem: if all firms in comparable group are under or over-valued then results are bogus.