CHAPTER 9: DISCOUNTED CASH FLOW (DCF) VALUATION

*

WITH FINANCIAL PLANNING MODELS
this version: Jul !"# !$$%
Ch&'ter (ontents
Overvie)*****************************************************************************************************************************************+
,*+* Wh&t -oes .v&lue o/ the /ir01 0e&n2*************************************************************************************%
,*!* 3sin4 the DCF v&lu&tion5su00&r**************************************************************************************,
,*%* Pro6e(tin4 the FCFs &n- -oin4 the DCF v&lu&tion )ith & /in&n(i&l 'l&nnin4 0o-el***********+7
,*8* A-v&n(e- se(tion: Wh&t9s the theor :ehin- the 0o-el2****************************************************!$
Su00&r***************************************************************************************************************************************!%
E;er(ises***************************************************************************************************************************************!8
Overvie)
In Ch&'ter < )e le&rne- ho) to use &((ountin4 (on(e'ts to :uil- & /in&n(i&l 'l&nnin4
0o-el o/ & (o0'&n* In this (h&'ter )e use /in&n(i&l 'l&nnin4 0o-els to v&lue & (o0'&n* This
is so0ethin4 th&t &l0ost ever /in&n(e s'e(i&list h&s to -o o((&sion&ll* The v&lu&tion te(hni=ue
)e e0'lo5(&lle- -is(ounte- (&sh /lo) >DCF? v&lu&tion5is the v&lu&tion te(hni=ue
univers&ll /&vore- : the /in&n(e 'ro/ession* DCF v&lu&tions &re o/ten :&se- on the /in&n(i&l
'l&nnin4 0o-els -is(usse- in Ch&'ter <* When these 0o-els &re use- to -o & DCF v&lu&tion#
the &re &lso use- to -o 0u(h o/ the sensitivit &n&lsis )hi(h hel's -eter0ine i/ the v&lu&tion is
re&son&:le*
@&lu&tion is not intrinsi(&ll -i//i(ult# :ut :e(&use there &re sever&l (o0'etin4
-e/initions o/ )h&t (onstitutes the .v&lue o/ & /ir0#1 'eo'le o/ten 4et (on/use-* To she- so0e
li4ht on this issue# Se(tion ,*+ -is(usses the -i//erent (on(e'ts o/ /ir0 v&lue* As ou )ill see in
Se(tion ,*+# /in&n(e s'e(i&lists o/ten i-enti/ the v&lue o/ the /ir0 )ith the 'resent v&lue o/ its
/uture (&sh /lo)s* We )ill use the /in&n(i&l 'l&nnin4 0o-els o/ Ch&'ter < to -eter0ine these
(&sh /lo)s*
A/ter -is(ussin4 the (on(e't o/ /ir0 v&lue in Se(tion ,*+# )e su00&riAe the ste's
involve- in & DCF v&lu&tion in Se(tion ,*!* We then 4o on to sho) ou ho) to v&lue & (o0'&n
: :uil-in4 & /ullB:lo)n DCF v&lu&tion 0o-el >Se(tion ,*%?*

Fin&n(e (on(e'ts use- Present v&lue Free (&sh /lo) Gor-on 0o-el >Ch&'ter C? Ter0in&l v&lue Mi-Be&r
v&lu&tion
E;(el /un(tions use- B NP@
B D&t& t&:les
,*+* Wh&t -oes .v&lue o/ the /ir01 0e&n2
The ter0s .v&lue o/ & (o0'&n1 or .v&lue o/ & /ir01 &re o/ten use- inter(h&n4e&:l :
/in&n(e 'ro/ession&ls* Even /in&n(e 'ro/ession&ls# ho)ever# (&n use & (on/usin4 v&riet o/
0e&nin4s /or these ter0s* Here &re & /e) o/ the 0e&nin4s )hi(h &re o/ten inten-e-: In /in&n(e the -e/inition
0ost o/ten use- /or ./ir0 v&lue1 is the /ollo)in4: The v&lue
o/ & /ir0 is the 0&rDet v&lue o/ the /ir09s e=uit 'lus the 0&rDet v&lue o/ the /ir09s
/in&n(i&l -e:t* This se(tion illustr&tes t)o 0etho-s o/ (o0'utin4 the /ir0 v&lue*
o The si0'lest 0etho- is to v&lue the /ir09s e=uit >its sh&res? usin4 the /ir09s
sh&re 'ri(e in the 0&rDet# &n- to &-- to this the v&lue o/ the /ir09s -e:t*
o A se(on- 0etho-# the DCF 0etho-# is :&se- on -is(ounte- (&sh /lo)s* In &
DCF v&lu&tion /ir0 v&lue e=u&ls the 'resent v&lue o/ the /ir09s /utures FCFs
'lus the v&lue o/ its (urrentl &v&il&:le li=ui- &ssets* O/ten )hen in-ivi-u&ls -is(uss the /ir0 v&lue# the re&ll
0e&n the v&lue o/ its
sh&res* It is :etter to use the ter0 e=uit v&lue /or the v&lue o/ & (o0'&n9s sh&res
&n- to use the ter0 /ir0 v&lue >or (o0'&n v&lue? to -enote the 0&rDet v&lue o/ the
/ir09s e=uit 'lus its -e:t* In our (&l(ul&tions )e &lso sho) ou ho) to (o0'ute the
v&lue o/ & /ir09s sh&res* So0eti0es the ter0 /ir0 v&lue is use- to -enote the &((ountin4 v&lue o/ the /ir0*
Also Dno)n &s the :ooD v&lue# this v&lue is :&se- on the /ir09s :&l&n(e sheets*
Ee(&use &((ountin4 st&te0ents &re :&se- on histori(&l v&lues# 'eo'le in /in&n(e 4ener&ll 're/er not to use this
-e/inition* At the en- o/ this se(tion )e illustr&te )h
)e -o not liDe this v&lu&tion 0etho-*

Mother:o&r- Shoes: Wh&t9s it )orth2
To illustr&te the -i//erent (on(e'ts o/ /ir0 v&lue# )e9ll tell the stor o/ Mother:o&r-
Shoes* Mother:o&r- is liste- on the Chi(&4o Sto(D E;(h&n4e# :ut the 0&6orit o/ the sto(D is
o)ne- : the Mother:o&r- /&0il# )hi(h /oun-e- the (o0'&n &n- still runs it* The (urrent
-&te is + J&nu&r !$$7# &n- the Mother:o&r-s h&ve re(eive- &n o//er /or their sh&res /ro0
Centur Shoe Intern&tion&l* The )oul- liDe to Dno) i/ the o//er is & /&ir one*
Their invest0ent &-visor# John M:& h&s &-vise- the0 th&t there &re t)o 'l&usi:le )&s
to v&lue the (o0'&n >John 6ust /inishe- :usiness s(hool &n- liDe- it so 0u(h th&t he (h&n4e-
his l&st n&0e to re/le(t his ne) st&tus?* E&(h o/ the t)o 0etho-s h&s &-v&nt&4es &n-
-is&-v&nt&4es*

The sh&re 'ri(e v&lu&tion: @&luin4 & Mother:o&r- : usin4 (urrent sh&re 'ri(e
The si0'lest )& to v&lue Mother:o&r- is looD &t the v&lue o/ its sh&re* Mother:o&r-
Shoes h&s one 0illion sh&res# )hi(h )ere tr&-in4 on %+ De(e0:er !$$8 &t F7$ 'er sh&re* Thus
the 0&rDet v&lue o/ the /ir09s e=uit is F7$ 0illion* In &--ition the (o0'&n9s :&l&n(e sheet
sho)s th&t it h&s shortBter0 -e:t o/ F!*7 0illion &n- lon4Bter0 -e:t o/ F"*7 0illionG John M:&
uses these :&l&n(e sheet v&lues >&lso (&lle- :ooD v&lues? o/ the -e:t &s &n &''ro;i0&tion to the +
-e:t9s 0&rDet v&lue*

The -is(ounte- (&sh /lo) >DCF? v&lu&tion: @&luin4 Mother:o&r- : -is(ountin4 its
/uture /ree (&sh /lo)s
The &-v&nt&4e o/ the sh&reB'ri(e v&lu&tion 0etho- illustr&te- &:ove is th&t it is ver
si0'le: The /ir0 v&lue e=u&ls the 0&rDet v&lue o/ the /ir09s sh&res 'lus the :ooD v&lue o/ its
-e:t* @&luin4 the (o0'&n &t its (urrent 'ri(e o/ F7$ 'er sh&re is 'er/e(tl &((e't&:le /or
so0eone (onsi-erin4 :uin4 & /e) sh&res o/ the (o0'&n# :ut it 0&Des less sense i/
Mother:o&r- Shoes is sellin4 & (ontrollin4 :lo(D o/ sh&res* In this (&se the 'ur(h&ser )oul-
'ro:&:l e;'e(t to '& 0ore /or the /ollo)in4 re&sons: I/ the 'ur(h&ser trie- to :u & :i4 :lo(D o/ sh&res o/
Mother:o&r- sh&res on the o'en
0&rDet# he )oul- 'ro:&:l h&ve to o//er 0ore th&n the (urrent 0&rDet 'ri(e 'er sh&re*
As he :ou4ht 0ore &n- 0ore sh&res# the 'ri(e )oul- 4o u'G in &--ition# the

1
This is common practice. Most company debt is not traded on financial markets, and therefore there is no
easily-
available market value for the debt. As a first approximation, most finance professionals use the book value of
a
firms debt as a proxy for the debts market value.
&nnoun(e0ent th&t so0eone )&s trin4 to t&De over Mother:o&r- Shoes )oul-5in
0&n (&ses5/or(e the sh&re 'ri(e u'* There &re :ene/its to (ontrollin4 & (o0'&n th&t &re not 'ri(e- in the
0&rDet 'ri(e 'er
sh&re* The 0&rDet 'ri(e o/ & sh&re re/le(ts the v&lue o/ & (o0'&n9s /uture -ivi-en-s
to & '&ssive sh&rehol-er )ho h&s no (ontrol over the (o0'&n* In 4ener&l the v&lue
o/ & (ontrollin4 :lo(D o/ sh&res is l&r4er th&n the 0&rDet v&lue# sin(e the (ontrollin4
sh&rehol-er (&n &(tu&ll -e(i-e )h&t the (o0'&n )ill -o* He (&n &lso -erive
(onsi-er&:le 'riv&te :ene/its /ro0 runnin4 the (o0'&n*

To -e&l )ith these 'ro:le0s# John M:& 'ro'oses to use the -is(ounte- (&sh /lo) >DCF?
v&lu&tion 0etho- to v&lue the sh&res* DCF v&lu&tions &re & st&n-&r- /in&n(e 0etho-olo4#
)hi(h -e/ines the v&lue o/ the /ir0 &s the 'resent v&lue o/ the /ir09s /uture /ree (&sh /lo)s
>FCF?# -is(ounte- &t the )ei4hte- &ver&4e (ost o/ (&'it&l >WACC?# 'lus the /ir09s initi&l (&sh
&n- 0&rDet&:le se(urities* Se(tion ,*8 -is(usses the theor :ehin- this 0etho- o/ v&lu&tion# :ut
/or the 0o0ent )e sDi' &ll the theor &n- si0'l 'resent the /or0ul&:

2
conomists use the term private benefits to discuss all kinds of financial and non-financial benefits associated
!ith
firm o!nership. The bi" car !ith a driver that the company "ives its president is a private benefit of
o!nership, and
so is the feelin" of o!nership#a psycholo"ical benefit, perhaps, but nonetheless valuable.
>Noti(e th&t the 'resent v&lue o/ the /ir09s /uture FCFs is o/ten (&lle- the /ir09s
enter'rise v&lue*? A/ter so0e )orD to esti0&te the /uture /ree (&sh /lo)s# John (o0es u' )ith
the /ollo)in4 v&lu&tion:
There &re & /e) thin4s to e;'l&in &:out this v&lu&tion: John h&s 'ro6e(te- 7 e&rs o/ /uture FCFs &n- h&s &lso
'ro6e(te- & ter0in&l v&lue &t the en- o/ the 7 e&rs* He e;'l&ins th&t the /in&n(e 0etho-olo4 re=uires hi0 to
esti0&te the &ll/utureFCFs 'resent v&lue o/ &ll the /uture /ree (&sh /lo)s: P@ * Ho)ever#
-is(ounte-&tWACC he thinDs this is too 0u(h 4uess)orD* Inste&- o/ esti0&tin4 &ll /uture FCFs# he9s
esti0&te- 7 e&rs o/ FCFs &n- then esti0&te- the ter0in&l v&lue# the v&lue o/
Mother:o&r- &t the en- o/ e&r 7:
I/ the )ei4hte- &ver&4e (ost o/ (&'it&l is !$H# the enter'rise v&lue# the 'resent v&lue o/
%
the FCFs &n- the ter0in&l v&lue# is FC<#C7"#8$"*

A--in4 (urrent :&l&n(es o/ (&sh &n- 0&rDet&:le se(urities to the 'resent v&lue o/ the
FCFs &n- su:tr&(tin4 out the v&lue o/ the /ir09s -e:ts 4ives &n e=uit v&lu&tion o/
F7,#+7"#8$" >(ell E+7?* Sin(e there &re one 0illion sh&res outst&n-in4# this v&lues e&(h
sh&re &t F7,*+C >(ell E+<?*

The /ir09s :ooD v&lue5& -e/inition )e9- r&ther not use
There9s &nother v&lu&tion 0etho- )hi(h John e;'l&ins to the Mother:o&r- /&0il5the
&((ountin4 -e/inition o/ /ir0 v&lue uses the :&l&n(e sheet to &rrive &t the v&lue o/ the /ir0* For
the (&se o/ Mother:o&r- Shoes# the :&l&n(e sheets &t the en- o/ !$$8 looD liDe:
The &((ountin4 -e/inition o/ /ir0 v&lue relies on :ooD v&lues# the v&lue o/ the /ir09s -e:t
&n- e=uit &s liste- in the /ir09s :&l&n(e sheet* Ie(&ll /ro0 Ch&'ter " th&t the &((ountin4
-e/inition# )hi(h is :&se- on histori(&l v&lues# is & :&(D)&r- looDin4 -e/inition* The /in&n(e
-e/inition o/ /ir0 v&lue is & /or)&r- looDin4 -e/inition >it -is(ounts the /uture &nti(i'&te- v&lues
o/ the (&sh /lo)s?* John M:& thinDs th&t the &((ountin4 -e/inition 4ives &n in&''ro'ri&te v&lu&tion# &n- he9s
ri4ht*
In the (&se o/ Mother:o&r- Shoes# the /or)&r-BlooDin4 DCF v&lu&tion
o/ the /ir0 is FC<#C7"#8$" )here&s the :&(D)&r-BlooDin4 &((ountin4 -e/inition is F+8#$$$#$$$*


,*!* 3sin4 the DCF v&lu&tion5su00&r
The DCF v&lu&tion o/ & /ir0 is :&se- on -is(ountin4 the /ir09s /uture e;'e(te- /ree (&sh
/lo)s >FCFs?# usin4 the )ei4hte- &ver&4e (ost o/ (&'it&l >WACC? &s the -is(ount r&te* In this
se(tion )e su00&riAe the ste's /or i0'le0entin4 this v&lu&tion# &n- in the ne;t se(tion )e
illustr&te & DCF v&lu&tion usin4 & /in&n(i&l 'l&nnin4 0o-el )e le&rne- in Ch&'ter <*

Ste' +: Esti0&te the )ei4hte- &ver&4e (ost o/ (&'it&l
The WACC is the -is(ount r&te /or the /uture FCFs* We -is(usse- the WACC in Ch&'ter
7 In this (h&'ter )e )ill not 4o into the -et&ils o/ C &n- 4&ve &n e;&0'le o/ ho) to esti0&te it*
esti0&tin4 the WACCG (&l(ul&tin4 the WACC ent&ils 0&n &ssu0'tions &n- in 0&n (&ses the
(&l(ul&tion itsel/ :e(o0es & to'i( o/ (ontrovers &0on4 the '&rties involve- in the v&lu&tion*
For this e;&0'le# )e &ssu0e th&t John M:&9s esti0&te o/ & !$H WACC is (orre(t* In Se(tion

$
%ot to dispara"e accountin" &very important' or accountants &most of !hom !ould readily a"ree'.
(
)ater in the book, *hapter 1( "ives another approach to estimatin" the +A**.
,*% )e )ill 'er/or0 so0e sensitivit &n&lsis >usin4 &n E;(el D&t& T&:le? to sho) ho) (h&n4es
in the WACC &//e(t the v&lu&tion*

Ste' !: Pro6e(t & re&son&:le nu0:er o/ FCFs
A /in&n(i&l 'l&nnin4 0o-el9s 're-i(tions o/ /uture FCFs &re :&se- on the &ssu0'tion th&t
the '&r&0eters o/ the 0o-el )ill not (h&n4e : too 0u(h* Most /in&n(i&l &n&lsts -e/ine
C
.re&son&:le1 to 0e&n nu0:er o/ 'erio-s over )hi(h this :&si( &ssu0'tion is not too sill*

Everone re(o4niAes th&t & /ir09s environ0ent is -n&0i( &n- th&t the 0o-el '&r&0eters )ill
(h&n4e over ti0e# & /&(t th&t is usu&ll &--resse- : -oin4 sensitivit &n&lsis >see se(tion ,*8?*
John h&s &ssu0e- th&t he (&n re&son&:l 'ro6e(t the ne;t 7 e&rs o/ (&sh /lo)s*

Ste' %: Pro6e(t the lon4Bter0 FCF 4ro)th r&te &n- the ter0in&l v&lue
@&lu&tion usin4 the DCF 0etho- in 'rin(i'le re=uires us to 'ro6e(t &n in/inite nu0:er o/
/uture FCFs# :ut in & st&n-&r- /in&n(i&l 'l&nnin4 0o-el )e 'ro6e(t onl & li0ite- nu0:er o/
FCFs* A solution to this 'ro:le0 is to -e/ine the /ir09s ter0in&l v&lue &s the /ir0 v&lue &t the
en- o/ e&r 7* The -e/inition John uses is (ont&ine- in Fi4ure +*


,
The author defines -not too silly. as somethin" he can explain to his mother !ith a strai"ht face &and that she
!ont lau"h at him'.
As ou (&n see# there &re % '&rts to this v&lu&tion e=u&tion:
Line + is the 'resent v&lue o/ the /irst 7 e&rs o/ /ree (&sh /lo)s* John h&s 'ro6e(te- these
(&sh /lo)s oneB:Bone# usin4 & /in&n(i&l 'l&nnin4 0o-el >-et&ils to (o0e in Se(tion ,*%?*
Inste&- o/ 'ro6e(tin4 the 'resent v&lue o/ e&(h o/ the (&sh /lo)s in e&rs C# "# <# J#
in/init# John h&s (hosen to su00&riAe the0 in the 'resent v&lue o/ the ter0in&l v&lue*
Ter0in&l v&lue is )h&t )e 'ro6e(t the /ir0 to :e )orth &t the en-
o/ 'ro6e(tion horiAon* In Se(tion ,*8 )e e;'l&in ho) this e;'ression /or the ter0in&l v&lue is -erive-* For no)
)e &ssu0e th&t John9s 're-i(tion o/ Mother:o&r-9s ter0in&l v&lue is (orre(t* Line % 4ives the v&lue o/ the (&sh
&n- 0&rDet&:le se(urities* The ter0in&l v&lue /or0ul& re=uires us to esti0&te the lon4Bter0 FCF 4ro)th r&te*
In the /in&n(i&l 'l&nnin4 0o-el /or the Mother:o&r- Shoes FCFs# this lon4Bter0 4ro)th r&te is -i//erent
/ro0 the s&les 4ro)th r&te 'ro6e(te- /or the (o0'&n9s ne;t /ive e&rs* As ou )ill see in Se(tion ,*%# John
'ro6e(ts & rel&tivel hi4h 4ro)th r&te o/ s&les o/ +$H /or Mother:o&r- over the 7 e&r horiAon o/ the 'l&nnin4
0o-el* John9s (riterion /or (hoosin4 the lon4Bter0 FCF 4ro)th r&te o/ the (o0'&n is th&t & (o0'&n9s (&sh
/lo)s (&nnot 4ro) /orever &t & r&te 4re&ter th&n the e(ono0 in )hi(h it o'er&tes* He esti0&tes th&t the lon4B
ter0 4ro)th o/ the 3*S* e(ono0 is 7 'er(ent# &n- th&t this r&te is &lso the lon4Bter0 r&te /or Mother:o&r-
Shoes* 3sin4 his 0o-el# John M:& esti0&tes th&t Mother:o&r-9s e&rB7 FCF is F+%#$!,#++$*
3sin4 the WACC o/ !$ 'er(ent &n- the lon4Bter0 FCF 4ro)th r&te o/ 7 'er(ent# the (o0'&n9s
ter0in&l v&lue is F,+#!$%#""%:
Ste' 8: Deter0ine the v&lue o/ the /ir0
At this 'oint &ll the ele0ents o/ the /ir0 v&lu&tion /or0ul& &re in 'l&(e:
BWACC: the -is(ount r&te /or the FCFs &n- the ter0in&l v&lue
B Five e&rs o/ FCFs 'ro6e(te- /ro0 the /in&n(i&l 'l&nnin4 0o-el
B The ter0in&l v&lue o/ the /ir0
BThe /ir09s initi&l >e&r $? :&l&n(es o/ (&sh &n- 0&rDet&:le se(urities
We (&n no) v&lue the /ir0:
The v&lue o/ the /ir0 is FC,#+7"#8$" >(ell E,?* In (ells E+7 &n- E+< )e9ve &--e- t)o
0ore ste's:

Ste' 7: @&lue the /ir09s e=uit : su:tr&(tin4 the v&lue o/ the /ir09s -e:t to-&
/ro0 the /ir0 v&lue
The /ir0 v&lue is the v&lue o/ the /ir09s -e:t K e=uit* We &re o/ten intereste- in v&luin4
onl the /ir09s e=uit5our esti0&te o/ the 0&rDet v&lue o/ the /ir09s sh&res*
Sto(D 0&rDet &n&lsts o/ten use the esti0&te o/ & /ir09s e=uit v&lue to &rrive &t & 'erB
sh&re v&lu&tion o/ the /ir0* The then (o0'&re this esti0&te- 'erBsh&re v&lue to the (urrent
0&rDet 'ri(e to (o0e u' )ith & :u or sell re(o00en-&tion /or the sto(D* Sin(e Mother:o&r-
Shoes h&s +#$$$#$$$ sh&res outst&n-in4# the esti0&te- 0&rDet v&lue 'er sh&re is
This sh&re v&lu&tion is hi4her th&n the (urrent 0&rDet v&lue 'er sh&re o/ F7$* I/ the DCF
v&lu&tion &n&lsis )ere :ein4 use- to 0&De re(o00en-&tions &:out the sto(D# )e )oul- e;'e(t
the &n&lst )oul- 0&De & .:u1 re(o00en-&tion /or the Mother:o&r- Shoes* In this (&se the
&n&lsis is use- : John M:& to re(o00en- th&t Mother:o&r- :e t&Den over /or 0ore th&n its
(urrent 'ri(e 'er sh&re*

Ste' C: A--in4 0i-Be&r v&lu&tion
In Ch&'ter 8 >'&4e$$$? )e -is(usse- 0i-Be&r v&lu&tion o/ (&sh /lo)s* The i-e& )&s
th&t )hen (&sh /lo)s o((ur over the (ourse o/ the e&r &n- not &t the en- o/ the e&r# )e shoul-
$*7
t&De the st&n-&r- 'resent v&lue /or0ul& &n- 0ulti'l it :
+ WACC * For Mother:o&r-
Shoes# 0i-Be&r v&lu&tion 0&Des sense# sin(e the (o0'&n9s s&les o((ur throu4hout the e&r &n-
not 6ust &t e&rBen-* In the s're&-sheet :elo) ou (&n see ho) 0i-Be&r v&lu&tion &//e(ts the
v&lue o/ the /ir0 &n- 'ro6e(te- sh&re v&lu&tion: Cell E< sho)s th&t the 'resent v&lue o/ /uture
(&sh /lo)s &n- ter0in&l v&lue /ir0 v&lue in(re&ses /ro0 FC, 0illion to F"7 0illion* In (ell E+<
ou (&n see th&t the 'ro6e(te- sh&re v&lue in(re&ses to FC7*"+*
Ste' ": Don9t trust &nthin4L Do & sensitivit &n&lsis
@&lu&tions &re :&se- on & /or0i-&:le nu0:er o/ &ssu0'tionsL When )e -o sensitivit
&n&lsis# )e ev&lu&te the e//e(t o/ (h&n4in4 v&lues o/ the 0&in v&ri&:les on the v&lue o/ the /ir0*
Our .)e&'on o/ (hoi(e1 /or sensitivit &n&lsis is the
D&t& T&:le /e&ture o/ E;(el >see Ch&'ter
%$?* We le&ve our -e0onstr&tions o/ sensitivit &n&lsis /or the ne;t se(tion*


,*%* Pro6e(tin4 the FCFs &n- -oin4 the DCF v&lu&tion )ith & /in&n(i&l
'l&nnin4 0o-el
So /&r )e9ve sho)n ho) John M:& 'er/or0s his v&lu&tion# :ut )e h&ven9t sho)n the
/in&n(i&l 'l&nnin4 0o-el )hi(h 'ro-u(es the /ree (&sh /lo)s*
The 0o-el looDs & lot liDe those -is(usse- in Ch&'ter <*
Here it is# )ith the 0i-Be&r v&lu&tion -is(usse- in the 'revious se(tion:
Sever&l /e&tures o/ the 0o-el use- : John M:& to v&lue Mother:o&r- Shoes &re:
Net /i;e- &ssets &re &ssu0e- (onst&nt* John &ssu0es th&t5&s lon4 &s -e're(i&tion is
investe- :&(D into /i;e- &ssets5Mother:o&r- Shoes )ill nee- no 0ore /i;e- &ssets*
Another )& o/ thinDin4 &:out this &ssu0'tion is th&t the 0&6or e;'enses in(urre- /or
/i;e- &ssets &re e=u&l to the -e're(i&tion e;'enses* As ou (&n see in ro) %$ o/ the 0o-el this -oes not 0e&n
th&t /i;e- &ssets &t (ost &re (onst&nt* It -oes 0e&n# ho)ever#
th&t in the FCF (&l(ul&tions lines 87 >-e're(i&tion? &n- 8< >(&'it&l e;'enses? (&n(el out* John &ssu0es th&t in
e&(h o/ the ne;t /ive e&rs# Mother:o&r- Shoes )ill re'& F+
0illion o/ its F+$ 0illion -e:t* C&sh is the 'lu4*

Given the /ullB:lo)n /in&n(i&l 'l&nnin4 0o-el# there &re o:viousl 0&n sensitivit
&n&lses )e (&n 'er/or0* Eelo) )e sho) t)o -&t& t&:les* The /irst t&:le &n&lAes the e//e(t o/
the s&les 4ro)th &ssu0'tion >(ell E! o/ the 0o-el? on the sh&re v&lu&tion* John M:& h&s
esti0&te- s&les 4ro)th o/ +$H &nnu&ll /or the ne;t 7 e&rs* As ou (&n see# the e//e(t o/ this
&ssu0'tion is =uite -r&0&ti(* The 4re&ter the s&les 4ro)th >(ell E!?# the 4re&ter the v&lu&tion o/
Mother:o&r-9s sh&res:
Excel Note: Data tables
T!s "a# be te a$$%o$%!ate $lace to %e&!e' Data Tables( '!c a%e co&e%e) !*
Ca$te%+++, Wat "a# be co*-.s!*/ !* te $%e&!o.s )ata table !s te 012,345 !* cell 637,
T!s !s a %e-e%e*ce to te sa%e $%!ce calc.lat!o* !* te !*!t!al "o)el Te )ata table as8s
Excel to %e)o t!s calc.lat!o* -o% te sales /%o'ts !* cells A32:A97,
A se(on- sensitivit &n&lsis 'er/or0e- : John M:& is the e//e(t o/ the )ei4hte-
&ver&4e (ost o/ (&'it&l &n- the lon4Bter0 4ro)th r&te >(ells E77 &n- E7C? on the 'erBsh&re
v&lu&tion* Noti(e th&t these t)o '&r&0eters &//e(t the v&lu&tion in t)o )&s:
To e;&0ine the e//e(t o/ these t)o '&r&0eters# John :uil-s & t)oB-i0ension&l -&t& t&:le:
The results 'ro-u(e- : this sensitivit &n&lsis &re not sur'risin4:
Goin4 &(ross ro)s sho)s th&t &s the WACC in(re&ses# the v&lue 'er sh&re -e(re&ses*
Sin(e & l&r4er WACC 0e&ns th&t the 'resent v&lue o/ & /uture (&sh /lo) is less# this is to
:e e;'e(te-*
Goin4 -o)n (olu0ns sho)s th&t the l&r4er the lon4Bter0 4ro)th r&te e;'e(te- /ro0
Mother:o&r- Shoes# the 0ore the sh&res &re )orth* A4&in# this is not & sur'rise# sin(e
l&r4er lon4Bter0 4ro)th r&tes 0e&n hi4her FCFs &/ter the e&rB7 0o-el horiAon* As
note- in the :o; :elo)# our ter0in&l v&lue 0o-el onl )orDs )hen the lon4Bter0 4ro)th
r&te is less th&n the WACC* When this &ssu0'tion is not true >0e&nin4: the lon4Bter0
WACC?# )e9ve h&- E;(el )rite .n0/1 >.no 0e&nin4/ul /i4ure1?*
The 4ro)th Mte(hni=ue /or -oin4 this is e;'l&ine- :elo)*
,*8* A-v&n(e- se(tion: Wh&t9s the theor :ehin- the 0o-el2
In this se(tion )e e;'l&in so0e theoreti(&l 'oints &:out the v&lu&tion 0o-el illustr&te- in
the 'revious se(tion* Not &ll o/ this is e&s# &n- ou 0& >un-erst&n-&:l? )&nt to sDi' this 1
se(tion*


Wh is the /ir09s v&lue rel&te- to the P@ o/ the /uture FCFs2
Our :&si( v&lu&tion /or0ul& is:
The enter'rise v&lue o/ the /ir0 is -e/ine- to :e the v&lue o/ the /ir09s o'er&tions* In
/in&n(i&l theor# the enter'rise v&lue is the 'resent v&lue o/ the /ir09s /uture &nti(i'&te- (&sh
/lo)s* In this se(tion )e e;'l&in these (on(e'ts*

The v&lu&tion 'ro(ess
One )& o/ vie)in4 v&lu&tion is throu4h the use o/ the &((ountin4 '&r&-i40# :ut usin4
0&rDet v&lues* We re)rite the :&l&n(e sheet : 0ovin4 the (urrent li&:ilities /ro0 the
li&:ilitiesNe=uit si-e to the &sset si-e o/ the :&l&n(e sheet:


1
+hy !ould an author put a section like this in this book/ 0ur experience is that ultimately almost all finance
professionals are called upon to do valuations. At some point in every valuation, someone is "oin" to 1uestion
your
techni1ues and theory. Thats the time to come back to this section.
Note th&t this 0e&ns th&t )e (&n )rite the enter'rise :&l&n(e sheet in & sli4htl -i//erent
/or0:
We (&n use the FCF 'ro6e(tions &n- & (ost o/ (&'it&l to -eter0ine the enter'rise v&lue o/
the /ir0* Su''ose )e h&ve -eter0ine- th&t the /ir09s )ei4hte- &ver&4e (ost o/ (&'it&l >WACC?
Then the enter'rise v&lue o/ the /ir0 is the -is(ounte- v&lue o/ the /ir09s 'ro6e(te-
is !$H*2
FCFs 'lus its ter0in&l v&lue:
In this /or0ul&# the Oe&rB7 Ter0in&l @&lue is & 'ro; /or the 'resent v&lue o/ &ll FCFs /ro0 e&r
C on)&r-s*2

Ter0in&l v&lue
In -eter0inin4 the ter0in&l v&lue )e use & version o/ the Gor-on 0o-el -es(ri:e- in
Ch&'ter C* We h&ve &ssu0e- th&t5&/ter the e&r 7 'ro6e(tion horiAon5the (&sh /lo)s )ill
4ro) &t & r&te o/ 4ro)th e=u&l to the s&les 4ro)th o/ +$H* This 4ives the ter0in&l v&lue &s:


2
3n *hapter , !e introduced the topic of the +A** and sho!ed you ho! to calculate this usin" the 4ordon
dividend model. 3n *hapter 1$ !e sho! an alternative calculation of the +A** !hich uses the security
market
line. 3n this chapter !e simply assume a value for the +A**.
2
+e dont actually pro5ect these cash flo!s. +e determine the terminal value based on year-( 6*6.
The l&st e=u&lit is -erive- in & 0&nner si0il&r to the -ivi-en- v&lu&tion o/ sh&res >the Gor-on
0o-el? -is(usse- in Ch&'ter C*


Su00&r
The v&lu&tion o/ & :usiness >.ho) 0u(h is it )orth1? is one o/ the 0ost i0'ort&nt
&(tivities o/ & /in&n(i&l &n&lst* In this (h&'ter )e h&ve -es(ri:e- ho) to -o & -is(ounte- (&sh
/lo) >DCF? v&lu&tion usin4 the /in&n(i&l 'l&nnin4 0o-els o/ Ch&'ter <* To -o & DCF v&lu&tion
ou h&ve to un-erst&n- &l0ost &ll /&(ets o/ the :usiness:
Ho) the :usiness )orDs5this &//e(ts the /in&n(i&l '&r&0eters use- in the /in&n(i&l
'l&nnin4 0o-el* The (o0'osition o/ the /ir09s (urrent &ssets &n- (urrent li&:ilities
>0e&nin4: its net )orDin4 (&'it&l nee-e- to -o its :usiness? &n- the &0ount o/ /i;e-
&ssets >:uil-in4s &n- e=ui'0ent &n- l&n-? nee-e- to -o this :usiness5&ll o/ these /&(tors
&//e(t & /ir09s v&lu&tion*
Ho) to (o0'ute the (ost o/ (&'it&l* The )ei4hte- &ver&4e (ost o/ (&'it&l >WACC? is the
-is(ount r&te use- to v&lue the /uture FCFs o/ the /ir0* In this (h&'ter )e h&ve not
-is(usse- its (o0'ut&tion >Ch&'ters C &n- +7 4ive -i//erent &s'e(ts o/ the WACC (o0'ut&tion?*
Ho) to use E;(el to -o the relev&nt (o0'ut&tions*
C*+* Wh&t -oes the /ir09s WACC 0e&n2
The )ei4hte- &ver&4e (ost o/ (&'it&l >WACC? is the &ver&4e return th&t the (o0'&n
h&s to '& to its e=uit &n- -e:t investors* Another )& o/ 'uttin4 this is th&t the WACC is the
!
&ver&4e return sh&rehol-ers &n- -e:thol-ers e;'e(t to re(eive /ro0 the (o0'&n* The
-e/inition o/ the WACC is:
Here9s & si0'le e;&0'le to sho) )h&t )e 0e&n: 3nite- Tr&ns'ort In(* h&s % 0illion
sh&res outst&n-in4G the (urrent 0&rDet 'ri(e 'er sh&re is F+$* The (o0'&n h&s &lso :orro)e-
* 3nite-
F+$ 0illion /ro0 its :&nDs &t & r&te o/ <HG this is the (o0'&n9s (ost o/ -e:t r
7 P 8$H*Tr&ns'ort h&s & t&; r&te o/ T*
The (o0'&n thinDs its sh&rehol-ers )&nt &n &nnu&l return on their invest0ent o/ !$HG this !$H return is the
(o0'&n9s (ost o/ e=uit r *To (o0'ute 3nite- Tr&ns'ort9s WACC )e use the /or0ul&:

2
3n finance the expected return, the re1uired return, the cost of capital &be it cost of e1uity or cost of debt', the
re1uired rate of return are all synonyms. They all represent the market-ad5usted rate that investors "et &or
demand'
on various investments or securities.
2
+e use the symbol T to indicate the corporate tax rate.
The 3nite- Tr&ns'ort WACC (o0'ut&tion sho)s ou th&t the WACC -e'en-s on /ive
(riti(&l v&ri&:les* r # the (ost o/ e=uit* r is the return re=uire- : the /ir09s sh&rehol-ers* O/ the /ive
'&r&0eters in the WACC (&l(ul&tion# r is the 0ost -i//i(ult to (&l(ul&te* A 0o-el /or (&l(ul&tin4 r
is 4iven in Se(tion C*!*


$
8o! did 9nited Transport come to the conclusion that its shareholders !ant a 2:; return/ This is the
1uestion in
the computation of the +A**, and !e !ill spend a lot of this chapter discussin" the ans!er. <o be patient=
E# the 0&rDet v&lue o/ & /ir09s e=uit* We )ill usu&ll t&De E to e=u&l the nu0:er o/
sh&res o/ the /ir0 ti0es the 0&rDet 'ri(e 'er sh&re*
r # the (ost o/ -e:t* r is the (ost o/ :orro)in4 /or the /ir0* In 0ost (&ses )e )ill t&De
D D
r
to :e the /ir09s 0&r4in&l interest r&te5the interest r&te &t )hi(h the /ir0 (oul- :orro)
D
&--ition&l /un-s /ro0 its :&nDs or : sellin4 :on-s* A -et&ile- e;&0'le o/ the
(&l(ul&tion o/ r
/or &n &(tu&l /ir0 is 4iven in Se(tion C*8*
D
D# the 0&rDet v&lue o/ the /ir09s -e:t* In 0ost (&ses )e )ill t&De D to :e the tot&l v&lue
o/ the /ir09s /in&n(i&l o:li4&tions* An &(tu&l e;&0'le o/ & (&l(ul&tion /or D is 4iven
:elo) in Se(tion C*8*
T # the /ir09s t&; r&te* Most o/ten )e (&l(ul&te T : (o0'utin4 the &ver&4e t&; r&te o/
C C
the /ir0G see Se(tion C*8 /or &n e;&0'le*


1,:, Te ;o%)o* )!&!)e*) "o)el: )!sco.*t!*/ a*t!c!$ate) )!&!)e*)s to )e%!&e
te -!%"<s cost o- e=.!t# %

In this se(tion )e 'resent & /or0ul& /or (o0'utin4 the /ir09s (ost o/ e=uit r * We )ill
(&ll the /or0ul& the Gor-on -ivi-en- 0o-el# in honor o/ Mron Gor-on )ho /irst set out the
(
0o-el in +,7,*
This se(tion h&s t)o su:se(tions:
In the /irst su:se(tion )e -erive & 0o-el /or (&l(ul&tin4 the v&lue o/ & /ir09s sh&res :&se-
on their /uture &nti(i'&te- -ivi-en-s*


(
The model is sometimes simply called the 4ordon model> others call it the dividend discount model.
Su00in4 u'
In this (h&'ter )e h&ve (&l(ul&te- the /ir09s )ei4hte-B&ver&4e (ost o/ (&'it&l >WACC?*
The WACC is the risDB&-6uste- -is(ount r&te /or the /ir09s /ree (&sh /lo)s* It is o/ten use- to
v&lue 'ro6e(ts )hose risDiness is si0il&r to the risDiness o/ the /ir09s e;istin4 &(tivities# &n- it is
&lso use- to -erive the v&lue o/ the /ir0* Eoth o/ these uses h&ve :een illustr&te- in this (h&'ter*
The WACC is -e/ine- &s:
In the t&:le :elo) )e su00&riAe ho) )e -erive- e&(h o/ the ele0ents o/ this /or0ul&:
A /in&l )&rnin4
Cost o/ (&'it&l (&l(ul&tions &re (riti(&l /or v&lu&tions &n- (ontroversi&l* The involve &
0i;ture o/ theor &n- 6u-40ent* Al0ost ever nu0:er in the WACC (&l(ul&tion &:ove (&n :e
-eter0ine- in sever&l )&s* In 0&n (&ses 'ro/ession&ls -o e;tensive sensitivit &n&lsis on the
WACC &n- the FCF 4ro)th to est&:lish & 'ri(e r&n4e5the r&n4e o/ v&lu&tions )hi(h &''e&rs to
:e re&son&:le# 4iven the v&ri&tion in 'l&usi:le &ssu0'tions* The 0ost i0'ort&nt 0o-i/i(&tion ou 0i4ht )&nt to
0&De to the WACC (&l(ul&tion &:ove involves the (ost o/ e=uit r*An i0'ort&nt (o0'etin4 0o-el to the
Gor-on 0o-el is the (&'it&l &sset 'ri(in4 0o-el >CAPM?* In Ch&'ter +8 )e )ill sho) ou ho) to use this
0o-el to (&l(ul&te the (ost o/ e=uit*