You are on page 1of 56

CAFM® Principles

Outline CAFM® Principles

During this presentation you will learn the following :

• Six important rules you should always remember in financial


modeling
• Excel sheet shortcut keys
• Dividend Discount Model (DDM Model)
• Free Cash Flow to the Equity (FCFE)
• Free Cash Flow to the Firm (FCFF)
• Return on Capital (ROC)
• Return on Investments (ROI)
• Reinvestment Rate
• The specific usage of each model, purposes and their limitations
Outline CAFM® Principles

During this presentation you will learn to model the following:

• Future Values (FV)


• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Multiple Internal Rate of Return (MIRR)
• Payback period
• Discounted Payback
• Loan Schedule and the PMT function
• Continuous Compounding
• Discounting using dated cash flows (XIRR and XNPV)
• Enterprise Value (EV)
Outline CAFM® Principles

• Estimating Betas
• CAPM (Cost of Equity)
• Expected returns using different approaches
• Cost of Debt
• WACC analysis-Optimal Capital Structure
• Gordon Dividend Model-Supernormal growth (two stages and three
stages supernormal growth) and constant growth
• Case: Titan Cements Valuation
Keyboard Navigation Only on Ms Excel! CAFM® Principles
-Limited Use of the Mouse!

 To become a professional financial modeler, you should be able to


navigate the spreadsheet with minimal usage of the mouse.

 We know it’s difficult to forbid the usage of the mouse as a


beginner, yet you should make sure that by the end of the program
you’ll be able to navigate the spreadsheet with limited usage of the
mouse.
Main Excel Shortcuts! CAFM® Principles

 There are about 150 Excel shortcut keys that is embedded in Excel
(We will let you have access for all the shortcut keys on Excel!), yet
you should be familiar with the most important ones that all
professional financial modelers are expected to know and use!
(Note: Shortcut Keys change slightly depending on the Excel version you’re using)

Let’s have fun by applying the shortcut keys on Excel!


Shortcut Keys Definition
Press “Ctrl” + “↓” Goes Down the cells
Press “Ctrl” + “↑” Goes Up the cells
Press “Ctrl” + “→” Goes to the last used cell to the Right
Press “Ctrl” + “←” Goes to the last used cell to the Left
Press “Ctrl” + “G” Enters a specific reference cell
Press “Ctrl” + “Home” Goes to the Top of the page
Press “Ctrl” + “End” Goes to the down right of the page
Main Excel Shortcuts! CAFM® Principles

Shortcut Keys Definition


Press “Ctrl” + “Page Up” / “Page Navigates between sheets
Down”
Press “Ctrl” + “Shift” + “Backspace’’ Selects the whole data very quickly
Press “Shift” + “Space” Selects an entire row
Press “Ctrl” + “Space” Selects an entire column
Press “Ctrl” + “Shift” + “+” Insert
Press “Ctrl” + “-“ Deletes a row or a column
Press “Ctrl” + “Tab” Switches between opened workbooks
Press “Alt” + “Tab” Switches between applications
Press “Ctrl” + “X” Cut
Press “Ctrl” + “R” Copies the left cell to the right one
Main Excel Shortcuts! CAFM® Principles

Shortcut Keys Definition


Press “Ctrl” + “D” Copies the upper cell to the down one
Press “Ctrl” + “B” Bold
Press “Ctrl” + “I” Italic
Press “Ctrl” + “U” Underlined
Press “Ctrl” + “1” To Format cells
Press “Alt” + “H” or “N” or Switches between home screen tabs
“P” or “M” or “A” or “R” or i.e : Home (H), Insert (N), Page layout (P), Formulas
“W” (M), Data (A), Review (R), View (W)
Press “Fn” + “F2” Edits formula of the existing cell
Press “Fn” + “F4” Locks the cell with dollar sign
i.e. : $F$4
*Press another time “F4”: will lead to fix only the row.
*Press another time “F4”: will lead to fix only the
column.
Main Excel Shortcuts! CAFM® Principles

Shortcut Keys Definition


Press “Alt” + “=” Brings you to the sum function
Press “Shift” + “F3” Brings you to the excel function wizard
Press “Ctrl” + “ ` ” Views all the excel formulas in the
spreadsheet
Press “Ctrl” + “ ` ” again Returns to the normal view
Press “Shift” + “F10” Access the right click of the mouse
Press “Ctrl” + “F3” Name a cell
Practicing! CAFM® Principles

 How do you get it to the top? You, practice, practice, practice.

 The only way you can learn to develop good financial models is by
practicing a lot.

 The primary objectives of this program are to show you how to learn
and practice financial modeling the right way and to provide you with a
wide range of real world financial models.
Importance of Financial Modeling CAFM® Principles

 Financial modeling is an essential skill for finance professionals and


students.

 MS Excel and its built in programming language, Visual Basic for


Applications (VBA), are the preferred tools for the job.

 However, modeling using Excel and VBA is rarely presented as an


integrated subject in program certificates.
Importance of Financial Modeling CAFM® Principles

 The result is that both practitioners and students follow time-consuming


trial and error approaches to modeling and end up with models that are
not sufficiently flexible powerful, and dynamic.

 By dynamic we mean revolver modeling, that is any change to any


assumption cell, should dynamically impact the full model with no manual
adjustments.
Prior Knowledge CAFM® Principles

 Developing good financial models requires combining knowledge of


finance, mathematics, Excel and VBA- using modeling skills.

 In each of these areas, the following is what the program assumes.

 In finance and mathematics, we assume that you have the necessary


basic knowledge.
Prior Knowledge CAFM® Principles

 In Excel, we assume that you know the basics, and we’ll cover the
advanced features of Excel that you need for modeling in detail.

 VBA will be one of the important languages you will learn from this
program. We assume that you know nothing about it!

 VBA is a powerful and very useful tool that is already embedded in your
MS Excel.
Prior Knowledge CAFM® Principles

 Very few people use VBA in modeling because they are afraid of
learning “programming”.

 We will teach you VBA and modeling with VBA using a simple class-
tested approach.

 The key is to learn VBA as a language the same way you learned your
mother tongue

 You will be surprised to find out how little you have to learn to be able to
develop models with VBA that are often more useful, powerful, and
flexible than Excel models.
Prior Knowledge CAFM® Principles

 Finally, we assume that you are new to modeling. Even if you have
some experience, you will quickly find yourself challenged as you build
on your skills.

 You will learn by imitating and practicing on numerous models from all
areas of finance, and you will be able to challenge yourself further by
developing extensions to these models.
A Financial Model is a Statistical Tool CAFM® Principles
• In developing a financial model, the basic thing you are doing is
summarizing a complex set of technical and economic factors into a
number (such as value per share, IRR or debt service coverage).

– Forecasting has become an essential tool for any business and it is


central to statistics -- in assessing value, credit analysis, corporate
strategy and other business functions, you must use some sort of
forecast.

– Some believe economic forecasting has limited effectiveness and


worse, is fundamentally dishonest because uncertain unanticipated
events such as the internet growth, high oil prices, sub-prime
crisis, falling dollar continually occur.

– The whole idea of modeling, like statistics, is quantification. If a


concept cannot be quantified, it is a philosophy. The fundamental
notion of statistics is presenting and summarizing information, this is
the same as a financial.
Danger of Believing too Much in Models CAFM® Principles
• Alan Greenspan, Financial Times.
– “The essential problem is that our models – both risk models and
econometric models – as complex as they have become – are still too
simple to capture the full array of governing variables that drive global
economic reality. A model, of necessity, is an abstraction from the full
detail of the real world.”

• Naseem Taleb:
– In the not too distant past, say the pre-computer days, projections
remained vague and qualitative, one had to make a mental effort to
keep track of them, and it was a strain to push scenarios into the future.
It took pencils, erasers, reams of paper, and huge wastebaskets to
engage in the activity. The activity of projecting, in short, was
effortful, undesirable, and marred with self doubt.

– But things changed with the intrusion of the spreadsheet. When you
put an Excel spreadsheet into computer literate hands, you get
projections effortlessly extending ad infinitum. We have become
excessively bureaucratic planners thanks to these potent computer
programs given to those who are incapable of handling their
knowledge.
Steps in Creating A Model CAFM® Principles
Whether you are creating a financial model using Excel or VBA, you must
take a systematic approach. A systematic approach always involves
planning ahead and this takes some time.

Step 1: Define and Structure the Problem


Step 2: Define the Input and Output Variables of the Model
Step 3: Decide Who Will Use the Model and How Often (A model that will
be used frequently should be designed differently)
Step 4: Understand the Financial and Mathematical Aspects of the Model
Step 5: Design the Model
Step 6: Create the Spreadsheets or Write the VBA Codes
Step 7: Test the Model
Step 8: Protect the Model (Don’t bother to protect a VBA model because
most users do not even know how to open them!)
Step 9: Document your Model (Diagrams, Flowcharts, assumptions, how it ‘s
structured)
Step 10: Update the Model as Necessary
Rules To Remember CAFM® Principles
When you start your financial model there are a few rules
you need to remember to build a working model
A model should identify key industry and business drivers and model around them. These key business
and financial drivers should ultimately reconcile with a company’s overall vision and strategic actions.

Avoid modeling around potential drivers that represent averages in themselves. Break them down into
inputs and let the output represent the weighted average. This is one of the most significant modeling flaws
often leading to wrong outputs.

Try to understand how each driver is likely to behave during the forecast period, e.g., some costs (e.g.,
variable) will behave as a % of sales while others (e.g., fixed) are likely to move more along inflation.

Make sure your model has plenty of cross-checks to ensure that (1) assumptions make sense and (2) your
model is built properly.

A model should be dynamic, i.e., any change to any assumption cell should dynamically impact the full
model. Beware: there should be no manual adjustment whatsoever.

Ideally, every cell should represent either a single assumption input (A1 = 10) or a formulaic output linking
only cells together, i.e., A11 = A1+A10. This is particularly important to build dynamic models that are also
easy to audit.
LOOKUP Functions CAFM® Principles
LOOKUP (Vector Form)-We are covering those functions because you are likely
to use in financial modeling

 Definition: Looks in a one-row or one-column range for a value and returns a


value from the same position in a second one-row or one-column range. (This is
called the vector form of LOOKUP).

The syntax of the vector form of the LOOKUP functions is:


LOOKUP(lookup_value,lookup_vector,result_vector)

Lookup_value: is the value that LOOKUP searches for in the first vector- it can be a
number, text, a logical value, or a name or reference that refers to a value.

Lookup_vector: is a range that contains only one row or one column-The values in
it can be text ( A..Z), or numbers(-1,0,1), or logical values (True, False).

Result_vector: is a range that contains only one row or column. It must be the
same size as lookup_vector
LOOKUP Functions CAFM® Principles

 If LOOKUP cannot find the lookup_value  It matches the largest value in the
lookup_vector that is less than the lookup_value. This make it possible to lookup
values where the lookup_value falls in range instead of matching a specific value.

If the lookup_value is smaller than the smallest value in the lookup_vector 
LOOKUP gives the #N/A error value

For example: The tax table in the following figure provides information for
calculating taxes for a single filer given his/her taxable income. In the table, the
marginal tax rate is 10% and the base tax amount is $0 for taxable income up to
$8,025. For income between $8,025 and $32,550 they are 15% and
$802.50, respectively; and so on.

Here is how you will use the LOOKUP function to look up the marginal tax rate and
the results you will get for various taxable incomes.

=LOOKUP(29000,D9:D14, H9:H14)  will return 15%


=LOOKUP(55000,D9:D14, H9:H14)  will return 25%
=LOOKUP(400000,D9:D14, H9:H14)  will return 35%
HLOOKUP and VLOOKUP Functions CAFM® Principles

 HLOOKUP and VLOOKUP are parallel functions that work the same way- They
are known as the array form.

 HLOOKUP: Searches for a value in the top row of a table or an array (range) of
values and then returns the value from a specified row in the same column of the
table or array.

VLOOKUP: Searches for a value in the left most column of table or array (range)
and then returns a value from a specified column in the same row of the table or
array.

Use HLOOKUP when your comparison values are located in a row across the top
of a table of data, and you want to look down a specified number of rows.

Use VLOOKUP when your comparison values are located in a column of the left of
the data you want to find.
HLOOKUP and VLOOKUP Functions CAFM® Principles

 The syntax of the HLOOKUP function is:

HLOOKUP (lookup_value,table_array,row_index_num,range_lookup)

Lookup_value: is the value to be found in the first row of the table.


*Lookup_value can be a value, a reference, or a text string.

Table_array: is a table of information in which data is looked up. Use a reference


to a range or a range name. The values in the first row of table_array can be
text, numbers, or logical values.

 If range_lookup is TRUE, then the values in the first row of table_array must be
placed in ascending order.

Row_index_num: is the row number in table_array from which the matching


value will be returned. A row_index_num of 1 returns the first row value in
table_array, a row_index_num of 2 returns the second row value in table_array,
and so on.
HLOOKUP and VLOOKUP Functions CAFM® Principles
 Range_lookup: is a logical value that specifies whether you want HLOOKUP
to find an exact match or an approximate match. If TRUE or omitted, an approximate
match is returned.

In other words, if an exact match is not found, the largest value that is less than
lookup_value is returned.

If FALSE, HLOOKUP will look for an exact match. If one is not found, the error
value #N/A! is returned. This argument is optional, and if omitted is assumed to be
TRUE.

For example:

=VLOOKUP(140000,D9:H14,3)  will return $35,650


=VLOOKUP(63000,D9:H14,3)  will return $14,260
=VLOOKUP(140000,D9:H14,3,FALSE)  will return #N/A!(no exact match).
=VLOOKUP(140000,D9:H14,2,TRUE)  will return 36%
OFFSET Function CAFM® Principles

 OFFSET: Returns the reference to a single cell or a range of cells that is specified
number of rows and columns from a cell or range of cells.

 The syntax of the OFFSET function is:


=OFFSET(base_reference,rows,columns,height,width)

Base_reference: is the reference to the base cell or range from which the resulting
reference is to be calculated.
Rows: is the number by which the row number of the resulting reference is to be
offset from that of the base_reference.
Columns: Work in the same way.
Heights and Width: specifies the number of rows and columns to be included in
the resulting reference

Check OFFSET Example of Excel Spreadsheet


PV and NPV Function CAFM® Principles

 Both concepts, present value and net present value, are related to the value today
of a set of future anticipated cash flows.

Present Value (PV): is used if you need to discount all cash flows expected future
cash flows ( Use if Cash Flows are equal).

PV syntax function is:


=PV(rate,nper,pmt,[FV],[type]) Type 0 (Default) : Payment done at end of
each period.
Type 1: Payment done at the beginning of
each period

 Net Present Value (NPV): is used to net expected cash flows to its value today (
i.e: Expected revenues –initial investment), Use if Cash Flows are NOT equal.

NPV syntax function is:


=NPV(rate,value1…valuen)
PV and NPV Function CAFM® Principles

Check PV and NPV Example on Excel Spreadsheet

Check PV with growth in Nperiods and PV with growth in infinite


periods Example on Excel spreadsheet
PMT Function CAFM® Principles

 PMT: Calculates the loan payment based on constant payments and constant
discount rate

 PMT function syntax is:

=PMT(rate,nper,pv,[fv],[type])
Loan Schedule:

Check Loan Schedule example on Excel spreadsheet


MIRR and Data Tables CAFM® Principles
Graphical Presentation
 If the investment cash flows include several negative cash flows (i.e.: several
investment inflows), then if you compute the IRR, this might mislead your investment
decision because such an investment might have Multiple Internal Rates of Return
(MIRR).

If we graph the NPV ( Y-axis) and the discount rate on (X-axis) and the NPV graph
crosses the x-axis twice Then we have Two different IRRMIRR
5.00
Two IRRs
0.00
Net present value 0% 10% 20% 30% 40%
-5.00

-10.00

-15.00 Discount rate

-20.00

-25.00

Excel’s IRR function allows us to add an extra argument that will help us find both
IRRs.

Instead of writing =IRR(B6:B11), we write =IRR(B6:B11,guess)


Note: The Guess should be any number between 0 and 0.5
MIRR and Data Tables CAFM® Principles
Graphical Presentation
If the NPV graph crosses the X-axis (i.e.: Discount rate axis) one time There is
only one IRR
NPV of Bond Cash Flows
1200
1000
800
600

NPV
400
200
0
-200 0% 5% 10% 15% 20%
-400
Discount rate

To be able to graph the NPV, you should learn how to construct a data table

Data Table: Are powerful commands that make it possible to do complex


sensitivity analyses. Excel offers the opportunity in which only one variable is
changed, or one in which two variables are changed.

Check example on Excel spreadsheet-MIRR and One_IRR_Graph


XNPV and XIRR Functions CAFM® Principles

 The XNPV and XIRR functions can be used if the cash flows are occurring not
on fixed periodic intervals ( i.e.: not semiannual, or annual).
They allow us to do computations on cash flows which occur on specific dates
that need not to be even intervals.
XNPV and XIRR Functions CAFM® Principles

 XIRR: The function [puts annualized return. It works by computing the daily IRR
and annualizing it, XIRR=(1+DailyIRR)^365 -1

The XIRR syntax function is:


=XIRR(values,data,[guess])

XNPV: Computes the net present Value of a series of cash flows occurring on
specific dates

The XNPV syntax function is:


=XNPV(rate,values,data)

 Check example on Excel Spreadsheet


Gordon Model and Cost of Equity CAFM® Principles

Gordon Model: The value of a share is the present value of the future
anticipated dividend stream from the share, where the future anticipated
dividends are discounted at the appropriate risk-adjusted cost of equity, Re

Gordon Model:
Gordon Model and Cost of Equity CAFM® Principles
Using the Gordon Model you can calculate the implied cost of equity the market
is using.

You might be interested to look at the cash flow to equity ( i.e.:


Dividends, Repurchase of stocks, and stock issuance), then you can get a second
implied value for the cost of equity.
Gordon Model and Cost of Equity- CAFM® Principles
Supernormal Growth

 The supernormal growth model can be used to compute the cost of


equity, Re, for companies whose historical equity payout data overstate any
anticipation of future growth rates.

The Growth rate (g) should not be greater than the cost of equity (Re), or else
the Gordon Model wouldn’t work.

This will yield us to divide the company growth into phases (Phase one:
Supernormal Growth where g>Re, and Phase Two: Where g is expected to remain
constant and lower than the cost of equity till perpetuity.

g = 30% g = 20% g (Constant) = 6%...

Supernormal Growth Phase Normal Growth Phase


Beta, β CAFM® Principles

Definition: A measure of the volatility, or systematic risk, of a security or a portfolio in


comparison to the market as a whole. Beta is used in the capital asset pricing model
(CAPM), a model that calculates the expected return of an asset based on its beta and
expected market returns

Beta is calculated using regression analysis, and you can think of beta as the
tendency of a security's returns to respond to swings in the market.

 A beta of 1 indicates that the security's price will move with the market.

A beta of less than 1 means that the security will be less volatile than the market.

 A beta of greater than 1 indicates that the security's price will be more volatile than
the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile
than the market.

Many utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-
based stocks have a beta of greater than 1, offering the possibility of a higher rate of
return, but also posing more risk.
Beta, β Modeling CAFM® Principles
 If you would like to calculate the β of a stock, you should:

1- Get at least a 5 year historical price of the stock (The prices could be monthly prices).
2-Rearrange the prices from oldest to newest.
3-Calcualte the returns of the stock by: (Pe-Pi/Pi).
4-Decide to which benchmark index you would like the stock to be compared.
5-Get at least 5 year historical prices of the benchmark index
6-Rearrange the prices of the index from oldest to newest
7-Calculate the returns of the index by: (Pe-Pi/Pi)-Some modelers use ln(Pe/Pi)
8-Get the Slope between Returns of the stock (Y-axis) and the Return of the Benchmark(X-
axis)

Or Step 8 can be replaced by three additional steps:

8-Calculate the Covariance of the returns between the stock and the benchmark
9-Calculate the Variance of the returns of the benchmark

10-Implement this formula:

rs: Returns of the stock


rb: Returns of the benchmark
CAPM, Cost of Equity Modeling CAFM® Principles

 To calculate the Cost of equity using the Capital Asset Pricing Model.

 You need to model:

1-Return of the market


2-Risk-Free rate
3-Beta, β
4-Tax-rate-If you would like to calculate the Tax-adjusted CAPM

 The CAPM is: Re = Rf (1-T) + β*[ E(Rm)-Rf (1-T)]

Note: The tax rate should be the marginal tax rate.

Check the example on the Excel spreadsheet


Arbitrage Pricing Theory-APT CAFM® Principles

Arbitrage Pricing Theory:

 Is a well-known method of estimating the price of an asset. The theory


assumes an asset's return is dependent on various macroeconomic, market
and security specific factors.
 The APT along with the CAPM is one of two influential theories on asset
pricing. The APT differs from the CAPM in that it is less restrictive in its
assumptions.

The APT formula is:


E(r j ) = r f + β j1RP1 + β j2RP2 + β j3RP3 + β j4RP4 + ... + β jn RPn
The factors or the Betas can be:
1-Industrial Production
2-CPI
3-Oil Price
4-Many others that you think could effect the asset price…etc
Cost of Debt CAFM® Principles

Cost of debt is fairly straightforward to calculate.

 The rate applied to determine the cost of debt (Rd) should be the current market
rate the company is paying on its debt.

 If the company is not paying market rates, an appropriate market rate payable by
the company should be estimated.
The estimated value could be computed from:
1-The most recent issued debt by the company (Figure our the yield of this debt)
2-If you don’t have access neither to the current market borrowing rate specified for
the company nor the yield of the most recent issued debt, you should use your
common sense in such a situation.

Note: An example is offered on the Excel spreadsheet.

Calculating the Cost of Debt


Because companies benefit from the tax deductions available on interest paid, the
net cost of the debt is actually the interest paid less the tax savings resulting from the
tax-deductible interest payment.
Cost of Debt CAFM® Principles

Calculating the Cost of Debt

Because companies benefit from the tax deductions available on interest paid, the
net cost of the debt is actually the interest paid less the tax savings resulting from the
tax-deductible interest payment.
Weighted Average Cost of Capital CAFM® Principles

All capital sources:

1- Common stock Included in a WACC


2-Preferred stock calculation
3-Bonds and any other long-term debt

 All else equal, the WACC of a firm increases as the beta and rate of return on
equity increases, as an increase in WACC notes a decrease in valuation and a
higher risk.

The WACC equation is the cost of each capital component multiplied by its
proportional weight and then summing:
Weighted Average Cost of Capital CAFM® Principles

WACC= We* Re + Wd*Rd*(1-Tc) + Wps*Rps

Where We (Weight of equity) , Wd (Weight of debt) , and Wps (Weight of


preferred Stocks) refer to the weights of market values of equity, debt, and
preferred stocks.

 If you have a small % of preferred stocks (below 5 % of capital) some


practitioners add it to debt

Note (1) : Tc is the corporate marginal tax rate


Note (2) : We will cover unlevered beta, levered beta, Country
Risk Premium, Default Spreads, and the advanced calculation
of WACC during our advanced valuation models
The Excel Spreadsheet embeds: Basic WACC
Calculations and Advanced one ( The
advanced WACC calculation may be
complicated but not difficult)
Basic Concepts for Valuation Models CAFM® Principles
There are many discounting methods. All of them give the same results when we
use the
proper cash flows and the appropriate discounting rate. Fair value cannot be
dependent on a model.

1. FCFF - free cash flows to the firm: The most traditional method, in which operating
and investment cash flows are discounted using WACC

2. FCFE - free cash flows to equity: In which cash flows are discounted using cost of
equity

3. CCFF - capital cash flows the firm: In which capital cash flows (CCFE = FCFE +
CFD, CFD-cash flows to debt) are discounted using weighted average cost of capital
before tax

4. CCFE - capital cash flows to equity: In which capital cash flows (CCFE = FCFF-
CFD, CFD-cash flows to debt) are discounted using adjusted cost of equity before tax

5. EVAF - incremental economic value added to the firm: In which economic cash
flows to the firm are discounted using WACC
Basic Concepts for Valuation Models CAFM® Principles

6. EVAE - incremental economic value added to equity: In which economic cash


flows to
equity are discounted using cost of equity

7. ECFF - economic cash flows to the firm: In which economic cash flows against
initial book value of equity and debt are discounted using WACC

8. ECFE - economic cash flows to equity: In which economic cash flows against
initial book value of equity are discounted using cost of equity

9. BRAF - business risk adjusted free cash flows to the firm: In which cash flows
are
discounted using unlevered cost of capital

10.BRAE - business risk adjusted free cash flows to equity: In which cash flows
are
discounted using unlevered cost of capital
Basic Concepts for Valuation Models CAFM® Principles

11. RFAF - risk-free-rate adjusted free cash flows to the firm: In which cash flows
are
discounted using risk-free interest rate

12. RFAE - risk-free-rate adjusted free cash flows to equity: In which cash flows
are
discounted using risk-free interest rate

13. APVF - adjusted present value: In which cash flows to the firm are discounted
using
unlevered cost of capital

14. APVE - adjusted present value: In which cash flows to equity are discounted
using
unlevered cost of capital

15.FEVA - financial and economic value added: Which decomposes cash flows into
various
streams, and discounts them with unlevered cost of capital
Basic Concepts for Valuation Models CAFM® Principles

16. DDM - dividend discount models: In which dividends and cash surpluses are discounted
using cost of equity
17. Decomposition method: In which operating, investment, tax shield cash and differences
between equity cost of capital and external cost of capital flows are discounted using cost
of equity.

According to a proposition by Modigiliani and Miller:

The Value of an Enterprise Assets (Va) = Value of debt (Vd) + Value of Equity (Ve)

Then the valuation should be of three parts:

1-Value the company’s debt


2-Value the company’s equity
3-Sum part (1) and part (2)

Note: Despite varying world all 17 discounting methods give the same values of the firm
and equity.
Dividend Discount Model-DDM CAFM® Principles

Dividend Discount Model-DDM:

•Multiple growth rates: two or more expected growth rates in dividends.


•Ultimately, growth rate must equal that of the economy as a whole.
•Assume growth at a rapid rate for n periods followed by steady growth

D0( 1 + g1 ) Dn( 1 + g c )
t
n 1
P0 = ∑ +
t =1 ( 1 + Re ) Re -g ( 1 + Re )
t n

The supernormal growing Terminal Value Discounted at


dividends discounted separately cost of equity to the Present
at cost of equity Value
FCFE and FCFF CAFM® Principles

Free Cash Flow to Equity (FCFE):


What could shareholders be paid?

FCFE = Net Inc. + Depreciation – Change in Noncash Working


Capital – Capital Expend. – Debt Repayments + Debt Issuance –
Preferred Dividends + New Preferred Stock Issued

Free Cash Flow to the Firm (FCFF):


What cash is available before any financing considerations?

FCFF = EBIT (1-tax rate) + Depreciation – Change in Noncash


Working Capital – Capital Expend – Change in PV of OL
Multiples in Relative Valuation CAFM® Principles

Relative Valuation: (Easy and widely used, yet you shouldn’t use it blindly!)
To do relative valuation:

1. We need to identify comparable assets and obtain market values for


these assets.
2. Convert these market values into standardized values, since the
absolute prices cannot be compared This process of standardizing
creates price multiples.
3. Compare the standardized value or multiple for the asset being
analyzed to the standardized values for comparable asset, controlling
for any differences between the firms that might affect the multiple, to
judge whether the asset is under or overvalued.
Multiples in Relative Valuation CAFM® Principles

Prices can be standardized using a common variable such as


earnings, cashflows, book value or revenues.

1- Earnings Multiples

– Price/Earnings Ratio (PE) and variants (PEG and Relative PE)


– Value/EBIT
– Value/EBITDA
--Value/Cash Flow

2- Book Value Multiples


– Price/Book Value(of Equity) (PBV)
– Value/ Book Value of Assets

3- Revenues
– Price/Sales per Share (PS)
– Value/Sales

4- Industry Specific Variable (Price/kwh, Price per ton of steel ....)


Multiples in Relative Valuation CAFM® Principles

Relative Valuation:

1- Define the multiple in use

-The same multiple can be defined in different ways by different users.


When comparing and using multiples, estimated by someone else, it is
critical that we understand how the multiples have been estimated.

2- Describe the multiple

- Too many people who use a multiple have no idea what its cross
sectional distribution is. If you do not know what the cross sectional
distribution of a multiple is, it is difficult to look at a number and pass
judgment on whether it is too high or low.
Multiples in Relative Valuation CAFM® Principles
3- Analyze the multiple
- It is critical that we understand the fundamentals that drive each
multiple, and the nature of the relationship between the multiple and
each variable.

4- Apply the multiple

-Defining the comparable universe and controlling for differences is far


more difficult in practice than it is in theory.

You Should ask yourself the following every time you are using a
multiple for Relative Valuation:

Is the multiple consistently defined?

-Both the value (the numerator) and the standardizing variable ( the
denominator) should be to the same claimholders in the firm. In other
words, the value of equity should be divided by equity earnings or equity
book value, and firm value should be divided by firm earnings or book
value.
CAFM® Principles

Some Valuation Tips and Formulas You Should Know!

FCFF = [(Old EBIT + Current OL Expense – Depreciation OL)(1-tax


rate)] + Current R&D – Amortization of R&D– (Capex - Depreciation – OL
Depreciation + M&A) – Change in NCWC – Change in PV of OL

Note: [Capex – Depreciation] Net Capex


Adjusted EBIT(Old EBIT + OL Rental Exp – Dep. Of OL)

FCFE= NI - (Capex – Depreciation) – (Change in NCWC) – Preferred


Dividends + New Preferred Stock issued + New Debt issued – Debt
Repayments

Note: Tax rate should be the effective tax rate. In most cases the
marginal tax rate is approximately equal to the effective tax
rate.
Books References CAFM® Principles
1. Aswath Damodaran (2001), The dark side of valuation: Valuing
young, distressed, and complex Businesses( 2nd ed.) ,FT Press.
2. Alastair L. Day (2012), Mastering financial modeling in Microsoft excel(3rd ed.), FT
Publishing.
3. Simon Benninga (2008), Financial modeling (3rd ed.) MIT Press.
4. Chandan Sengupta (2010), Financial analysis and modeling( 2nd ed.), Wiley Finance.
5. Masari, M., & Gianfrate, G. (2014). The valuation of financial companies: Tools and
techniques to value banks, insurance companies, and other financial institutions (1st
ed.). Wiley Finance.
6. Koller, T., & Goedhart, M. (2010). Valuation: Measuring and managing the value of
companies (5th ed.). Hoboken, N.J.: John Wiley & Sons.
7. Kieso, D., Weygandt, J., & Warfield, T. (2014). Intermediate accounting (15th ed.).
Wiley John, & Sons, Incorporated