Chapter 2 Equity Valuation - Part 2

Equity Valuation
Analysis of Investments &

Management of Portfolios
10TH EDITION
Reilly & Brown
© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Free Cash Flow
Models
18-2
Free Cash Flow Approach
What are the uses of cash inside the company?
– First: pay for the net investment in long term assets
– Second: pay for the net investment in working capital
– The remaining is free to distribute to all of the firm investors
(bondholders and stockholders)
– The remaining is called FCFF: Free Cash to Flow to the
Firm
– If debt holders are paid their cash : the remaining is called
FCFE: Free Cash Flow to Equity
18-3
The Main Valuation formulas ;

Firm Value = FCFF discounted at the WACC
Equity Value = FCFE discounted at the CAPM

Or
Equity Value = Firm Value – market value of debt
18-4
Calculating FCFF
= Net income
+ Noncash charges
+ the after tax interest cost
– Fixed capital investment
– working capital investment
FCFF = NI + NCC+ {Int x (1-tax)} – FCinv - WCinv
18-5
Calculating FCFF
FCFF = NI + NCC + {Int x (1-tax)} – Fcinv – Wcinv
Or
FCFF = {EBIT x (1-tax)} +NCC-Fcinv – Wcinv
18-6
Calculating FCFE
FCFE = FCFF - {Int x (1-tax)} + net borrowing
Net borrowing: newly issued debt – debt

repayments
18-7
18-8
Ex. 11:
• Calculate FCFF and FCFE
Net income 10,000,000
Non cash charges 300,000
Interest expense 1,800,000
tax rate 20%
Fixed capital investment 5,000,000
Working capital investment 2,000,000
Net borrowing 4,000,000
EBIT 14,300,000
Ex.11:
• FCFF = NI + NCC + {Int x (1-tax)} – Fcinv – Wcinv
• 4,740,000 = 10,000,000+ 300,000+{1,800,000×(1-20%)}-
5,000,000-2,000,000
Or
• FCFF = {EBIT x (1-tax)} +NCC -Fcinv – Wcinv
• 4,740,000= {14,300,000×(1-20%)}+300,000-5,000,000-
4,000,000
18-9
Ex. 11:
• FCFE = FCFF - {Int x (1-tax)} + net borrowing
• 7,300,000= 4,740,000-{1,800,000×(1-20%)}+4,000,000
18-10
Ex. 12:
tax rate 20%
EBIT 6,800,000
18-11
• Answer
• FCFF = 1,740,000
• FCFE = 4,300,000
18-12
Valuation using FCF model
One stage FCF model = FCF / k-g
Note that K for the firm will differ than to equity
18-13
Multi-stage FCF model = present value of all cash

flows during the first stage + cash flow during
the second stage
Usually first stage has a high or variable growth

rates, while the second stage has a constant
growth rate (stable stage)
18-14
Ex. 13:
You have calculated the expected FCF of a
company during two stages of growth, the
first stage FCF for the next five years are as
follows
Year year 1 year 2 year 3 year 4 year 5
FCF 5.00 7.00 7.80 8.7 10
18-15
Ex. 13:
After five-year period, the second stage will
have a stabilized growth 5%.The required
rate of return of the company is 14.5%. What
is the value of this company?
18-16
solving for the terminal value
• First step
FCF6 FCF5 (1 + g ) $10(1.05)

P5 = = = = $110.52
k−g k−g 0.145 − 0.05
18-17
Finally: Present value of all CFs
• Final step,
$5 $7 $7.8 $8.7 $10 + $110.52

𝑉0 = + + + + = 81.20
1.145 1.1452 1.1453 1.1454 1.1455
• The value of the firm is $81.20
18-18
Comparables approach in valuating
equity
18-19
Comparative Value Approaches
• If we assume that market is perfect and so

securities traded are fairly priced
• So generally we can use market prices of
traded stocks to value or price of other non-
traded stocks
• However this approach can still be used to
price actively trade stocks
18-20
• Price to Earnings
• Price-to-book ratio
• Price-to-cash-flow ratio
• Price-to-sales ratio
18-21
• Ex.14 :
• If for company XYZ ,, we want to calculate its
PE
• Knowing that E:earnings:net income, and
market price : P
• If Earnings per share(EPS) = $4, and current
price is $ 40, then P/E ratio = 40/4 =10x
18-22
• So if we only know P/E = 10x , and the E

which is $4, can you calculate the P0
• P0= PE ratio x E
• P0= 10 x 4= $40
18-23
Ex.15 :
• if you know that the average PE ratio of
the market is 16x, and that your company’s
earnings per share EPS is $3, valuate your
company.
18-24
• Real Example :
• V0= 16 x 3 = $48
• Usually we use market average PE or

industry average PE or a limited number of
peers (comparables)
•
18-25
Ex.16:
• Assume that for industry X , there are only three
companies in the market with the following
information
• Calculate the average PE for the industry
Company Price EPS

A 45.0 5.0
B 30.0 3.5
C 12.0 2.0
18-26
• Answer
Company Price EPS PE
A 45.0 5.0 9.0

B 30.0 3.5 8.6
C 12.0 2.0 6.0
Average 7.9
PE
18-27
Ex.17:
• If a new company will be listed in the stock
market
• Your company has an EPS of USD 20
• Estimate the price of the new company using the
comparable company approach
18-28
• Answer
• Value = EPS x average PE
• 157.14 = 20 x 7.9
18-29
Comparing the Valuation Models
• In practice
– Values from these models may differ
– Analysts are always forced to make
simplifying assumptions
18-30
Free Cash Flow
Models
18-31
What are the uses of cash inside the company?
– First: pay for the net investment in long term assets
– Second: pay for the net investment in working capital
– The remaining is free to distribute to all of the firm investors
(bondholders and stockholders)
– The remaining is called FCFF: Free Cash to Flow to the
Firm
– If debt holders are paid their cash : the remaining is called
FCFE: Free Cash Flow to Equity
18-32
The Main Valuation formulas ;

Firm Value = FCFF discounted at the WACC
Equity Value = FCFE discounted at the CAPM

Or
Equity Value = Firm Value – market value of debt
18-33
Calculating FCFF
= Net income
+ Noncash charges
+ the after tax interest cost
– Fixed capital investment
– working capital investment
FCFF = NI + NCC+ {Int x (1-tax)} – FCinv - WCinv
18-34
Calculating FCFF
FCFF = NI + NCC + {Int x (1-tax)} – Fcinv – Wcinv
Or
FCFF = {EBIT x (1-tax)} +NCC-Fcinv – Wcinv
18-35
Calculating FCFE
FCFE = FCFF - {Int x (1-tax)} + net borrowing
Net borrowing: newly issued debt – debt

repayments
18-36
18-37
Ex. 11:
tax rate 20%
EBIT 14,300,000
Ex.11:
• FCFF = NI + NCC + {Int x (1-tax)} – Fcinv – Wcinv
• 4,740,000 = 10,000,000+ 300,000+{1,800,000×(1-20%)}-
5,000,000-2,000,000
Or
• FCFF = {EBIT x (1-tax)} +NCC -Fcinv – Wcinv
• 4,740,000= {14,300,000×(1-20%)}+300,000-5,000,000-
4,000,000
18-38
Ex. 11:
• FCFE = FCFF - {Int x (1-tax)} + net borrowing
• 7,300,000= 4,740,000-{1,800,000×(1-20%)}+4,000,000
18-39
Ex. 12:
tax rate 20%
EBIT 6,800,000
18-40
• Answer
• FCFF = 1,740,000
• FCFE = 4,300,000
18-41
One stage FCF model = FCF / k-g
Note that K for the firm will differ than to equity
18-42
Multi-stage FCF model = present value of all cash

flows during the first stage + cash flow during
the second stage
Usually first stage has a high or variable growth

rates, while the second stage has a constant
growth rate (stable stage)
18-43
Ex. 13:
You have calculated the expected FCF of a
company during two stages of growth, the
first stage FCF for the next five years are as
follows
Year year 1 year 2 year 3 year 4 year 5
FCF 5.00 7.00 7.80 8.7 10
18-44
Ex. 13:
After five-year period, the second stage will
have a stabilized growth 5%.The required
rate of return of the company is 14.5%. What
is the value of this company?
18-45
solving for the terminal value
• First step
FCF6 FCF5 (1 + g ) $10(1.05)

P5 = = = = $110.52
k−g k−g 0.145 − 0.05
18-46
Finally: Present value of all CFs
• Final step,
$5 $7 $7.8 $8.7 $10 + $110.52

𝑉0 = + + + + = 81.20
1.145 1.1452 1.1453 1.1454 1.1455
• The value of the firm is $81.20
18-47
Comparables approach in valuating
equity
18-48
• If we assume that market is perfect and so

securities traded are fairly priced
• So generally we can use market prices of
traded stocks to value or price of other non-
traded stocks
• However this approach can still be used to
price actively trade stocks
18-49
• Price to Earnings
• Price-to-book ratio
• Price-to-cash-flow ratio
• Price-to-sales ratio
18-50
• Ex.14 :
• If for company XYZ ,, we want to calculate its
PE
• Knowing that E:earnings:net income, and
market price : P
• If Earnings per share(EPS) = $4, and current
price is $ 40, then P/E ratio = 40/4 =10x
18-51
• So if we only know P/E = 10x , and the E

which is $4, can you calculate the P0
• P0= PE ratio x E
• P0= 10 x 4= $40
18-52
Ex.15 :
• if you know that the average PE ratio of
the market is 16x, and that your company’s
earnings per share EPS is $3, valuate your
company.
18-53
• Real Example :
• V0= 16 x 3 = $48
• Usually we use market average PE or

industry average PE or a limited number of
peers (comparables)
•
18-54
Ex.16:
• Assume that for industry X , there are only three
companies in the market with the following
information
• Calculate the average PE for the industry
Company Price EPS

A 45.0 5.0
B 30.0 3.5
C 12.0 2.0
18-55
• Answer
Company Price EPS PE
A 45.0 5.0 9.0

B 30.0 3.5 8.6
C 12.0 2.0 6.0
Average 7.9
PE
18-56
Ex.17:
• If a new company will be listed in the stock
market
• Your company has an EPS of USD 20
• Estimate the price of the new company using the
comparable company approach
18-57
• Answer
• Value = EPS x average PE
• 157.14 = 20 x 7.9
18-58
Comparing the Valuation Models
• In practice
– Values from these models may differ
– Analysts are always forced to make
simplifying assumptions
18-59

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Chapter 2 Equity Valuation - Part 2

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Equity Valuation

Analysis of Investments &

Reilly & Brown

The Main Valuation formulas ;

Equity Value = FCFE discounted at the CAPM

FCFF = {EBIT x (1-tax)} +NCC-Fcinv – Wcinv

Net borrowing: newly issued debt – debt

Free Cash Flow Approach

Valuation using FCF model

One stage FCF model = FCF / k-g

Note that K for the firm will differ than to equity

Valuation using FCF model

Multi-stage FCF model = present value of all cash

Usually first stage has a high or variable growth

FCF6 FCF5 (1 + g ) $10(1.05)

$5 $7 $7.8 $8.7 $10 + $110.52

• The value of the firm is $81.20

• If we assume that market is perfect and so

• So if we only know P/E = 10x , and the E

• Usually we use market average PE or

Company Price EPS

Company Price EPS PE

A 45.0 5.0 9.0

C 12.0 2.0 6.0

The Main Valuation formulas ;

Equity Value = FCFE discounted at the CAPM

FCFF = {EBIT x (1-tax)} +NCC-Fcinv – Wcinv

Net borrowing: newly issued debt – debt

Free Cash Flow Approach

Valuation using FCF model

One stage FCF model = FCF / k-g

Note that K for the firm will differ than to equity

Valuation using FCF model

Multi-stage FCF model = present value of all cash

Usually first stage has a high or variable growth

FCF6 FCF5 (1 + g ) $10(1.05)

$5 $7 $7.8 $8.7 $10 + $110.52

• The value of the firm is $81.20

• If we assume that market is perfect and so

• So if we only know P/E = 10x , and the E

• Usually we use market average PE or

Company Price EPS

Company Price EPS PE

A 45.0 5.0 9.0

C 12.0 2.0 6.0

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