Valuation

Hyder Ali (PhD, FHEA)

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 Agenda
• Why Valuation?
– To help you understand why study this course
– What is output of your project?
• What matters in valuation?
– What are the required inputs for your project
• Discounted Cash Flow (DCF) approach

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 Important to Note
• Some concepts from Book
– Valuation: Measuring and Managing the Value of
Companies, 7th Edition [2020]
– McKinsey & Company Inc., Tim Koller, Marc
Goedhart, David Wessels

• For reference, I have used

– [KGW 2020]

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 Why Valuation
 “Financial crises occur when people make bad
valuations” [KGW, 2020]

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 Why Valuation?
The value maximization game
Capital allocation (investor perspective)
• Which firms/industries/asset classes will have the best growth?
• Where can money be best put to use?
Capital allocation (corporate perspective)
• Invest in growth or pay back money to investors?
• Sell assets/Restructure?

Knowing valuation principles helps you

survive and thrive in this game!
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 What do economists mean by value?
Intrinsic value (fundamental value)
• The present value of future expected cash flows discounted at the
appropriate risk-adjusted discount rate

Fair (market) value

• The expected price at which an asset would sell in an open and unregulated
market between a rational seller and a rational buyer when both have
access to equal information

Economic value (investment value, strategic value)

• The value of ownership considering the specific situation of a particular
individual or organization (taxes, financing, synergies, specific skills etc)

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 More on Value
A firm does not have a value in its own right
• what we value is the ownership of a share in the company
• The right to make decisions (control rights)
• The right to receive future dividends (cash flow rights)

Most valuations are based on an assumption of “going concern”

• We expect the firm to continue to operate indefinitely
• However, some valuations assume the different parts of the firm will be
immediately sold

The price in a transaction often deviates from an estimated

market value
• Negotiating power and skills matter…
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What matters in Valuation?
Cash Flows

Risks

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 What matters in Valuation?
[1. Cash Flows]
The lazy view:
• “The value of an asset equals what somebody is willing to
pay for it”
• YOU RISK OVERPAYING FOR THE ASSET!

Other perspective:
• Value is determined by expected future cash flows…
• The conservation of value principle (KGW, 2020):
• “Anything that doesn’t increase cash flow doesn’t
increase value”

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 What matters in Valuation?
[2. Risk]
There is always a competing investment opportunity
• Investors like expected return…
• … but they do not like risk (unless appropriately compensated)

The compensation for risk that investors require constitutes the firm’s cost of capital

The guiding principle of value creation (KGW, 2020):

• Value is created when a firm invests capital that generate cash flows at a
rate that exceeds the firm’s (risk-adjusted) cost of capital

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 Important to note
Application of valuation
• The principles of valuation (cash flows and risk) hold for any
asset
• For example:
• Real estate, bonds, paintings, and so on

However, the process to value a firm’s equity

•may involve valuing other assets as part of the process…
•…but the end goal is the price-per-share

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 Techniques for valuation

• Discounted free cash flow (DCF)

• Residual income valuation
There are many • Discounted dividend valuation
to choose from… • Relative valuation
• …and more

• Based on the insights that cash flow is what

DCF is the matters…
standard • … and that cash flows have to exceed the risk-
related cost of capital
technique • KGW (2020): “DCF remains a favourite”

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BUILDING BLOCKS OF DCF
VALUATION

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 Discounted Cash Flow (DCF)
Required Output = Intrinsic value per share

Three basic
variables in DCF
valuation

Net Operating Invested Capital Cash Flow to Firm

Profit Less Adjusted
Taxes (NOPLAT) (IC) (FCFF)

NOPLAT is also known NOPAT [Net Operating Profit After Taxes]

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 Why NOPLAT (and not earnings)?
NOPLAT = after tax profit of core operations

NOPLAT removes the effect of capital structure

Analytical adjustments:
• Reverse/exclude all non-core, extraordinary and financial items
from the firm’s earnings- statement
• Examples: gain/loss on asset sales, amortization of goodwill,
interest expenses
• Make the corresponding adjustments to the tax expense (to
obtain operating taxes)!

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 NOPLAT
Net Operating Profit Less Adjusted Taxes

Operating revenues
less Operating costs
less Depreciation
= Operating profit (EBITA)
less Operating taxes
= NOPLAT
Notes: Non-operating revenues and costs have been excluded, as has been Finance
items (interest expense, etc). The operating tax expense corresponds to the net of the
remaining operating revenues and costs.
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 Invested Capital (IC)
• IC represents the amount of capital that has been invested
in the company’s core operating assets

• Analytical adjustments: Exclude all non-core and financial

assets and liabilities from the firm’s balance sheet

• Examples of excluded items: Derivatives used for hedging,

Investments used for trading

• Non-core and financial assets are part of the value, but

added back in a later stage (more on this later)

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 Invested Capital (IC)
Key operating assets included in IC
• Plant, property, and equipment
• Accounts receivables
• Inventories
• Operating cash
• Deferred costs (prepaid asset)
Key operating liabilities subtracted
• Accounts payables
• Deferred income (prepayments from customers)

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 Free Cash Flow to Firm
• FCFF is the cash flow from core operations
after deducting required investment outlays

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 Free Cash Flow vs Net cash flow
• FCFF is a measure of the surplus cash flow that
could potentially be paid out to investors
– Based on operating and investing activities
• Cash generated through operations
• Effectiveness and efficiency of operations

• Net cash flows covers activities such as:

– Operating
– Investing
– Financing [Not part of FCFs]

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Calculating Free Cash Flow to Firm
Direct Method [Using Cash Flow Statement]
 Free cash flow = Cash flow from operations – Capital
expenditures [Simplest – assuming 100% equity]

 Free cash flow = Cash flow from operations +

Interest – Tax shield on interest – Capital
expenditures

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Calculating Free Cash Flow to Firm
Indirect Method [Deriving the FCFs]
 Start with Net Income or Operating Income [NOPLAT]

 Analytical adjustments: Add back/subtract all non-

cash flow items in NOPLAT
– Examples: Depreciation, non-cash pension expenses

 Free Cash Flow = NOPLAT + Non-cash operating

expenses – Investments in invested capital
– Investments in invested capital = Investments in long-term
operating assets + Investments in working capital 22
 Question
• FCFs start with income [Net or operating]
– Revenue
– Cost
• Revenue can be on credit [No inflow]
• All costs not incurred in cash [No outflow]
• Why FCFs still cash flows not income?
• Answer:
– Impact is taken in taken by Net working capital
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Unlevered vs Levered Free Cash Flows

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Unlevered vs Levered Free Cash Flows

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Unlevered vs Levered Free Cash Flows

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Unlevered vs Levered Free Cash Flows

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Unlevered vs Levered Free Cash Flows

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 FCFF
Cash Flow Statement and Income Statement
Using Cash Flow from operations

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 FCFF
Income Statement and Balance Sheet
Using EBIT (Operating Income)

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 FCFF
Income Statement and Balance Sheet
Using Net Income

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Value Drivers of FCFs

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3 more concepts in DCF valuation

Weighted Average Cost of Capital

(WACC)

Return on Invested Capital (ROIC)

Economic Profit (EP)

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 Why a cost of capital (WACC)?
• WACC is a measure of the firm’s cost of capital
– We use it as a discount rate…
– …to adjust future cash flows for risk

• WACC can be thought of as the opportunity cost

of the firm’s investors

• WACC represents the return investors could

obtain elsewhere in the market at the same level
of risk

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 Discount rate
Weighted Average Cost of Capital (WACC)

D E
WACC  rd  1 t   re 
D E D E

WACC = weighted average cost of capital

rd = cost of debt
T = tax rate
D = market value of debt
re = cost of equity
E = market value of equity

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 Return on Invested Capital (ROIC)
• ROIC is defined as:
– NOPLAT/IC

• ROIC is a measure of how much NOPLAT is

generated by each unit of invested capital

• ROIC is a normalized measure of operating

performance that can be compared across
firms
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 Economic profit

Economic profit (EP)

EP = IC · (ROIC – WACC)

EP = NOPLAT – (IC · WACC)

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 Why Economic Profit (EP)
• EP is a direct measure of the shareholder value
that is generated in a particular period

• EP indicates whether or not the firm manages to

create returns that exceed its cost of capital

• EP comes with many names and varieties:

– Residual income, Shareholder Value Added (SVA),
Economic Value Added (EVA)

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VALUATION BY DCF

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 DCF Valuation
• The value of an asset is
– the sum of the present value of its forecasted expected
free cash flows


FCFFt
Value of asset t0  t
t 1 (1WACC)

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 Two-stage valuation models
• To increase precision (accuracy) in the valuation, it is
often divided into two (or more) steps

• We usually have one detailed forecast in which

growth and or profits are mapped out…

• …and one that captures the value of cash flows in

perpetuity (“the steady state”)
– Terminal value
– Stable growth rates and profits
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 Valuation Diagram – DCF from Free
Cash Flow
• Valuation using discounted cash flows requires
forecasted cash flows, application of a discount rate
and measurement of continuing value (also referred
to as horizon value or terminal value)

Cash Flow Cash Flow Cash Flow Cash Flow Continuing Value

Enterprise Value Discount Rate is WACC

Net Debt

Equity Value

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Equity Cash Flow, Debt Cash Flow, Free
Cash Flow and
Cost of Equity, Cost of Debt and WACC
Value of Equity
Equity Cash Flow and Value of Equity :
PV of Cash Flows at
Dividends less Equity Issued Cost of Equity

+ +

Value of Debt
Debt Cash Flow and Market Value of Debt :
PV of Cash Flows at
Net Interest plus Net Debt Payments Incremental Cost of Debt

= =

Value of Enterprise
Free Cash Flow:
PV of Cash Flows
EBITDA – Op Taxes – Cap Exp – WC Chg At WACC

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Terminal Value in Corporate Model
Year after explicit
period to establish
stable cash flows
Gordon’s
CFt x (1+g)/
(WACC-g)

Explicit Forecast
History Terminal Value EV/EBITDA
Period that Reflects
PV of Cash Long-term
Growth Rate
Year t Infinity and ROIC

Step 2: PV from Year t to Step 1: PV to year t –

current year End of period t, so Market to
Gordon’s method Book Ratio
must use t+1 cash that
Make sure Cash Flow in
flows Reflects
Valuation period t reflects realistic
Long-term
Date ROIC, Working Capital
ROE
that reflects long-term
growth and realistic
capital expenditures

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 The 2-stage FCFF model
 FCFFt n1 
 
t n
FCFFt   kw  g n  
Vt 0 
t 1 1 k w  1 k w 
t n

• Where:
• kw = WACC = weighted average cost of capital
• g = growth rate (growth in FCFF)

• More stages can easily be added

• Note: The above formula assumes constant WACC

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Valuation of operating assets by DCF,
example

2009 2010 2011 2012 2013 2014 ∞

FCFF 1,327 1,290 1,240 1,215 1,273 1,335 47,311
Discounted FCFF 1,233 1,113 994 905 881 858 30,405

Explicit forecast horizon Terminal value

PV(FCFF of operating assets)= 35,530

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 Enterprise value
• In a DCF valuation of a company, total asset value is
referred to as Enterprise value
– ”Enterprise DCF”

• PV(FCFF of operating assets) is typically the main asset

• To get enterprise value, we add two asset categories:

– Enterprise value = PV(FCFF of operating assets)
+ PV(Non-core operating assets)
+ PV(Financial assets)

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 Non-operating assets
Non-core operating assets
• Equity accounted investments
• (20-50% ownership, influence but not control)
• Investments in business ventures where ownership <20% ownership (no
control, no influence)
• E.g. joint ventures, strategic investments
Financial assets
• Investments in traded securities (shares, bonds, etc)
• Derivative assets (net of derivative liabilities)
• Excess cash (more than what is required for operations)
• And so on

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 Quantifying enterprise value
• So: the main present value-calculation focuses on the
core, operating assets of the firm

• Non-operating assets and financial assets are added

back in the final enterprise value calculation

• Non-operating assets may also be estimated with

present value-techniques
– Data & time often limits the PV-approach
– Simpler valuation methods can be used (e.g. multiples)
– Book values may be reasonable approximations

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 Example enterprise value

PV (FCFF from core operations) = 35,530

Excess cash = 387 (financial asset)
Equity accounted investments = 2,173 (non-core operating asset)
Other financial assets = 1,070 (financial asset)
Tax assets = 149 (financial asset)
Enterprise value = 39,309

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 Equity value
• To arrive at the value of equity (which is what
we attempt to value), non-equity claims must
be subtracted

• Equity is the residual claim – all other

contractual claims need to be fulfilled first

• Equity value = Enterprise value – Non-equity

claims
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 Non-equity claims
Non-equity claims fall into three categories
• Debt
• Debt equivalents
• Hybrid claims

Common non-equity claims

• Debt
• Operating leases (debt equivalent)
• Pension obligations (debt equivalent)
• Preferred stock (hybrid claim)
• Employee options (hybrid claim)
• Minority interest (hybrid claim)

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 Example equity value

Enterprise value = 39,309

Short term debt = (1,073)
Long term debt = (9,083)
Pension obligations = (916)
Non-operating liabilities = (374)
Minority interest = (2,342)
Equity value = 25,818

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 Steps in DCF-valuation
Carry out analysis of firm and industry (incl. historical performance)

Make forecast of the firm’s NOPLAT, FCFF, WACC, and so on

Calculate present value of FCFF from core operations

Add non-core operating and financial assets to obtain enterprise value

Subtract non-equity claims (debt etc) from enterprise value to obtain equity value

Divide equity value by number of shares outstanding to obtain your estimate of the share price

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