CF Session 5 - Pricing of Equity

Avijit Bansal
Indian Institute of Management Calcutta

January 7, 2023

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Free cash flows (FCF)

FCF is defined as the cash left after accounting for operating expenses and
reinvestment requirements.

FCF is not impacted by the capital structure and is more reflective of the
fundamentals of the firm. Dividends/Earnings will be impacted by the capital
structure (interest expenses).

FCF recognizes non-cash expenses such as depreciation. Furthermore, it accounts for

the change in the non-cash net working capital and the reinvestment requirements.

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Free cash flows

+ EBIT × (1 - Tax Rate)

+ Non-cash Expenses (Depreciation and Amortization)
− Change in Non-cash NWC
− CAPEX

Free Cash Flows

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FCF versus FCF(E)

FCF(E) is arrived at after netting out interest payment and debt repayment. It is the
free cash flow available to only the equity investors.

Free cash flows Free cash flows to equity investors

Does not depend on capital structure Impacted by capital structure

Working average cost of capital (WACC) Risk-adjusted cost of equity (re )

Provides value of a firm Provides value of equity

= EBIT × (1 - T) + Dep - ∆NWC - CAPEX = FCF - interest×(1-T) - net debt repayment

P∞ E0 [FCFt ] P∞ E0 [FCFEt ]
Firm Value = t=1 (1 + WACC )t
Equity Value = t=1 (1 + r )t
e

Note: When the firm has no debt, FCF and FCF(E) are same

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Alternative approaches to valuation

Intrinsic Valuation Relative Valuation

Cashflows, growth and risk Comparable assets

Dividend discount model Price to fundamental ratio
Discounted Cash flow model

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Relative valuation

Identifying comparable assets - growth, risk, cash flow patterns

Converting the market value into standardized value (creating price multiple)

Compare the multiple after controlling for differences

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Price to earnings ratio: what drives it?

DPS1 DPS0 × (1 + g)
P0 = =
r −g r −g

Divide both sides by EPS

P0 Payout Ratio × (1 + g)
PE = =
EPS0 r −g

Other things constant, g ↑ ⇒ Price to Earnings ↑

Other things constant, r ↑ ⇒ Price to Earnings ↓

Other things constant, Payout Ratio ↑ ⇒ Price to Earnings ↑

Note: when varying payout ratio keeping g constant, one is varying ROE

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Book value multiples

Market Value of Equity

Price to Book =
BookValueofEquity

DPS1 DPS0 × (1 + g) EPS0 × Payout Ratio × (1 + g)

P0 = = =
r −g r −g r −g

EPS0
ROE =
Book Value of Equity

BV0 × ROE × Payout Ratio × (1 + g)

P0 =
r −g

P0 ROE × Payout Ratio × (1 + g)

=
BV0 r −g

Other things constant, ROE ↑ ⇒ Price to Book ↑

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Revenue multiples: Price to Sales

Market Value of Equity

Price to Sales =
Revenue

DPS1 DPS0 × (1 + g) EPS0 × Payout Ratio × (1 + g)

P0 = = =
r −g r −g r −g

S0 = Sales per share

EPS0
= Net Profit Margin
S0

P0 Net Profit Margin × Payout Ratio × (1 + g)

=
S0 r −g

Other things constant, Net Profit Margin ↑ ⇒ Price to Sales ↑

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References I

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