Chapter 3: Value

Lecture 3.2: Value Measurement

 Net Debt
and Other
Claims
Enterprise Value = Value BU 1 + Value BU 2 + Value BU 3 + Value
Non Core Asset – Value Non Core Liability

Equity Value = Enterprise Value – Net Debt and Other Claims

Value = MARKET Value

DCF Methodology
The value of an asset (including a company) is equal to the value of all future expected cash flows
discounted taking into account the required rate of return demanded by investors (the cost of capital)

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4

𝑉𝑎𝑙𝑢𝑒 = + + + +⋯
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)4

Forward-Looking Cash Flow Based

 Sales, million $ Year Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
1
Company A $100 $120 $130 $140 $150 $160 $170

Company B $100 $90 $80 $70 $60 $50 $40

 All else being equal, company A clearly seems to have a better outlook for the future than company B.
 Yet, if we were to make our valuation based on the financial statements information presented in 2016
without doing any forecasting, we would probably be misled into believing both had the same value.
 This simple example shows the perils of non-forecasting valuation methods.
 Valuation models that avoid doing the forecasting will always be limited in its
applicability, mostly because they will fail to take into account how the
company is expected to evolve in the future, which ultimately is what will
determine its value

 Fundamental analysis is the method of analyzing information, forecasting

payoffs from that information and arriving at a valuation based on those
forecasts. It is the technique that allows us to incorporate into the value of a
firm its future behavior, which is what non forecasting valuation methods fail
to do
Company A:
1 2 3 4 5
Revenue 1,000€ 1,050€ 1,1103€ 1,158€ 1,216€ Growth = 5%
Earnings 100€ 105€ 110€ 116€ 122€ RONIC = 20%
Investment -25€ -26€ -28€ -29€ -30€
Cash Flow 75€ 79€ 83€ 87€ 91€

Company B:
1 2 3 4 5
Revenue 1,000€ 1,050€ 1,1103€ 1,158€ 1,216€ Growth = 5%
Earnings 100€ 105€ 110€ 116€ 122€ RONIC = 10%
Investment -50€ -52€ -55€ -58€ -61€
Cash Flow 50€ 53€ 55€ 58€ 61€
 Many executives, boards, analysts and financial media fail to understand that accounting earnings and value
creation are not one and the same and focus solely on earnings maximization.

 Most of this bias towards earnings comes from its feasibility – since they follow accounting rules, they are less
subject to interpretation and are in theory easily verifiable.

 However, earnings are a very poor metric of value creation:

Because the income statement is built according to principles which are not always verified (either
intentionally or not) and

Because a higher ROIC is not necessarily showcased in earnings

 The pitfalls of managers attempting to maximize earnings instead of maximizing value are numerous and typically
involve value destruction on the long run.

 Earnings definitely should not be used to measure value.

 Because we are going to be valuing the company in separate parts, we need the cash flow for each
respective part. This means that we want to isolate the cash flows that are actually from the core
business of the firm (and if we want to value per business unit, we will also need to separate the cash
flows per business unit)

 The financing decisions should not be included in this cash flow since the financial effects are
captured elsewhere (typically in the cost of capital if we are using NPV, or through separate terms to
add to the value of the firm If we are using APV)

 For this reason, the cash flow with which the model works is called the FREE CASH FLOW.
Unfortunately, the cash flow statement prepared according to accounting standards does not
seem to respect this.
Transactions involving financial assets are included in the investments section not distinguishing what is
part of our core operations and what is not
Interest payments and receipts as well as dividend payments can be included in the operating section
rather than in the financing section (always true for US firms)
Tax cash flows are all included in the operating section, and not allocated to operating and section
Changes in cash are not properly allocated to the investment section (operating cash) and financing
section (remaining one)
 One alternative that is often used is to use the expression:
FCF = EBIT *(1 – tax rate) + Depreciation and Amortization – Δ Operating Working Capital – Capital
Expenditures – Acquisitions
 This works as a “quick” fix and is widely used in practice but it has one major problem: it is still very hard
to separate different company elements (different business units, elements that are non core, financial
elements that might be included in the same balance sheet captions, etc.) It also makes ROIC calculation
difficult (which we will need), especially for different business units.
 In reality, this form is used but when we are dealing with large companies with complex activities, it is
prone to mistakes (double counting of elements of the company, poor classification of financial elements,
etc.). It is a fine approximation to value small companies/ projects
 However, it is fairly easy to calculate the free cash flows as we want them to be if we just take the
financial statements in their reformulated version, as these are already separated according to the same
principles we want to follow to value the company.

OPERATIONAL EQUITY
RESULT NON CURRENT
ASSETS
CORE RESULT NET DEBT AND
CORE INVESTED OTHER CLAIMS
NON CURRENT CAPITAL
FINANCIAL RESULT LIABILITIES

NON CORE RESULT

CURRENT
ASSETS CURRENT
FISCAL RESULT LIABILITIES NON CORE EQUITY
FINANCIAL RESULT INVESTED
CAPITAL
 CORE BUSINESS
BS T-1 BS T IS T

NET DEBT NET DEBT CORE RESULT

FCF = CORE RESULT – CHANGE IN CORE INVESTED
CORE
INVESTED
AND OTHER
CLAIMS
CORE
INVESTED
AND OTHER
CLAIMS
CAPITAL
CAPITAL CAPITAL

NON CORE
RESULT

NON CORE EQUITY NON CORE EQUITY FINANCIAL

INVESTED INVESTED RESULT
CAPITAL CAPITAL
 NON CORE BUSINESS
BS T-1 BS T IS T

NET DEBT NET DEBT CORE RESULT

FCF = NON CORE RESULT – CHANGE IN NON CORE
CORE
INVESTED
AND OTHER
CLAIMS
CORE
INVESTED
AND OTHER
CLAIMS
INVESTED CAPITAL
CAPITAL CAPITAL

NON CORE
RESULT

NON CORE EQUITY NON CORE EQUITY FINANCIAL

INVESTED INVESTED RESULT
CAPITAL CAPITAL
 FINANCIAL
BS T-1 BS T IS T

CORE RESULT
CORE
NET DEBT
AND OTHER CORE
NET DEBT
AND OTHER FINANCING CF = NET DEBT AND OTHER CLAIMS
INVESTED CLAIMS INVESTED CLAIMS
CAPITAL CAPITAL CASH FLOWS + EQUITY CASH FLOWS =
(FINANCIAL RESULT + CHANGE IN NET DEBT AND
NON CORE
RESULT OTHER CLAIMS) + (CHANGE IN EQUITY –
NON CORE NON CORE
COMPREHENSIVE INCOME)
EQUITY EQUITY FINANCIAL
INVESTED INVESTED RESULT
CAPITAL CAPITAL
NET CASH FLOW FROM OPERATIONS AND INVESTMENTS = NET CASH FLOW FROM DEBTHOLDERS +
NET CASH FLOW FROM EQUITY

FREE CASH FLOW = - FINANCING CASH FLOW

(Cash Conservation Equation)

 Net Debt
and Other
Claims
 We want everything to be in market value but that doesn’t mean we need to explicitly calculate the market value of all elements:
 Sometimes book value is an “okay” proxy for market value (e.g. regular, short term bond that the firm has as a financial asset)
 Sometimes these elements are not material enough to be worth it to spend all the extra time figuring out their true market value

 Alternatives:
 DCF Models
 Multiples
 Market Capitalizations (if available)
 Market Prices (if available)
 Book Values
 Etc.

 The most important thing is 1) Do not forget to include them and 2) Do not make the mistake of including their cash flows in the
previous part or they will be double counted!
 Core Operating Items Non Core Operating Items Financing Items

Items directly associated with the core
business/ activity of the company (i.e. the
reason for the company to exist in the first
place).
These are items that you would (tend to)
find in every company of a certain sector: for
instance, in every airline you would find fuel
inventories, trade receivables, etc.
Items that are specific to a certain company, Items directly related with the way the
or that we believe are not strictly necessary company “finances” its activity (and not with
to the operations, e.g. employees pension the activity itself), including for example all
funds (whose value may vary a lot types of debt related instruments and debt
depending on the company's pension funds related payment1
policies), provisions not linked to the daily
activities (e.g. litigation, restructuring, etc.),
elements related with profit sharing
schemes, all types of secondary investments
companies do (in stock, bonds, real estate,
etc.)

(1) Although it is out of the scope of the course, whenever you classify an item as financing, to be 100% consistent, you would have to "find" their implicit opportunity cost, which you would then incorporate in the WACC. [Remember that the
WACC is the weighted average opportunity cost of every "type of financing". Thus, whatever you have considered to be financing should be considered in the WACC.]
• Some mistakes are fatal and can really undermine your valuation (e.g. debt cannot be classified as anything other than
financial).

• For the most part though, don't overly stress about this classification since, theoretically speaking, for valuation purposes the
final result would always be the same, whatever your classification, as long as you are totally consistent in your assumptions.
Obviously, this is rarely the case, which means that your choice has more to do with how you prefer to value an item than
anything else.

• Recall that every item is included in the valuation, either through the unlevered operating free cash flows (core operating
items), or through separate valuation (non-core operating items), or again, through separate valuation (financing items).

• So if, for instance, you believe the best estimate you can make for the value of a certain asset/ liability comes from taking its
market value (or even book value in some cases), it’s probably best to classify it as non-core operating rather than have it as
operating and then estimating all the future cash flows (and the respective cost of capital).
 NON EXAHUSTIVE EXAMPLE

Sales

Operational Costs

Depreciations

Adjusted Taxes

Operating Income

Changes in Invested Capital

Free Cash Flow

 NON EXAHUSTIVE EXAMPLE

Sales

Operational Costs
On a first glance, there appears to be some problems
with this structure:
Depreciations
- Depreciations are not even a cash movement

Adjusted Taxes - Not all sales and costs are actual cash inflows or
cash outflows
Operating Income - Why would I include the changes in invested capital
as being investment instead of just CAPEX?
Changes in Invested Capital

Free Cash Flow

 NON EXAHUSTIVE EXAMPLE

Example:
Year 0 Year 1
Sales 100 200
Accounts 50 75
Receivable

How much is cash received from sales in year 1??

• It is not 200 since part of it was not received upfront and is still due from clients!
• We need to calculate it taking into account the change in accounts receivable!
 NON EXAHUSTIVE EXAMPLE

Example:

Receivements from Clients

Accounts Receivable Initial + Sales– Receivements from Clients = Accounts Receivable Final

Receivements from Clients = Accounts Receivable Initial + Sales – Accounts Receivable Final

Receivements from Clients = Sales – Change in

Accounts Receivable
 NON EXAHUSTIVE EXAMPLE

Example:

Year 0 Year 1
Sales 100 200
Accounts Receivable 50 75

Change in Receivables 25

Receivements from 200-25 = 175

Clients
 NON EXAHUSTIVE EXAMPLE

Example:
Year 0 Year 1
PP&E 10,000 12,000
Depreciation 1,000 1,000
Expenditure

How much was CAPEX?

• It is not 2,000 since there was a part that depreciated in year 0!
 NON EXAHUSTIVE EXAMPLE

Example:

CAPEX Investment

PP&E Initial + CAPEX – Depreciation = PP&E Final

CAPEX = PP&E Final + Depreciation – PP&E Initial

CAPEX = Depreciation + Changes in PP&E

 NON EXAHUSTIVE EXAMPLE

Sales

Operational Costs

Depreciations

Adjusted Taxes

Change in Receivables

Change in Inventories
Changes in Invested Capital
Change in PP&E

Change in Payables

Free Cash Flow

 NON EXAHUSTIVE EXAMPLE

Sales

Change in Receivables

Operational Costs

Change in Inventories

Change in Payables

Depreciations

Change in PP&E

Adjusted Taxes

Free Cash Flow