ADVANCED CORPORATE VALUATION

TOPIC 1 – ESTIMATING THE COST OF CAPITAL (WACC)

When it comes to performing a company’s value analysis, there are two styles of analysis which can be performed:
o Technical analysis: focuses on analysing the price and volume movements of an asset using charts and other
technical tools. This kind of analysis basically believes that the price of an asset reflects all relevant information
about that asset, including fundamental factors and is basically a statistical-quantitative type of analysis;
o Fundamental analysis instead, involves examining the underlying financial and economic factors that can affect an
asset’s value. These factors might include the company’s financial statements, industry trends, macroeconomic
indicators,…This type of analysis studies the cause (the most probable one) of past/future market movements. As
suggested, it is based both on accounting and non-accounting information. The objective of fundamental analysis
is to determine the asset’s intrinsic value and assess whether its current stock price is overvalued or undervalued.
While fundamental analysis is often used by long-term investors who are interested in the underlying value of an asset,
technical analysis is commonly used by short-term traders who seek to profit from short-term price fluctuations. Both
approaches have their strengths and weaknesses, and many investors and traders use a combination of both methods to
make investment decisions.
In order to perform fundamental analysis, a series of steps must be taken and correctly followed and one must take into
account factors which are both internal and external to the valuation object.
1. First step is to identify the company’s financial statements. They provide an overview of the company’s financial
performance and help understand its revenues and costs structure, as well as, leverage and sources of cashflow;
2. Secondly, you analyse the financial statements in order to find trends and patters in the company’s financial
performance;
3. You move your analysis to the company’s industry in order to evaluate the industry-specific characteristics and
study the firm’s competitors. This involves researching industry trends, market share and competitive advantage
to understand how the company fits into the broader market. One basically looks at the industry’s 5 forces and
more specifically studies how the firm decides to react to them;
4. You also consider macroeconomic factors which can overall impact the company’s revenues, expenses and profits.

It is overall, indeed, important to observe the whole accounting environment and to analyse a company’s choice as to
how to represent specific figures also in relationship wit the accounting system and accounting strategy which the firm
pursues. Accounting strategy specifically refers to the approach that a company uses to manage the financial
information and achieve its financial goals.

As we can see, fundamental analysis takes the lead from analysing the company’s financial statements and it is, therefore,
extremely important to identify some relations within/across financial statements:
o ASSETS = LIABILITIES + OWNER’S EQUITY : it is the fundamental equation which guides any accounting
principle. Nonetheless, in practice, it is very often violated and any valuation would be affected by the violation of
this equation. Since this equation directly involves the display of a company’s capital structure, it guides the
discount rate estimation and – if the given capital structure is not reliable – then also the computed WACC won’t be
suitable in order to perform a valuation;
o NET CHANGE IN CASH = CF from Operations + CF from Investing + CF from Financing + Foreign Currency
Adjustments (→ they come from holding cash in a currency which is not the reporting currency of the analysed
firm and are, thus, sensitive to changes in the current exchange rate). Of course, the “net change in cash”-formula is
able to connect balance sheet and income statement;
o COMPREHENSIVE INCOME = NET INCOME + DIRTY SURPLUS ITEMS (→ it is the same as “Other Comprehensive
Income” and is so-called as opposed to Clean Surplus, which in turn is based on a series of assumptions. Clean
 Surplus is defined, indeed, as the number which sets Dirty Surplus to zero – OCI =0). The Clean Surplus
assumption is nonetheless very restrictive, since it basically assumes that Book Value of Equity at t = BVE at t-1 +
NI – Div and, consequently, that there are no other sources of income than those listed in the income statement. In
reality, as we all know, we also have other source of income which might come from the gain in value of a specific
asset tangible or intangible. Indeed, if an asset gains in value, you do not actually realize an income (since you do
not receive money for that), but at the same time your asset side grows, since it is now worth more. As a
consequence, the unrealized gain must not be included in the Income Statement, but rather listed in the Other
Comprehensive Income Statement.
Why do we need to have an OCI statement? Exactly because those gains or losses we list in such a document are
not realized and they are basically out of the firm’s control since they most likely are related to market
fluctuations. The income statement is, thus, clean and pertains to the firm valuation only.
o RETAINED EARNINGS at t = Retained Earnings at t-1 + Net Income at t – Dividends at t : also this formula strictly
depends on the clean surplus assumption underlying that all transactions affecting equity are listed only in the
income statement and that retained earnings are indicative of the overall book value of equity. Dividends should
be defined as net dividends (without taking into account new shares issuance and share repurchases programs).
Also financial ratios are of primary use when performing a fundamental analysis. As a matter of fact, investors usually
consider ratios measing liquidity, solvency, operating activity, profitability and market ratios. Much analysis for valuation
purposes focuses more specifically on profitability ratios – such as ROE and ROA – and market ratios – more widely known
as multiples, such as Price-to-earnings or market-to-book.
In order to assess the firm’s return on capital, though, the most widely used ratios are:
o ROA (Return on Asset) which ignores the firm’s chosen capital structure, and examines how well the firm can
convert a $ of assets into one dollar of earnings. There are “two versions” of ROA – an adjusted and one unadjusted
one.
Net Income
ROA (unadj . )=
Avg . Asset

Net Income+ ( 1−τ ) Interest Expense

ROA ( adj. )=
Avg . Asset

o ROE (Return on Equity): considering the firm’s capital structure, how well does the firm convert a dollar of equity
into earnings? That is, what is the return earned on a dollar of capital invested by owners?

Net Income Reminder: here, we talk about book value of equity. If

ROE= we took market value, we would be constructing a
Avg . Equity multiple rather than a ratio

As one might imagine, there is a huge trade-off between Profit Margin and Asset Turnover. Their values, indeed,
are able to tell us a lot about the strategy the firm is pursuing – whether it is a cost-leader or a differentiator in its
industry. As a matter of fact, the firm’s strategy might be based either on cost efficiency or on a quality premium.
Consequently, it is important to analyse and look attentively at those ratios in order to understand which strategy
the analysed firm is pursuing: firms having the same ROA might pursue very different strategies.
As a consequence, a company has two strategies to increase its ROA:
either increase profit margin or increase asset turnover. Nonetheless,
none of these options comes with an easy achievement. As a matter of
fact, an increase in profit margin requires the firm to target another
segment of customers, meaning that their customer base is not
supportive of the project. In addition to this, you probably won’t succeed
in reaching premium customers since you might lack brand name,
expertise,….. In the same way, also increasing asset turnover could be
In addition to the considerations about ROA, we also notice that financial leverage plays an extremely important role in
eventually determining ROE (which is a direct valuation input through WACC). As one can notice and easily deduct, indeed,
if you increase leverage, then you should automatically increase ROE, as well. So, why don’t firms increase their debt
financing even more? Well, because increasing leverage comes at a cost: you will, for sure, increase ROE, but at the same
time you would also increase the risk perception of a company. Less of your income would go to shareholders, because part
of it will be used to repay debt and the probability of default increases proportionally with debt, as well. In other words,
increasing financial leverage would lead to increasing cost of debt, which means a higher WACC and consequently a lower
valuation for the firm.
The cost of capital or WACC, indeed, is the specific discount rate which comes into play when performing a company’s
valuation using enterprise discounted cashflows. It represents the opportunity cost that investors face for investing their
funds in one particular business instead of others with similar risk. The most important principle underlying a successful
implementation of the cost of capital is consistency between the components playing a role in the WACC and the free
cashflow. Since the free cashflow is the cashflow available to all financial investors, the company’s WACC must also include
the required return for each type of investor in the firm.
As already pointed out, cost of capital basically represents the opportunity cost for investors for deciding to invest in one
asset rather than in another of same risk. When determining a single asset cost of equity – or expected return-, we start off
with some basic assumptions:
o all investors are alike and have the same beliefs about the future;
o investors like high stock returns but dislike uncertainty about returns;
o investors hold portfolios of stock;
o they combine stocks in their portfolio to maximize expected return for any given risk level, or minimize risk for
any given level of expected returns.
The set of portfolios for which this assumptions hold is known as the efficient frontier. When one adds risk-free borrowing
and lending, it is possible to find out that all investors hold some combination of the risk-free rate and the tangent
portfolio. In equilibrium, all stocks have to be held, so the tangent portfolio must include all stocks – must be the market
portfolio.
Portfolio mathematics, then, allows us to determine the relationship between expected return of a security (security j ) and
its risk in any efficient portfolio. The market portfolio is, of course, considered to be efficient and its return is consequently
given by the following formula: E ( R j ,t )=R F , t + β j∗( E ( R M ,t −R F , t ) )

β in this case is considered, then, the unique source of risk, representative, indeed, of market risk. It basically describes the
sensitivity of the single security’s performance with respect to the market outcome. When putting together securities in
order to form a portfolio, the investor has the chance to reduce the overall beta of the portfolio by performing a
diversification strategy. This strategy involves investing in stocks, whose reaction to the market is opposite. Nonetheless,
there is always a limit to diversification, represented by systematic risk.
In sum: for common equity securities, shareholders must be compensated for:
o the use of money ( R F , t)
o risk of investing in equity securities;
o (firm-specific) risk coefficients
Firms with higher systematic risk coefficients are supposed to have higher expected returns. The relationship between risk
and expected return is specified by the asset pricing models: CAPM and Fama-French 3 Factor models are the most widely
known.

Estimating the Cost of Equity As suggested, then, the cost of equity is built on three factors: the risk-free rate, the market
premium and a company-specific risk adjustment. The most commonly used model to estimate the cost of equity is the
CAPM.
The CAPM approach, specifically, defines a stock’s risk as its sensitivity to the stock market and postulates that the
expected rate of return on any security equals the risk-free rate plus the security’s β times the market risk premium:
R j ,t −RF ,t =α j + β j∗( R M , t−R F ,t ). In the model, two parameters must be highlighted in their importance:
o R j ,t −RF ,t = is the realized excess return on security j in period t ;
o R M ,t −R F ,t = is the realized excess return on the market in period t .
Moreover, it is important to underline that the fact that the abnormal return of the security over and above the risk-free
rate in the chosen period automatically implies that the expected value for the α is zero. Consequently, when the alpha
takes up a value different than zero, we can interpret it in two ways:
1. It could indicate a security abnormal return, indicating that there is an excess return is the security which the
model is not able to capture and explain;
2. The model is wrong in the assumption that the sole source of risk for a single stock is represented by the market.
Nonetheless, the CAPM has some limitations in that it represents an estimate of the stock sensitivity based on market risk
premia which were computed with reference to past returns of both the market and the stock.
Beta Estimation It has been proved that the β of a single company is not constant at all, whereas the CAPM – being a static
model – assumes it is. As a matter of fact, it basically varies according to the firm’s age.
As a matter of fact, when a company is young and in the early stages of growth, it might have a higher beta because of being
more susceptible to changes in market conditions and might also be more reliant on external financing sources. As the firm
matures and becomes more established, its β might decrease as the company might become less vulnerable to market
volatility and gains greater financial stability. This is because young firms typically have a higher degree of uncertainty and
risk associated with them compared to more established firms. Nevertheless, we must also take into account that the
observations of time-varying βs are also subject to mean reversion: this is because high βs stocks tend to be overvalued on
the market, whereas low β stocks tend to be undervalued relative to their long-term average. Over time, nonetheless,
investors will realize the incorrect pricing of the stock and will shift their investment from high β to low β stocks, causing
the prices of high β stocks to decrease and those of low β stocks to increase. Another fundamental limitation in the analysis
of β relationship to firm’s age is the fact that it is based on an event window and therefore we exclude any other factor
which might have caused the beta to be that high or that low. In addition to this, the number of the firms turning “n-years
old” is monotonically decreasing over the registered time-frame.

Commercial betas, instead, refer to the βs of a company in a specific industry or sector. These β are calculated based on the
returns of firms that operate in the same industry or sector and are used to estimate the risk and the expected return of a
particular company within that industry or sector. When we look at the sources investors refer to in order to evaluate their
investments, we have two main websites:
o Yahoo, Reuters: Yahoo Finance obtains its data from Reuters, according to which “ the β that we use is the β of
equity. Beta is, then, the monthly price change of a particular company relative to the monthly price change of the
S&P 500. The time period for β is 5 years when available and not less than 2.5 years. The value is updated
monthly”. This statement brings about one of the first issues related to β estimation: what is the correct time-
period you should consider when estimating the β and what is the frequency of returns you should be using?
Indeed, the choice of the frequency of returns could highly influence the results related to the firm’s β estimation.
If the taken return were daily, they would be too volatile and biased towards zero, whereas taking yearly returns
might oblige you to face the problem of a lack of observations. Weekly and monthly returns are consequently the
most used type of returns and usually β are calculate – as suggested – on price changes (if it is a dividends paying
company, important to take returns),
o Bloomberg: the latter provides two betas. The historical (raw) beta and the adjusted beta. The historical beta
measures the response of a company’s return to the market return over a 24-month period (can be changes), with
no adjustments for dividends, etc.
The adjusted β is derived by the historical β, then modified by the assumption that a security’s true beta will move
toward the market average of 1, over time: Adj . Beta=0.67∗Historical β +0.33+1 .
Nonetheless, as pointed out beforehand, there are some issues with the estimation of β. The first estimation issue comes
from the fact that betas can be highly influenced by the market index not being accurate because of mispriced stocks. For
instance, the market index between 1997 and 2003 (the “bubble years”) was highly biased because of the presence of
some overvalued industries which gained more and more weight in determining the market returns. As a consequence,
market risk premium was higher in those years, thus causing an overvaluation for any kind of stock valued through the
CAPM.
In addition to this, also stock liquidity plays a role in determining the β of a single company. This directly contradicts the
assumption that the market is the only source of risk. The influence of the perceived liquidity of an asset is, nonetheless,
not taken into account by the CAPM model. As a matter of fact, a single asset which is not liquid is much more risky than an
asset yielding the same degree of market co-movement but being liquid. This consideration can bring many investors to
undervalue the risk of holding illiquid stocks in their portfolio.
CAPM Issues All these spotted issues led scholars to the conclusion that risk is not theoretically based but comes from
empirical observations made by the investors, who – when investing- take into account also other fundamental factors they
assume to be potential sources of risk. In a paper published in 2001 Journal of Finance, James Cochrane exactly argues that
the discount rate computed through the CAPM Model was flawed and too simplistic since it does not take fully into account
the risks and uncertainties inherent in financial markets. Instead of the classical CAPM, then, he proposes an alternative
model known as the consumption-based capital asset pricing model, which considers how investor consume goods and
services over time and incorporate factors such as inflation, economic growth, and other macroeconomic variables. This
new approach basically considers how investors consume goods and services over time following the idea that investors
care not only about the total return of a security, but rather about how those returns are distributed over time. As a
consequence, to calculate the discount rates using the CCAPM, Cochrane first estimates the expected growth rate of
consumption, which he argues is a key determinant of asset prices. He, then, calculates the equity premium, which is the
excess return that investors require to hold stocks instead of risk-free assets. The equity premium is then added to the risk-
free rate and this approach is intended to capture the time-varying risk and uncertainty inherent in financial markets and
to provide a more realistic estimate of discount rates and asset prices. This methodology, then, already took into account
the fact that investors care a lot about future consumption of goods and services, and that asset prices should be based on
expected future consumption rather than simply on current market conditions.

Fama and French 3--Factor Model In their paper, written in 1993, Fama and French basically challenge the traditional
CAPM Model, which assumes as a sole relevant risk factor the market risk premium. Fama and French argue, indeed, that
there are other important factors that affect the returns of stocks and bonds, and the first one they decided to investigate is
the book-to-market ratio of the firm. The methodology used in the paper involves analysing the returns of a large number
of stocks over a long period of time, from 1963 (year when the CAPM model was introduced) to 1990 by dividing these
stocks and constructing portfolios based on a specific fundamental – in this case, book-to-market and size factor (based on
the market capitalization of the firm). By doing so, Fama and French introduce the concepts of:
o “value” stocks, those with a high book-to-market ratio (they are cheaply traded with respect to their
fundamentals);
o “growth” stocks, those with a low book-to-market ratio (they are expensive on the market).
Based on historical data, the paper observed that there is a significant difference in returns between value and growth
stocks, even after controlling for the market risk-premium. More specifically, the initial result was that β(growth) >
β(value) and the more they proceeded on time, the more the βs of the two stocks became similar even if the average
returns of the two firms did not. The spread between the average returns of the stocks has conversely even increased. This
was considered a sufficient proof in order to establish that book-to-market ratio could represent some form of risk for
investors and should therefore be included in the discount rate used. Also small firms are registered to perform better than
big firms when correcting for risk premium, thereby making also size a potential source of risk.
Fama and French, then, included both the size and book-to-market factors in a new expected return estimation model – the
3-Factor Model: R j ,t −RF ,t =α j + β j∗( R M ,t −R F , t ) + s j SM Bt + h j HM Lt + ε j , t

Both the HML (high – low book-to-value) and SMB (small-big) factors are constructed as long-short portfolios. This means
that they basically capture the difference in returns between the high-book and low-book, as well as, between the small
and big firms. Why taking the difference and form a factor instead of regressing the single portfolio returns? Well, there are
two reasons for this:
1. You can measure the book value and the size of a firm only periodically (once a year for the book value, potentially
once a decade for the size). Conversely, you can constantly monitor the HML and SMB variations;
2. Additionally, only public firms are required to disclose their book-to-market ratio, meaning that using a simple
portfolio return would have restricted the use of the model to public firms only. Conversely, the model needs to be
applied to other firms, as well. If size or B/M ratio entails some risk, then they represent a risk also for any other
firm for which you cannot measure B/M.

Construction of factor – mimicking portfolios

1. Stocks are ranked based on a factor (a specific characteristic at a certain point of time)
2. Firms with the higher value for that characteristics are placed in the top-decile, whereas the lowest values are in
the bottom decile;
3. Returns for each decile are tracked;
4. The difference in returns (“spread) between the top decile and the bottom decile has economic mean.

Validity Tests In order to understand how to better capture risk and thereby convey an accurate discount rate for the
single stock security, two types of validity tests are performed.
The first validity test makes use of historical average risk premia and basically faces the question whether or not it is worth
it to include an intercept in the model. As a matter of fact, if we assume the market risk premium, SMB and HML to be the
only sources of risk for a single security, then the intercept would be zero. These factors should, indeed, be able to
effectively capture all the risk. In order to check the validity of the model we do the following:
 1. You run the classical CAPM regression R j ,t −RF ,t =α j + β j∗( R M ,t −R F , t ) for a 5-year period of time, taking as
market risk premium the average risk premium between 1990-1995, since the forecast are made for 1996. You
run this model by including and not including the discount factor;
2. You repeat the same regression for all the firm in your sample;
3. In year 1996, once you observe the realized return for each single analysed firm, you correlate the computed
expected return to the realized returns for that year.

CAPM
E (R j , t )=α j + β j∗( R M ,t −RF ,t ) ρ=2.92 %
CAPM
E (R j , t )=β j∗( RM , t−R F ,t ) ρ=3.03 %
3−.!
E (R j ,t )=α j+ β j∗( R M , t−R F ,t ) + s j SM B t +h j HM Lt + ε j ,t ρ=3.37 %
3−¿! (R )=β ∗( R −R )+ s SM B +h HM L +ε ¿
E j,t j M ,t F,t j t j t j,t
ρ=1.14 %

The result of the validity test, then, confirms that the CAPM provides the most reliable estimate for the single stock return
and one might be surprised by the fact that the three-factor model is, in fact, disappointing in its estimate when the
intercept is taken out of the model. This is because the model requires the estimation of multiple factors, whose noise and
errors in estimate do not cancel out since they are multiplied with each other (they actually compound, causing the
estimate to be severely biased).
In the second part of the validity test, instead of using historical realized premia, we make use of the forward-looking
premia and the result change completely:

CAPM
E (R j , t )=α j + β j∗( R M ,t −RF ,t ) ρ=9.89 %
CAPM
E (R j , t )=β j∗( RM , t−R F ,t ) ρ=20.00 %
3−.!
E (R j ,t )=α j+ β j∗( R M , t−R F ,t ) + s j SM B t +h j HM Lt + ε j ,t ρ=12.78 %
3−¿! (R )=β ∗( R −R )+ s SM B +h HM L +ε ¿
E j,t j M ,t F,t j t j t j,t
ρ=21.33 %

The purpose of this second test is to isolate the measurement value only to the other variables which we take into account
besides the risk premium. As we can see, the correlation between the estimated and realized value is very high, thus
underlying the fact that the precision of the market risk premium estimate is essential in determining a good model for
prediction and consequently an accurate discount rate.

Fama and French 5--Factor Model In 2015, then Fama and French, inspiring their work on the findings of Hou, Xue and
Zang, introduced their 5-Factor Model. They basically added a profitability factor based on operating profit less interest
expense and an investment factor based on asset growth.

The appropriate discount rate for the entire firm In order to find an appropriate discount rate for the entire firm and not
just for equity, one usually needs to refer to the economic balance sheet, meaning a balance sheet able to isolate the capital
structure of the firm and ideally presenting the intrinsic values of the balance sheet assets.

Why focusing on the Economic BS rather than in the classical accounting one? Well, the main difference is that the
accounting balance sheet is able to provide only a snapshot of a company’s assets, liabilities and equity at a given point in
time. As a matter of fact, it focuses more on historical costs and accounting rules, which might not reflect the true economic
value of the company’s assets and liabilities. In contrast, the economic balance sheet focuses on the market value of a
company’s assets and liabilities, which reflects their true economic value. It takes into account not only the historical cost
of assets but also their expected future cashflows and market prices. As a consequence, the economic balance sheet is able
to provide a more accurate assessment of a company’s net worth, which is the difference between the market value of its
assets and the market value of its liabilities.
In order to have a better idea of the appropriate discount rate mirroring the intrinsic risk of the analysed firm, we also
need to unlever our β. This implies the finding of the unlevered cost of capital r u , used to discount FCFUs in the APV model
and to discount interest tax shields under certain specific circumstances. It is also useful to compute a comparable firm’s
cost of equity when the latter has different capital structure. How to unlever a company β? Well, this depends on the
specific assumptions which were made about its capital structure: if we assume that the firm has a fixed debt schedule
(Modigliani – Miller) or if we assume that the firm has a target capital structure (Miles – Ezzel). As one might easily
imagine, the second option appears much more plausible: every firm more or less has a target capital structure they would
like to reach, whereas no company actually maintains its level of debt perfectly constant over time (this assumption is
actually extremely binding and not applicable in real life).
o If the firm has a fixed debt schedule (= dollar debt forecasts year by year), then the appropriate way to unlever the
bata in to make debt forecasts independent of the firm value and consider interests tax shield as risky as the debt
itself. As a consequence, we discount ITS at the company’s cost of debt:

( ) ( )
Equity ( 1−τ ) Debt
β U =β E +βD
Equity− [ (1−τ ) Debt ] Equity−[ ( 1−τ ) Debt ]

o if the firm has a target capital structure (= expressed as % of the enterprise value), then the firm will constantly
strive to keep that specific %age and the evolution of the enterprise basically drives the debt forecast for the
following years. In such a case, the tax shield derived from debt has the same riskiness as the enterprise value and
should therefore be discounted at the unlevered cost of capital.

( ) ( )
Equity ( 1−τq ) Debt
β U =β E +βD
Equity− [ (1−τq ) Debt ] Equity−[ ( 1−τq ) Debt ]

rD
q= → when a company has a capital structure that is different from its target capital structure, the value of the tax
1+ r D
shield needs to be somehow degraded or reduced. For instance, if a company currently has more debt than its target
capital structure requires, it might incur in the risk of financial distress or bankruptcy, which could lead to higher cost of
debt and ultimately a reduction of the value of the tax shield. This assumption helps us more accurately estimate the
company’s unlevered β and its underlying risk profile.

Is a target capital structure really wanted and pursued? There are some competing theories with respect to the capital
structure of a single firm:
o Pecking -order theory: firms will use internal funds, debt issues and equity issues (only as a last resort). The
capital structure of a single firm is consequently described as an outcome of the past profitability and investment
opportunities;
o Trade-off theory: firms will strive for a target capital structure, balancing the advantages and disadvantages from
leveraging in an imperfect market;
o Market-timing theory: capital structure merely reflects management’s opportunities to issue overpriced shares
(suppose, for instance, that a firm went IPO and immediately after than we observe a negative abnormal return
over 5-10 years after the going public of the firm. Why did this happen? Managers were able to see that the stocks
were overpriced and consequently took the chance to sell these shares on the market. This implies that the
management’s strategy basically was the one of exploiting the overpricing of the stock in that moment by issuing
new equity without caring about the D/E ratio of the firm or the target capital structure which should be kept).
An evidence, coming from a 2001 survey asking CFOs whether they had a capital structure in mind when making project
decisions, revealed that 81% of firms have an implicit or explicit target capital structure in mind. This is confirmed by
Leary and Roberts, who tried to explore the trade-off theory empirically by including transaction costs. The starting points
for the research were mainly two:
1. Prior empirical research raises doubts about the validity of the trade-off model (contradicting Garaham/Harvey
survey result);
2. Altinkilic and Hansen (2000) postulated the theory that debt and equity issuance costs consist both of a fixed and
a convex variable cost.
The paper uses a large sample of publicly traded us firms over a 25-year period and finds that firms do engage in
significant rebalancing of heir capital structures. They basically employ a dynamic panel data model to test whether firms
rebalance their capital structures in response to changes in their asset volatility, profitability and growth opportunities.
From the research results, we can observe that those firms which were taken under analysis had an initial return of -10%:
this implies that the company’s value of equity went down conspicuously, whereas the D/E ratio inevitably increased
(since it is computed based on market valued of both debt and equity). This implies that in Year 0 (the starting point for
the analysis), we for sure need to witness a positive spike in the returns. Nonetheless, in order to eliminate all those factor
which could affect the D/E ratio of a firm (macroeconomics factors, LBOs,…), the authors decided to compare a firm D/E
with the one of a benchmark by taking the difference between their rations. Thus, they created a variable known as D/E
gap. This metric allows us, indeed, to be sure that the change in capital structure performed by a single firm is not the
result of a trend.
Nonetheless, why are the results projected in the graph evidence that companies are pursuing a target capital structure?
If the companies were indifferent, then the
graph would be representing a straight line.
Conversely, it looks like they have a peak in
the D/E ratio and then it goes down – meaning
the difference between the companies and the
benchmark shrinks. This is a suggestion that
firms tend to aim at reaching the capital
structure of the benchmark company.
Nonetheless, the paper provides no indication
as of whether firms intentionally pursue this
target capital structure or they are passive
about that. The chart only tells us that it is a
long-term process for a firm to reach this
capital structure.

( ) ( )
Equity ( 1−τq ) Debt
Re-levering β: β U =β E +βD → β U =β E∗w E + β D + w D
Equity− [ (1−τq ) Debt ] Equity−[ ( 1−τq ) Debt ]
wE wD

( β U −β D w D )
As a consequence, the formula for re-levering β is given by: β E =
wE

TOPIC 2 – MULTIPLES VALUATION

As one might know, multiples valuation is a valuation method in which the analysed company is valued based on ratios
characterising its comparables. Usually, the ratios such an analysis makes use of see the market value or enterprise value
be put into relation to certain financial metrics such as earnings, revenues or cashflows. Under certain very restrictive
assumptions, some market multiples are considered to be equivalent to the theoretical discounted valuation approaches.
The main difference between the two approaches, indeed, evolves around how steady state is modelled. The multiple
approach, indeed, assumes that the market price reflects the true value of the company and that the company’s financial
metrics are comparable to those of its peers. By doing so, the multiple approach does not take into account a company’s
future growth prospects, cashflow projections or capital expenditures. In contrast, the DCF approach calculates the present
value of a company’s CF by discounting them back to the present value and, consequently, this approach is based on the
premise that a company’s true value is based on its ability to generate cashflows over time, which is not taken into account
at all by the multiples approach.
When performing a multiples valuation, you should follow these five steps:
1. You start with he premise that the target firm is totally mispriced by the market;
2. You select on average correctly prices firms comparable to the target (the main assumption made by the multiples
valuation model is that pricing of comparables is on average correct);
3. You choose a metric;
4. You calculate the multiple for the comparable firms;
5. You apply the multiple to the target firm to get a value.
The key question when performing a multiple valuation remains, nonetheless, the following: how to control for value
drivers in a multiple valuation? Well, first of all one should identify the key drivers of the valuation multiple and assess
how they impact the multiple. For instance, for a P/E multiple, the key drivers might include earnings growth, profitability
and risk. Once you have identified the key value drivers, then you should quantify their impact on the valuation multiple.
This can be done by calculating correlations between the value drivers and the valuation multiple. To control for the
drivers, it is then important to adjust the valuation multiple as to reflect the impact of the drivers. If earnings growth is a
fundamental driver, then a good choice would be to adjust the P/E multiple if the company reflecting the multiple is having
a faster or slower growth than its peers.

P/E Multiple Simple P/E Valuation Estimate the firm’s j share price assuming that the target firm is similar in all respects
to the comparable firms.

Compute the P/E ratio for the comps: $ 22.50/ $ 3.00=7.50 x (basically, the stock market pays 7.50$ for each dollar in
earnings)
Apply the multiple to the firm J → 7.50 x∗4 $=$ 30 per share

Is this price too high or too low for firm j ?

Well, if you look at those which are considered to be the value drivers of the multiple, we see that firm j and its comparable
firm have very different costs of equity. The return on equity of the comparable firm is higher by 400bp, which implies that
the discount rate used to estimate the price of that specific share is higher than the one we should potentially use for
evaluating firm j. As a consequence, the cashflows generated by firm j are not considered as risky as the ones of its
comparable, and for this reason they should be discounted less heavily, thereby yielding a higher valuation for firm j with
respect to the one obtained through the multiple valuation.
Also the growth rate presents a problem: the growth rate of the comparable firm is too high with respect to the one of the
analysed firm, meaning that this P/E ratio applies too high of a growth prospect on firm j with respect to its actual growth
potential. The estimated price is too high and you could potentially scale it down through the PEG ratio (P/E ratio /
growth).
Also dividends could represent a potential problem: a dividend paying company has, indeed, higher EPS by definition.

A general problem about multiples and about the P/E ratio more specifically is the following: valuation mechanisms are
based in the idea that a company’s stock price reflects its expected future earnings potential. Nonetheless, P/E ratios are
based on a company’s current market price per share and its EPS over the most recent fiscal year, thereby not taking into
account at all the future potential of the firm. If we attempt at creating a Leading P/E ratio, we obtain the following:
∞
Di v j ,t
P j=∑ t
t=1 ( 1+ r j )
Assumes some dividend payout policy (0 < d < 1)
∞
d j , t∗EPS j ,t
P j=∑ t
t=1 ( 1+r j )
∞
EPS j ,t For stable companies, we assume cashflows = earnings → payout ratio is 100%
P j=∑ t
t=1 ( 1+ r j )
EPS j , 1 EPS j , 2 EPS j , 3 EPS j , 4 EPS j , ∞
P j= 1
+ 2
+ 3
+ 4
+…+ ∞
( 1+ r j ) ( 1+ r j ) ( 1+ r j ) ( 1+ r j ) ( 1+r j )
If EPS is constant in perpetuity, then e have the following: EP S 1=EP S 2=EP S3 =EP S 4=…=EP S ∞

P j=EPS j
( 1
1
+
1
2
+
1
3
+
1
( 1+r j ) ( 1+r j ) ( 1+r j ) ( 1+r j )
4
+…+
1
( 1+r j )
∞
) PJ
=
1
EP S J r E
1
¿
rE
As we can see, then, P/E ratio represents a steady state based on assumptions like no growth, 100% payout ratio and a
somewhat defined dividend payout policy:

P 1
o … without growth (only risky): Leading =
E rE
P 1
o =
… with growth: Leading
E r E−g
P 1
o …with dividends: Leading = ∗d
E r E−g

Exactly because the P/E multiple represents a steady state based on historical events which already happened, research
has investigated whether P/E multiple computed with today’s values for EPS performs better or not that the same multiple
computed for forecasted values of EPS. Surprisingly enough, when comparing the multiple price estimation with the
stock’s current price on the market, the multiples which witness greater accuracy are those based on forecasts for future
EPS (Accuracy ranking: 1. Price/EPS-2; 2. Price/EPS-1; 3. Price/Actual EPS). How comes that the multiples based on a two-
year forecast perform better than the one based on the actual EPS? Well, this is because the generally used multiples –
which take into account the current values for the specific metrics – are based on historical performances. Conversely, the
prime force which drives prices on the market are expectations on which also forecasts for future EPSs are based. As a
matter of fact, the whole point of forecasting EPS is to bring them closer to what we assume could be the future steady
state of the company and are, indeed, more relevant in representing the current price valuation for a specific stock. In
addition to this, the P/E multiple based on forecasts for EPS is generally considered to be a more useful valuation metric
than the multiple based on today’s value of EPS for some other reasons. Besides being based on the same force which
actually drives prices on the market, a forward-looking P/E makes a more relevant metric for those investors who are
interested in the future prospects of the company, whereas the multiple based on the current EPS value may not reflect the
company’s future growth potential. Tendentially, forecasts also give an idea of the expected growth rate of the company,
which is not reflected in the multiple based on today’s value of EPS. In addition to this, the P/E forecasted multiple also
adjusts for cyclicality, meaning it accounts for changes in the company’s earnings due to business cycles or economic
conditions. In contrast, the multiple based on today’s value of EPS might not fully reflect the impact of cyclicality on the
company’s earnings.

Price-to-sales Multiple The price-to-sales (P/S) ratio is a valuation metric that compares a company’s stock price to its
revenue per share. It is calculated by dividing the company’s market capitalization (or stock price) by its total revenue over
the past 12 months, or sometimes by the revenues expected over the next 12 months.
The P/S ratio is commonly employed as a valuation metric for those companies that are not yet profitable or have
inconsistent earnings. This is because revenue is seen as a more stable and reliable measure of a company’s financial
health than earnings, which can be affected by a wide range of factors. In this case, indeed, you are assuming that the
leverage is the same among the firm and its comparables. In addition to this, price-to-sales ratios assume the following:
o Sales figures are comparable across firms (similar revenue recognition practices)
o Revenue growth is similar across firms
o All other elements of income statement are similar across firms:
- Margins, operating costs (CGS, SG&A)
- Financing costs (interest expenses) → very unlikely

Example Pricing through P/S ratio Using a price-to-sales ratio and Macy’s as its comparable, will you buy or sell the
shares of BigLots?

Computation of the price-to-sale ratio: $ 15.04 /$ 17,364=0.2629

Target company share price: 0.2629∗6,199=1,668.91 → $ 46.97 per share
As of the current valuation, we can observe that the market is actually overvaluing Big Lots Corp. and consequently it
would be profitable for the firm to sell the stock.
Nonetheless, as with the previous multiple, we need to make a comparison between the two companies which we assume
to be comparables. First of all, Macy’s is more levered than Big Lots, as a consequence, the multiple valuation output will
for sure not be accurate, since it assumes the two companies to have the same capital structure. It would be appropriate to
use a more consistent multiple:
E V / Sales=shares∗price +452+ 4,407+3,185 ¿/17,167=0.7330 → Big Lots=0.7330∗6,199=4,543.62
EV −Debt =4,543.62−36−1,691=2,816.92 → Price=2,816.92 /59.68=$ 79.26
When using a more consistent multiple, the stock appears to even be undervalued on the market and we would, therefore,
opt for a buy recommendation.

Research on Multiples

Andrew W. Alford (1992), The Effect of the Set of Comparable Firms on the Accuracy of the P/E Valuation Method, 1992
In the paper, Alford examines the accuracy of the P/E Multiple and how its performance is actually affected by the selection
of comparable firms. More specific Alford’s study uses a simulation model to test the accuracy of the P/E ratio under
different scenarios of comparable firms – more specifically, when those are selected on the basis of risky, industry, and
earnings growth separately. The paper finds that industry membership or a combination of risk and earnings growth are
proved to be effective criterial for selecting comparable firms, whereas partitioning firms strictly on the basis of either risk
or growth does not contribute to improving accuracy. Analogously, selecting comparable firms solely on the basis of risk or
growth is not advantageous either. In order to identify the membership of a company to a specific industry group, the
author referred to the SIC code and noted that the accuracy of the ratio increased together with the number of digits
selected as identification up until the third digit. Adjusting P/E multiples for differences in leverage across comparable
firms, instead, decreases accuracy, whereas the precision of the performed prediction appears to improve together with the
size of the firm.

Liu, Nissim and Thomas , Equity Valuation Using Multiples, 2002

The paper focuses on the use of multiples as a valuation method for equity and specifically focuses on the measurement
and the choice of the metric. The main question resides in whether – for aggregation purposes – it is better to use the
mean, median or the harmonic mean and what is the best multiple to choose overall and for different specific industries.
When it comes to the aggregation method, the authors find that the harmonic mean provides better accuracy. The reason
for this is that the harmonic mean gives more weight to lower multiples, which are more relevant to the valuation of firms
with low earnings or sales. In contrast the arithmetic mean would give equal weights for all the multiples, regardless of the
size of the firm. In other words, the harmonic mean takes into account the skewness of the multiples distribution when it
comes to aggregating multiples of a comparables environment. By taking the harmonic mean, moreover, you basically try
to neutralize all those external factors which might influence a lower EPS for some specific comparable firms, like
management decisions or some firm -specific adjustments.

Francis, Schipper and Vincent, The Relative and Incremental Explanatory Power of Earnings and Alternative Performance
Measure of returns, 2003
The paper examines the relative and incremental explanatory power of earnings and alternative performance measures for
stock returns. Besides finding out that earnings-based multiples are usually preferred and perform better for predicting
stock returns as compared to non-earnings based multiples, the authors also assessed that metrics other than earnings are
actually preferred for valuation in some industries:
o P/EBITDA for oil & gas equipment, healthcare facilities and telecommunications → they are high capital intensive
industries: have a lot of PPE and consequently depreciation turns out to be a relevant item in the P&L. In addition
to this, we must remember that Depreciation is also a very accounting sensitive item: it would change according to
the assumptions made about uselful life, salvage value and depreciation method. Therefrom it follows that a P/E
multiple for such kind of companies might affect the valuation extremely heavily and might threaten the validity of
the selected comparables’ multiples, since those companies might differ in terms of method and assumptions in
how they approach depreciation with respect to the firm under evaluation;
o P/CFO for chemicals, industrial metals, paper & forest products → these industries are characterized by a
relatively long economic cycle and therefore present a lot of accrual accounting items on their balance sheet. By
using CFO, then, you basically get rid of accrual accounting items and consequently give a more precise picture of
the actual operating performance of the firm.
o Revenue per mile, cost per mile, load factor for airlines;
o New Orders and Order Backlog for homebuilding;
o Restaurants for same-store-sales
Nonetheless, the question remains whether investors actually do prefer to evaluate companies in the specific industries
with the advised multiples?
Key finding: investors act as if they prefer earnings, even for industries where an ex-ante preferred (non-earnings) metric
was identified.

TOPIC 4 – FORECASTING AND PRO-FORMA STATEMENTS

When we need to evaluate a firm, the starting point of the valuation is always the preparation of pro-forma statements.
Those basically are statements that are based on assumptions or projections, rather than actual historical data. These
statements are typically used for forecasting future financial performance, evaluating potential business decisions, and
assessing the impact of different options. Pro-forma income statements show the projected revenues, expenses, and profits
of a company based on certain. When performing the first step of valuation, the key is not only to focus on projecting the
two fundamental statements (income statements and balance sheet), but also on defining the projected Statement of
Cashflows.
As a matter of fact, the Statement of Cashflow is useful because it helps us analyse the firm’s cash in- and outflows, and
since the Free Cashflow (FCF) valuation model is the dominant valuation model in practice, understanding the statement
of cashflows would allow us to better understand where the company FCF comes from.
In addition to this, the statement of cashflows also provides the analyst with a lot of additional information about:
o the firm’s size;
o the firm’s growth strategy (internal vs. external growth)
o the firm’s dividend policy
o the firm’s financing policy;
o the firm’s stage in the business cycle;
o ….

STATEMENT OF CASH FLOWS

Net Income (Net Loss)

Adjust for items that do not produce or use CF from operations:
Plus: Depreciation and Amortization expense
Minus/Plus: Gains/Losses on sales of assets
Adjust for changes in working capital (receivables, payments, inventory)

= Cash Flows from Operations (CFO)

Sales of long-term assets

Purchases of long-term assets

= Cash Flows from Investing (CFI)

Issued debt of equity

Stock repurchases
Cash dividend payments

= Cash Flows from Financing (CF)

(+/- Foreign currency translation adjustment [FCA])

The direct and indirect method are two ways to calculate the cashflow
ΔCASH = CFO + CFI + CFF+ FCA from Operations (CFO) section of the cashflow statement. Both
methods usually arrive at the same result, but the indirect method is
usually more straightforward to calculate and therefore most widely
used in practice. However, the direct method provides more detailed
information on the company’s operating cash receipts and payments,
which can be useful for analysis purposes. The direct method, indeed,
contains information which is not contained in any other financial
statement

Statement of Cashflows vs. Balance Sheet - Dell Inc.

 Difference in the Account Receivable item:

Acc. Receivable at t – Acc. Receivable at t-1 =

6,476 – 6,629 = - 153

→ what does this mean? If the receivables

diminish, this means that we are waiting for
clients to pay us less money with respect to
the previous year. Hence, we have collected
some money and, consequently, we witness
some positive cash inflow.

The change in inventory follows the same

principle as the change in accounts
receivable: here, inventory goes up by + 22
→ this implies that the company has bought
some inventory and consequently has
witnessed a cash outflow.

When people pre-order and pre-pay the product, the firm does not concretely realize the value of the merch which was sold.
This implies that in this case, a decline in short-term deferred revenues implies a cash inflow for the company - someone has
paid
As we can see, there are some
discrepancies with respect to the
differences computed on the balance
sheet → why?

- Accounts Receivable: those are usually

presented on the balance sheet, net of the
Allowance for Doubtful Account (an
estimate of the receivables which won’t
be collected by the firm): the discrepancy
in the SCF might be related to changes in
such an estimate;
- Inventory: follows a similar logic. In the
balance sheet the item is also presented
net of a valuation allowance item which
takes into account expected obsolescence
or expected returns derived from storing
the items. Also in this case, the
discrepancy might be caused by changes
in such an allowance
In the case of deferred revenues, the discrepancy with respect to the difference
computed in the balance sheet is conspicuous – in this case the reason might
reside in a potential acquisition.

More on SCFs Individual items on realized (=actual) SCFs often do not articulate with changes in balance sheets. A
general rule is the following: if you have access to a SCF use it, since it will be more accurate – for sure – than any other
difference you might calculate on your own. It will, for instance, take into account those changes in expectations and
estimates which caused discrepancies also on the Dell SCFs.
In addition to this, individual items on forecasted SCFs must articulate: forecasts are expected values and sometimes a
realized SCF item might be higher or lower than a change in the BS, sometimes lower. On average, nonetheless, the SCF
number and the BS difference in cash in/out-flows should be equal. Transactions that don’t involve cash, nonetheless, must
not be part of the SCFs, but they should only be reported on the balance sheet.
IFRS also requires the presentation of an SCF, but it presents an important difference with respect to the US GAAP: interest
and dividends may be classified as operating, investing, or financing cashflows, provided that they are classified
consistently from period to period.

Basics for Performing Valuation In order to perform a valuation analysis of a single company or project, we must have a
payment stream as a starting point. This payment stream must be operational and consistent with theory. We will consider
two broad types of payment items:
o Cash-based streams: dividends, free cashflows (in different versions)
o Accrual-based streams: abnormal earnings (also called residual income), economic value added (EVA, also called
economic profit).
Because the resulting valuation models derive from the same theory, they should also yield the same results (if the model
assumptions are 100% true).
Where do we get those data attributes? There are three sources. The first one requires the valuation analyst to calculate
them on their own through pro-forma forecasts (forecasts full of financial statement from which we derive a valuation
attribute) or through statistical forecasting.
Another way is to rely on management forecasts, which nonetheless are voluntarily provided and there are always biased
in terms of what they say when they do the following. Fewer than 10% of firms provide point forecasts, whereas the
majority of them usually provide range, minimum or maximum forecasts. The legal/institutional environment changes
over time, and with it the popularity of management forecasts, which are more and more attentive in relation to litigation
concerns. Some firms even have discontinued giving quarterly forecasts in recent years and – on average- these firms have
poorer performances. Earnings forecasts dominate and almost never provide forecasts past the following year.
Management forecast, additionally, can never substitute pro-forma forecasts, but they can be helpful to guide or compare
against.
The final and potentially most reliable way of getting forecasts is represented by analysts forecasts: about 30-40% of
publicly traded firms are not followed by a single analyst, and therefore one usually relies on analyst consensus. Analysts
tend to forecast earnings (not FCF, residual income or EVA – those you would need to derive). Furthermore, analysts tend
to forecast for the current year and one year out, and only sometimes long-term growth (LTG) rate for earnings. Much of a
firm’s value is captured by the terminal value, which bases on the growth rate provided by analysts. Analysts’ forecasts
tend, nonetheless, to be biased and can never substitute for pro-forma forecasts, but they can be helpful to guide or
compare against.

Pro-Forma Financial Statements Some predictions of the firm’s financial statements are done given forecasts based on
economic conditions, industry- and firm-specific abilities and firm-specific strategies. Predictions and assumptions should
be reasonable an consistent in terms in how they compare he firm’s part and how they compare them to similar firms, as
well as, they should explain the economic rationale behind their being different from what expected. The financial
statements must articulate.

Steps in Building the Financial Model

STEP 1: Forecast sales revenues (revenue growth rate): in order to forecast revenues, we almost always use a variable
indicated as sales growth rate. Behind it there are always a series of questions: volume vs. price? Product mix? Different
Growth Rates by Segment? What level of sales growth is reasonable?

STEP 2: Project operating expenses (CGS; SG&A,…): this is often expressed as a % of dales (that might vary with sales level,
to capture the fixed/variable cost assumptions). Behind it, some fundamental nodes need to be taken into account: what is
the firm’s cost structure? Is there a high proportion of variable costs or of fixed costs? Also in this case, the operating
expenses need to be forecasted separately according to the different segments.
STEP 3: Project assets needed to support revenues and operating expenses (balance sheet projections): in this case we
have the choice between two different potential approaches: economic driver approach and the total assets approach. The
economic driver approach, more specifically, involves identifying the key drivers that impact a company financial
performance on the asset side (account receivables, inventory,…). This approach is useful because it allows companies to
identify the key drivers of their financial performance and develop a more accurate forecast for their future financial
performance. It also helps companies to identify potential risks and opportunities that might impact their financial
performance, and to develop strategies to mitigate these risks or take advantage of these opportunities. The total asset
approach instead, starts by projecting growth in total assets and sales are supposed to drive total assets (through the TAT
ratio). At this point, total assets should be allocated to individual assets, assuming – nonetheless – changes or constancy in
the mix of assets held by the firm.

STEP 4: Project operating liabilities needed to support revenues and operating expenses: also in this case we adopt the
economic driver approach.

STEP 5: Project financing for assets: in this case the key is to determine the D/E ratio for the single firm ( in book value
terms). At this point of the forecasting way, you should ask yourself whether to express debt as a given % of total assets or
to keep it fixed in terms of dollar amount. When it comes to common equity, the analyst must forecast potential
issuances/repurchases of stocks. If there is no specific knowledge about future operations, one usually keeps the number
of shares constant. Under that assumption that any transaction with the equity market is zero NPV (that is, firms buy
back/issue shares at the fair value), future share transactions have zero value implication for current owners.
Because many firms have target capital structure, in market value terms, deciding on book values of debt and equity may
require an iterative process.

STEP 6: Return to the I/S and calculate the cost of financing: the cost of financing of the firm is derives by the amount of
interest-bearing debt and interest rate. The cost of debt is consequently determined by the % debt which is reported as
interest expense.

STEP 7: DERIVE THE CASHFLOW IMPLICATIONS (= mechanically derive the statement of cashflow): The set of
assumptions made in order to derive the company’s pro-forma statements will for sure generate some projection of
cashflow into or out of the firm (“the plug” in the system of pro-formas). This brings about the necessity to understand
what the firm plans to do with the cashflow which is projected to have generated. This can have effects on the capital
structure and make sure your scenario is internally consistent:
o Excess Cashflow: build up cash balance? Invest in marketable securities? (leads to liquidity hoarding) Pay down
debt? Repurchase stock? Pay dividends?
o Insufficient Cashflow: extend A/P? Shorten A/R? (not always possible for the firm: the basic assumption is that the
firm is already managing their cash-balance optimally. In addition to this, clients and suppliers also have a say in
determining when money should be received/paid) Increase debt’ Issue equity? Cut dividends? (never a good
idea because of the bad signals it sends)

Issues in Dell (A) Pro-forma derivation

o Capital Expenditures (CapEx) estimation: CapEx is needed for re-investment and growth and it is forecasted by
making a series of assumptions:
- The company uses assets until worthless;
- The useful life assumption is correct = an asset will be retired (and will need to be replaced) only when fully
depreciated (no salvage value is forecasted).

(1) Gross PPE at t = Gross PPE at t-1 + CapEx at t - Retired Assets at t :

(2) AccumDepreciation at t = AccumDepreciation at t-1 + DeprExpense
at t - AccDeprRetiredAssets at t

(3) NetPPE at t = NetPPE at t-1 + CapEx at t - DeprExp at t

ASSUMPTION: they are set equal
Net PPE at t = GrossPPE - AccDepreciation

When we assume that the firm is not growing (has reached steady state), would it be a good assumption to set
CapEx
equal to depreciation? No, never do this. As a matter of fact, depreciation is paid in terms of “useful life” money,
whereas CapEx is an investment which you pay in terms of today’s money.
More or less the same procedure is performed also for intangible assets. Those are, nonetheless, almost always
 presented at net value, which means that their current value is given by: NetIntanginles at t = NetIntangibles at t-
1
+ Additions at t - Amortization at t .
Intangible assets are generally expensed as incurred when they are generated internally and this holds for
development expenses, as well, under US GAAP. Some other intangibles are, instead, recorded on the balance
sheet, but only when these are acquired. Some intangibles have- by definition- an indefinite life and are
consequently not amortized (i.e. goodwill, in-process R&D). Some software development costs are allowed to be
capitalized under US GAAP, whereas only development expenses can be capitalized under IFRS (if they actually
reach and respect some specific pre-requisites)
o Retained Earnings: dividends as plug in the system

For 2021

Retained Earnings at t (16,891)

= Retained Earnings at t-1 (15,682)

Who are the recipients?
+ Net Earnings at t 2,538
1. NCI holders (fixed amount
- Total Dividends at t - DIV for 2021 corresponding from the
earnings generated from them)
2. CE – holders

In this case, we witness a form of value generation within the firm based on explicit forecasts based on the cash
balance (which we assume it to be perfectly managed). As a consequence, all retained earnings are distributed as
dividends to NCI or Common Equity holders. The “normal dividends” – meaning the expected, realistic payout in the
form of cash – is given by the firm’s dividend payout policy.

Many SCF items are simply changes in individual

accounts.

Examples
1. Inventories went from 3,281 (in 2020) to
3,277 (in 2021)
2. Total Financing receivables went from 9,743
(in 2020) to 10,310 (in 2021)
3. Short-term debt went from 7,737 (in 2020) to
8,507 (in 2021)

Change in Net PPE and Intangible assets

needs to be split in two components:

1. Depreciation and Amortization are

non-cash expenses which are in
need to be added back in order to
form CFO;
2. CapEx and Addition to Intangibles
instead are negative cash outflows
to be taken into account in CFI

The income generated also needs to be split:

1. Dividends to shareholders;
2. Payout to NCI Holders and Others (an assumption
guides the sum paid out to NCI holders – meaning
the one that they simply realize their cost of capital
→ they are paid out exactly the amount of revenues
they are generating)
Pensions and Other Postretirement Plans There is a focus on defined-benefit plans (not defined- contribution plans).
Firms are liable for cash flow consequences in the future and have to disclose the underfunded status of pension plans.
How to treat them? Theoretically firms should always have a situation of perfect hedging of pension liabilities (should hold
pension assets in the same quantity as pension liabilities). In practice it is rarely so, since -on average- firms have a pension
gap of more or less 11% of their own market capitalization. When proceeding with the construction of SCF, pension gaps
should be classified as operating liabilities by default (there is no direct cost of financing associated with them
nonetheless). If you treat it as a financing form of debt, then there would be some direct consequences: it would influence
both the WACC (by altering the debt-to-capital ratio) and the equity value (you would need to subtract from EV).

TOPIC 4 – CASH-FLOW BASED METHODS OF VALUATION

The Discounted Dividend Model The discounted dividend model basically computes the value of equity by assuming
dividends as sole cashflow to shareholders.

∞
Di v t ( 1+ g ) Di v T
Value 0=∑ t
+ T
t =1 ( 1+r j ) ( r e −g ) ( 1+r e )
The values resulting from the dividend model are difficult to interpret (as measures of intrinsic value) because many firms
pay no or very small amounts of dividends to their shareholders because of pure corporate choice. For this reason,
dividend models based on cash dividends tend to underestimate value and it is hard to use them in practice without
further transformation.

The Free Cashflow Model When approaching the dividend model, you might soon recall and state the validity of
Modigliani and Miller’s dividend policy irrelevance. Therefore, you leave the assumption that the only paid out amount to
shareholders is represented by dividends and – consequently- you assume that any cash that can be paid out will be paid
out. The amount eventually paid out is called Free Cashflow (FCF). FCF are exactly those cashflows which are available for
distribution and can be of two types:
o Free Cashflows of the Unlevered Firm (FCFU) are the cashflows available for distribution to all claimants;
o Free Cashflows to Common Equity (FCFE) are cashflows available for distribution to the common equity
claimants.

∞
FC Ft ( 1+ g ) FCF T
Valu e0=∑ t
+ T
t =1 ( 1+ r j ) ( r e −g ) ( 1+r e )

Dealing with Financial Assets There are some assets which the company presents into their financial statements which
are not considerable as useful in their operations and, thus, need to be evaluated separately.
The most simplistic definition identifies financial assets as those assets not being used in operations (i.e. investments and
marketable securities). When inspecting the balance sheet these assets present themselves with three fundamental
characteristics:
1. have some value;
2. generate some income;
3. are source of constant cash in- and outflows.

There are two fundamentally different approaches to dealing with such assets

Operating Asset View → All Assets are needed for Net Debt View → FA are not needed in
operations operations

o Financial assets are treated as operating o Financial assets are treated as contra-
assets; debt assets (they are assets which the
o Their income is treated like any other firm can sell to repay debt)
operating income o Their income is treated as contra-debt,
as well
The Firm’s Cost of Capital – The WACC The WACC is a blended rate, which is used to discount flows to all claimants
(equity holders, debt holders and NCI holders). This basically takes into account the discount rates for all types of capital
provided:
1. Common equity providers, r E
2. Preferred Stock providers, r PS
3. Non-controlling interest holders (=minority interest holders), r NCI
4. Debt providers, r D
The assigned weights are supposed to reflect the capital structure on the economic balance sheet.

r WACC =wD ( 1−τ ) r D +w PS∗r PS + wNCI ( 1−τ ) r NCI +w E∗r E

Example Calculating Starbuck’s WACC (Operating Asset View) - STEP 1: Derive Outstanding Shares

Data:
o Risk-free rate (r f ) = 2%
o Risk premium (r M −r f ¿ = 4.75%
o SBUX’ β = 0.72
o r E=r f + β ( r M −r f ) = 5.42%
o Observed price as of 9/29/2019 = $ 88.4
o Market Value of Equity = $ 104,742.3

When determining the number of shares outstanding one needs to control for those shares which the company has
repurchased and kept in their portfolio (not those which the company has cancelled → if the companies cancels the
amount of stocks repurchased, those stocks cannot be issued at any other time in the future. This can also be seen as a
positive signal that the company is no longer in need of money). The indication of “ authorized shares” indicates the
maximum amount of shares which the company can issue without requiring further approval.

STEP 2: Derive SBUX’s Cost of Debt → there are many ways in which cost of debt can be derived for a single company:
1. If they have bonds outstanding, you can look at the weighted average coupon rate (nominal value dependent → the
book value of debt can though such a proxy be issued at par or at discount);
2. Look at the bonds issued by the firm and – if traded in a liquid market – take the yield to maturity of those bonds
as a proxy for cost of debt;
3. Risk-free rate + spread (dependant on the firm’s credit rating)
4. Create a synthetic rating of the firm – in the case it was not rated – by computing the firm’s interest coverage ratio
The problem when looking at migration rates and deriving an average cost of debt for the single firm based on the chances
it gets up- or downgraded is the following: statistically, the probability that a company gets a worse rating or is withdrawn
at all, is much higher than the chances the company has of getting a better grade. This implies that a good company might
overestimate its cost of debt by undergoing such a procedure, with the direct consequence of underestimating its own
value.

Another more effective way to calculate a company’s cost of debt might be to take the weighted average of effective
interest rates on the company’s outstanding bonds. The weights need, nonetheless, to be calculated as a % of the total fair
value of debt which was estimated by the company itself (according to whether the bond was issued at par, at a premium
or at a discount).

Resulting r D is 3.3823%

Information on debt:
o Cost of debt (r D) = 3.3823%
o Long term debt = 11, 167 +/- Fair Value Adjustment = + 866
o Total Debt = 12,033

STEP 3: SBUX’S NCI and r NCI

NCI is basically the portion of the company or of

a subsidiary which the parent company does
not own → there are some externals which
control part of the subsidiary (a minor part,
since they are non-controlling)
STEP 4: derive the company’s effective tax rate

→ Tax Expenses / Pre-tax Earnings

OPERATING ASSET VIEW

FCFU Calculation The Free Cash Flow of the Unlevered Firm abstracts from financing, i.e. the source of cash and can be
calculated through different approaches:
o CFO method (starts off with the Cash Flow from Operations)
o Earnings Before Interest and Taxes (EBIT) method
In particular, if the Statement of Cashflow is available, the CFO method is generally easier to use, since it already adjusts for
relevant changes in net operating assets. If the goal is to compute a realized FCFU from actual financials, then the CFO
method is the only one which should be use. The drawback of the CFO method, nonetheless, is the one that it assume any
single change in the balance sheet derives from a cash operation (and it is rarely so).
Net Income
CFO Method
Plus: Depreciation and amortization expense and other non-
Cash Flow from Operations (CFO) cash expenses

Less: Increase in required cash Less: any non-cash gains

Plus: Cash Interest paid Less: increases in WC (Working Capital)

Less: Interest Tax Shield Less: Increases in long-term Net Operating Assets

Less: Capital Expenditures

Cash Flow From Operations (CFO)
= FCFU

FCFUs are then cashflows available for distribution to all claimants, and as we can understand from the structure of the
CFO method, they are generated primarily by two sources:

CFO
(1) Cash generated by the firm’s operations - increase in required cash
+ cash interest paid
- tax-shield on interest expense

Less: CFI
(2) Less: Cash paid for capital expenditures and other = CapEx (why? Because under
investments in the firm’s operations Operating Assets View there is no asset
which is not used in operations and
consequently no investment can be
made in any other type of assets
Interest Expense vs. Cash Interest Paid Interest Expense is the calculatory cost of debt financing and basically represents
the amount of interest expense deducted for tax purposes. Cash Interest Paid, instead, is the amount of interest expense
actually paid in cash during the year. The difference between these two items is that interest expense can be classified as
follows: an accrued interest expense if the firm has a net liability, a prepaid interest expense if the firm has a net asset. Both
of these would typically appear as part of “accrued liabilities” or “prepaid assets” which are part of the operations section
of the SCF. Firms, then, must disclose both Interest Expense and Cash Interest Paid in their financial statements (the
interest expense must be disclosed in the income statement of footnote, whereas the Cash Interest Paid must be disclosed
either below the statement of cashflows [US GAAP] or on the statement of cashflows [IFRS]).
If the interest expense is deductible, moreover, there is preferential tax treatment for debt financing. One of the
fundamental advantages of debt, indeed, is the present value of the income taxes saved by the firm’s ability to deduct
interest payments. The debt advantage is year t is called the “interest tax shield” (ITS) and equals the interest expense in
year t times the corporate tax rate in year t → ITS=Interest Expense∗τ .
For calculating the tax shield, we take Interest Expense as a reference and we typically use the effective tax rate (in going-
concern valuations).

Cash Balances Cash Balance refers to the amount of cash and cash equivalents that a company holds at particular point of
time. This includes cash in hand, bank accounts, and short term investments that can be readily converted to cash. When
calculating FCFU, cash balance is an important factor to consider because it affects the company’s overall value. Cash
balance can be used to pay off debt, fund investments or distribute dividends to shareholders. Therefore, it can have a
significant impact on the company’s ability to generate future free cashflows.
More specifically, the required cash balance is the amount of cash the firm needs to maintain for operations. Typically, we
infer target balances from comparable firms or make an assumption about industry norms. Target cash balances are
usually a small percentage of revenues and for some industries, they are actually quite large. As excess cash balance,
instead, we understand cash over and above the required cash balance. Excess cash at this point is added to the value of the
firm in the final step of a free cash flow valuation (if temporary). How do we know how to identify excess cash balances?
Well, one usually looks at the cash/sales ratio for comparable firms and looks at the historical cash/sales ratio for the firm
in question.
When looking at the historical cash/sales ratio for the single firm, you are able to take into account firm-specific factors,
whereas you are excluding the consideration of any other recent macroeconomic/industry causes of holding cash. The
inverse happens, instead, if you look at the comparable companies (you completely eliminate any firm-specific
consideration).

Example Starbucks’s Cash Balances

SCENARIO 1: Assuming optimal cash management

Fiscal Year ending, Sep 29 2019 The whole difference in cash is

accounted for as a change in required
Change in required cash - 6,069.7 cash (the firm optimally balances cash
meaning they do not have excess cash)
Excess Cash -

SCENARIO 2: Assuming required cash balances are 3.0% of sales

Fiscal Year Ending, Sep 29 2019

This period required cash 755.26

Last period required cash 741.59

Change in required cash
Excess cash
Excess cash is identified as Cash and
53.67
Equivalents for 2019 – (Last Period
Required Cash + Changes in required
(2,686.6 – 795.26) = 1,891.3
Cash)

Starbucks’s FCFU under Operating Asset View

Assuming optimal cash management

Fiscal Year ending, Sep 29 2019

CFO 5,047

- Increase in required cash 6,069.7

+ Cash Interest Paid 299.5

- Interest Tax Shield (ITS) (331 * 0.1952) = 64.6

+ Non- Controlling Interests (=MI)

NO ADJUSTMENT NEEDED IN THIS CASE
- Tax Shield to NCI

- Capital Expenditures ( = CFI) -1,010.8

= FCFU 10,340.80

Free Cash Flow to Common Equity (FCFE) FCFE is that portion of FCFU which is made available to common equity
holders only. As a consequence, when calculating FCFE, non-equity contributions are treated as sources of payment for
common equity claims, i.e. borrowing money is a way to fund a common equity dividend. FCFE treats non-equity payments
as obligation which reduce the cash flow available for payments to common equity claimants.
FCFE are cashflows available for distribution to the firm’s equity holders and, as it was for FCFU, also adjustments for all
non-common equity cash transactions are needed:

FCFU

- Cash Interest Paid - Other Payments to non-common equity holders

+ Tax Shield (debt repayments, preferred share dividends, etc…)

- Payments to NCI – holders + Other inflows from non-common equity holders

+ Tax Shield (new loans,…)

Example Starbucks’s FCFE Calculation We start off by examining the SCF Financing Section in order to understand which
transactions refer to non-common equity holders and which do.

ALL THOSE GO BACK TO

EQUITY HOLDERS

TAX-DEDUCTION PRE-PAYMENT on behalf on employees (cash outflow which ensures the employees are paying their
income tax // form of compensation)

Assuming optimal cash management

FCFU 10,340.8
Normally, we would have a negative sign
- Cash Interest Paid (299.5) connected to NCI Expense (they are basically the
portion which is paid to NCI holders, but which is
- Tax Shield on Interest Expense (64.6 ) seen as an expense by common-equity holders)
→ NCI are making losses, which implies that we
- NCI Expense (-5.7) need to add back the amount
In addition, the amount is expressed after.-tax →
+ Tax Shield on NCI (1.1) (-4.6)/(1-0.1952) = - 5.7
+ Changes in Short-term debt (SBUX has them at 0)

+ Changes in LT- Debt (needs to be split between new loans taken

and amount repaid → gives signal that the firm is trusted enough
to be granted new credit)

The Principle of the Free Cash Flow Valuation

The real question when we perform those two kinds of valuation is, why do we have two methods for evaluating the firm?
Shouldn’t they yield the same result?
o FCFU Model treats the firm as completely unlevered. There are no adjustments for debt-related payments and no
add-backs of cash received by debt issuances (or any other non-common equity transactions). This model, then,
values the stream of the Free Cashflows of the firm as if the latter was completely financed through equity. This
will yield a total firm value and not a common equity value. Note that, when we value the FCFU, the cash flows are
not and should not be discounted as the cost of equity, since at least a portion of that cashflow will reflect non-
equity claims, which have different risk profiles with respect to equity claims. To get the equity value, deduct the
value of non-equity claims (and add any excess cash) from the total firm value. There are two approaches to
evaluate the firm based on the FCFU Model: 1) the WACC method; 2) the API method;
o FCFE Model: when discounting FCFE, we use the company’s computed cost of equity to directly obtain the equity
value. This model, then, kind of takes into account the capital structure of the firm – and more specifically the
current one. Differently, the FCFU model only incorporates a capital structure (through WACC), which nonetheless
does not need to be the current one but could also be the target one for the company.

FCFU Valuation – the WACC Method

1. Discount the FCFUs at the weighted average cost of debt r WACC . Assume constant discount rates and a tax rate τ .

T
FCF U t ( 1+g ) FCF U T
Enterprise Valu e 0=∑ t
+ T
+ Excess Cash
t =1 ( 1+r WACC ) ( r WACC −g ) ( 1+r WACC )
2. Then subtract the value of non-equity claims (and add any excess cash) to get the value of the common equity.

T
FCF U t ( 1+g ) FCF U T
Enterprise Valu e 0=∑ t
+ T
+ Excess Cash−Deb t 0−P S 0−NC I 0
t =1 ( 1+r WACC ) ( r WACC −g ) ( 1+r WACC )
Example Assume Starbucks is in steady state now (T=0), and will grow at the expected rate of inflation (2%) in
perpetuity.
FCFU Valuation - Principle of APV Valuation Basically the APV Model (Adjusted Present Value) is a method of valuing a
company which breaks down its value into separate components, including the value of the company’ operations and the
value of any financing benefits or costs. The APV Model follows a series of principles:
1. r U is an unlevered discount rate and consequently can only be used in an unlevered FCFU model. This discount
rate, moreover, abstracts from the tax advantage of using debt or NCI(it is calculated through the use of the
unlevered β);
2. Thus, the enterprise value consists of several parts
- Present Value of the FCFU stream;
- Present Value of ITS Stream;
- Present Value of the TS on MI payments (if applicable) TAKES THE TAX POSITION
- Present Value of the Tax Sword on interest income (if under Net Debt View) INTO ACCOUNT
3. Advantages of the APV Model are that it is easier when the capital structure changes during the forecasted years
(avoids WACC calculation each year) and easier when the tax rate changes during the forecast years.

Example APV Valuation Model for Dell

Fiscal Year Ending, Sept 29 2021

FCFU 1,046

Plus: Interest Tax Shield 607 These are respectively computed

as:
Plus: NCI Tax Shield 111 - Cash Interest Paid * Tax rate
- MV of NCI * Tax rate
Total 2,663.71

WACC Valuation vs. APV Valuation

o The WACC method assumes a constant capital structure, a constant cost of debt and a constant tax rate. As a
consequence, also the assumed discount rate (WACC) is kept constant for the valuation. Despite then relying on an
unlevered CF, the fact that those are discounted through the WACC somehow brings the capital structure into the
valuation (be it the current or the target capital structure);
o The APV Valuation method, instead, can be adapted to a changing capital structure which relies, for instance, on a
fixed debt schedule. This cashflow is discounted at the unlevered discount rate, which also in this case remains
constant independently of the current capital structure.

NET DEBT VIEW

FCFU Valuation under Net Debt View As opposed to the Operating Asset View, the Net Debt View basically assumes that
financial assets are used by the firm as contra-debt assets and, therefore, we should also treat the income they generate as
a contra-financing item. The first step in performing a valuation under this assumption is to basically identify a company’s
financial assets.
Example Estimating Starbucks’s Financial Assets
As a consequence, total value of debt will be given by:
Long term debt
+/- Fair Value Adj.
- FV of Financial Assets
Net Debt
Starbucks’s FCFU under Net Debt View (Assuming required cash balances are 3% of sales)
Fiscal Year ending, Sep 29
CFO
- Increase in required Cash
+ Cash Interest Paid
- Interest Tax Shield (ITS)
- Interest Income
+ Tax sword on interest income
- Capital Expenditures
= FCFU
In this case, we basically assume both
LT and ST investments made by the
firm are of financing nature and are,
therefore, used as contra-debt
securities (potentially held for sale in
case of liquidity shortage to face
debt)
11,167.0
+ 866
(290.5) → 70.5 + 220.0 (ST Investments + LT Investments)
11,742.5
Consider the whole interest income
as coming from investment of
financing nature → it can all be used
in order to offset debt
2019
5,047.0
Interest income is computed only on the
(53.7) amount of assets which are legitimately
recognized as Financial Assets → not all types
299.5 of investments could be identified as such
(64.6)
(96.5)
In this case, we are basically undoing a penalty that
an all equity firm should not have incurred in → you
18.8
are “deleting” the amount of taxes paid on interest
income (96.5 * Tax Rate for the firm)
2,076.9
3,972.1
Which assets can be considered as contra-debt instruments? Which of them are exclusively used for operations?

OPERATING INVESTMENTS

To derive Financial Assets you basically start from the total CFI and do the
following:

CFI (1,010.8)

- Investment for Operating Assets (- 1,066.1)

= Investment in Financial Assets 2,076.9

Starbucks’s FCFE under Net Debt View (Assuming required cash balances are 3.0% of sales)

Here, we are basically undoing what we did to

arrive at FCFU (we neutralize previous operations)

All items in the CFI that we considered Financial

Asset related

FCFU Valuation under Net Debt View (Assuming

required cash balances are 3.0% of sales)

It is the amount of Debt net of the identified

Financial Assets
Example APV Valuation Model for Dell

Fiscal Year Ending, Sept 29 2021

FCFU 2,220

Plus: Interest Tax Shield 607

Plus: NCI Tax Shield 111

Plus: Tax Sword 2

Total 2, 940

Differences to OA View

o In the FCFU calculation: deduction of FA-related interest income (net of tax) and different definition of CapEx
o In the FCFU valuation: capital structure shift (debt is expressed net of Financial Assets), only net debt is deducted
from EV at the end

TOPIC 5 – ACCRUAL- BASED MODELS FOR VALUATION

Free Cash Flow Valuation models rely heavily on the terminal value and, therefore, the appear to be very sensitive to
estimated growth rates, discount rated and steady states conditions. In addition to this, they are subject to the timing of
payment streams and are highly volatile over time. Estimating the period in which payments will occur is difficult, if not
impossible. Accrual based valuation models, instead, being based on earnings, present less volatile results but bring about
the problem of important accounting measures and estimates. Moreover, they are able to provide a more accurate picture
of a company’s financial health than cash-flow based methods because they take into account all the company’s assets,
liabilities, revenues and expenses, including those that have not been paid or received in cash. By doing so, these models
can provide a more comprehensive view of a company financial position and its future potential.

Abnormal Earnings Model The abnormal earnings valuation (AEV) is a type of accrual-based valuation model that
estimates the intrinsic value of a company based on its current earnings and expected future earnings. This model starts off
from the idea that a company’s earnings are split into normal and abnormal earnings, where normal earnings are the
earnings that a company can generate from its assets and operations, whereas abnormal earnings are the earnings that
exceed what would be considered normal and are generated through extraordinary events (changes in market conditions,
new product or launches, or other unexpected events). The AEV model is also known as the residual income his model is
fundamentally based on one single assumption: Clean Surplus. The latter basically imposes that ROE is given by the current
Net Income of the firm over the previous period’s BV of equity. In this sense, then, abnormal earnings are defined as the
difference between earnings and cost of equity in or (equivalently) as the difference between ROE and r E, multiplied by
the last period’s BV of equity in % terms.

T
N I t−r E Bt−1 ( 1+ g ) ( N I T −r E BT−1 )
Equity Valu e0 =B 0+ ∑ t
+ T
t =1 ( 1+r E ) ( r E −g ) ( 1+r E )

T
(ROEt −r E )Bt −1 ( 1+ g ) ( RO ET −r E ) BT −1
Equity Valu e0 =B 0+ ∑ t
+ T
t =1 ( 1+ r E ) ( r E−g )( 1+ r E )

The implication of such assumptions are the following:

 1. Definition of shareholder value: you create shareholder value when RO E T >r E and this represent a necessary
condition in order for MVE > BVE
2. Dynamic valuation view: firm value is expected to increase when the expectation of future ROE increases and the
discount rate r E decreases
On valuation date, then, equity value would be given by: PV of abnormal earnings PLUS current BV (→ Equity Value Directly
obtained by the company).

A E2021 A E2027∗( 1+ g )
Equity Valu e0 =BV T + +…+ 7
1+r e ( r e −g ) ( 1+r E )

Book Value at Valuation Date = Past Investments + Past

OUR EXPECTATION OF FUTURE SHAREHOLDER VALUE
Earnings (net of “net dividends”)
CREATION

Example Dell’s Abnormal Earnings 2027

N I 2027 2,925
RO E 2027= = =113.21 %
BV E2026 2,584

Abnormal Earning s2027 =[ RO E 2027−r E ]∗BV E2026 =( 113.21 %−7.85 % )∗2,684=$ 282,786.24

Abnormal Earnings should be computed for each valuation year and discounted to present value terms. They should then
be added to BV of equity as of today to give an idea of the firm’s equity value

Economic Value Added (or Economic Profit) Model The Economic Value Added Model (EVA) is an accrual-based financial
performance measure that is able to evaluate a company’s profitability by taking into account the cost of capital. Its key
principle is that a company only creates value for its shareholders if it earns more than the cost of capital it uses to finance
its operations. In other words, a company needs to generate returns that exceed the cost of capital to create value for
shareholders.
To calculate EVA, the model subtracts the cost of capital from the company’s net operating profits after taxes (NOPAT),
which is computed by subtracting operating expenses and taxes from its operating revenues.

T
( ROI C t −r WACC ) I Ct −1 ( 1+ g ) ( ROI C T −r WACC ) I C T−1
Enterprise Value 0=I C 0 + ∑ t
+ T
t=1 ( 1+ r WACC ) ( r WACC −g ) ( 1+r WACC )
EXPLICIT FORECASTS TERMINAL VALUE
CURRENT INVESTED CAPITAL
→ Who is investing in the firm? TOTAL MARKET VALUE ADDED
1. Debt holders
2. NCI holders
3. PS holders
4. Common Equity Holders
STEP 1: DEFINE INVESTED CAPITAL (IC) → the latter is represented by the book value of the firm’s operating assets less
book value of the firms operating liabilities or – equivalently- as the book value of the firm’s financing (=all sources of
capital) less book value of any “net debt items” (i.e. financial assets are classified as financing). Nonetheless, it is important
to mention that this definition will change according to how you define your assets (whether you adopt the Operating
Assets or the Net debt view).

Example Dell’s Valuation through EVA Method

Current liabilities:
2026 2027 Short-term debt 9.263 9.388
Current assets: Accounts payable 23.130 23.616
Cash and cash equivalents 11.009 11.248 Accrued and other current liabilities 11.670 11.923
Accounts receivable, net 15.413 15.748 Short-term deferred service revenue 16.514 16.873
Total current liabilities 60.577 61.800
Short-term financing receivables, net 6.385 6.524
Inventories, net 3.581 3.657
Long-term debt 42.346 41.575
Other current assets 7.926 8.099 Long-term deferred service revenue 14.862 15.185
Total current assets 44.315 45.276 Other non-current liabilities 6.605 6.749
Total liabilities 124.391 125.309

METHOD
Computer equipment 1: sum all operating Redeemable shares 629 629

assets and liabilities on the BS

Land and buildings
Stockholders’ equity:
Machinery and other equipment Common stock and capital in excess of $.01 par
Property, plant, and equipment, gross 17.614 17.997 value; shares authorized: 9,143; shares issued:
745 in 2019 and 721 in 2018,
METHOD 2: sum all the financing respectively; shares outstanding: 743 in 2019
Accumulated Depreciation
assets on the BS (invested by -9.531 -9.707 and 719 and 2018, respectively 16.091 16.091
Property, plant, and equipment, net
claimants) 8.084 8.291 Treasury stock at cost: 2 shares in 2020 and 2019, respectively
-65 -65
Accumulated deficit -12.733 -11.872
Long-term Investments 1.321 1.350 Accumulated other comprehensive income (loss) -709 -709
Total common equity 2.584 3.445
Long-term financing receivables, net 5.505 5.624
Goodwill 41.691 41.691
Non-controlling interest 4.729 4.729
Intangible assets, net 19.307 19.507 Total stockholders’ equity 7.313 8.174
Other non-current assets 12.110 12.373
Total assets 132.332 134.111 Total liabilities and equity 132.332 134.111

STEP 2: DEFINE NOPAT FOR 2027 → this basically represents the net income of a firm whose operations are assumed to be
all equity financed. When defining what constitutes NOPAT and what does not, it is important to define which items of the
P&L are considerable as operating and which as financing.

CONTROVERSIAL ITEM: interest income and

interest expense can – under IFRS- be classified
either under operating or under financing
cashflows. As a consequence, it is difficult to
classify such an item by default
METHOD 1: All operating revenues and income assets less all operating expenses, all adjusted for cash

OPERATING INCOME
you add the whole sum in case of Operating Asset View, otherwise you limit
+ Interest Income yourself to adding the part which cannot be considered as being proceeds
from Financial Assets
- Other

= NOP (Net Operating Income)

- Tax Expenses (23% as effective tax rate)

= NOPAT

METHOD 2: Net Income plus all financing expenses (less any financial-asset-related income), adjusted for taxes

NET INCOME TO SHAREHOLDERS (DIV)

+ Net Income to NCI Shareholders

+ Interest Expense

- Tax Shield on Interest Expense

= NOPAT (2027)

EV A 2027 =NOPA T 2027 −r WACC∗I C 2026 OR ALTERNATIVELY EV A 2027 =( ROI C 2027 −r WACC )∗I C 2026

NOPA T 2027
ROI C2027 =
I C 2026
Digression : also when performing accrual-based methods of valuation, WACC iteration is still necessary. Nonetheless, it
might be surprising that the “optimal WACC” which you found for the FCFU or FCFCE methods, are not the same as those
which might come up as a result of the abnormal-earnings model. Why this? Well, first of all because those models actually
depend very differently from the WACC. It is also worth mentioning that the WACC should, nonetheless, not change as a
consequence of the valuation model used, but rather they are heavily affected by the quality of their pro-formas. Their
deviations, indeed, depend on how strongly steady state is violated.

EVA- Differences under Net Debt View

1. Invested Capital computation: deduct financial assets;

2. NOPAT: Interest Income (less tax sword) not included
3. Recalculate r WACC with the reduced weight on debt
4. Equity Value = Enterprise value – Net Debt Value (- Others)

SIMILAR TO THE FCFE CONCEPT, THERE CANNOT BE A DIFFERENCE IN VIEWS IN THE ABNORMAL EARNINGS MODEL

TOPIC 6 – COMPLEXITIES IN VALUATIONS

The Importance of Steady State Steady State is an important concept in a company’s valuation, as it represents the point at
which a company’s future cashflows are expected to stabilize and grow at a constant rate over the long term. When valuing
a company, the steady state period is typically used to estimate the terminal value, which represents the value of the
company beyond the projection period. This is important because most companies are expected to continue operating
beyond the projection period, and estimating a company’s value beyond this period is necessary to calculate the total
intrinsic value.
Not only is the terminal value calculation essential to determine a company’s intrinsic value, but it is rather “heavy” and
influential on the final result of the valuation.

The graph basically indicated how much of

the forecasted value comes out of the terminal
value year’s assumptions (growth with
respect to the perpetuity) → as we can see,
the forecasts made about TV are much more
influential for any kind of industry with
respect to the discounted cashflows.

When we evaluate a company, we basically

assume the reaching of a maturity state once the
terminal value period is reached (decline is
rarely modelled in finance unless there are some
specific reasons to). In addition to this, since we
assume a constant growth rate, it is important to
pay attention when it comes to determining its
value. A useful practice, is to calculate the
growth rate which was applied to the terminal
value itself and eventually compare it with the
growth rate which you would like to impose in
the terminal value calculation. If the growth rate
you need to impose in the future to reach steady
state is too high, this means that the current
estimated CF is too low and there is something
wrong in the pro-formas.
TERMINAL VALUE ASSUMPTION

( 1+g )∗Valuation Attribut eT

T VT=
r−g
Interpretation: what happens at T will go on in perpetuity (growing at the established rate g ). As a consequence, there are
two things which need to be checked thoroughly:
o It must make economic sense to continue economic activity in perpetuity (economic steady state conditions) →
VALUABILITY OF THE ASSUMPTIONS;
o Our set of forecasted financial statements must actually be in steady state at T (mechanical steady state condition)
→ UNDERLYING DATA QUALITY OF PRO-FORMAS

Economic Steady State Economic steady state requires some assumptions to be necessarily true at the terminal value
year (since they represent the very definition as to describe steady state):
o FCFU > 0 / FCFCE > 0 : the firm must have positive FCF (no operations can be sustained or continued in
perpetuity if it generates negative cashflows);
o ROE ≥ r E / ROIC ≥ r E: these conditions both imply that Abnormal Earnings and Economic Value Added are
positive values. The firm, indeed, must earn at least its cost of capital (otherwise abnormal earnings would be
negative in perpetuity → perpetual shareholder value destruction);
o Dividends = FCFC: all free cash should be paid out to the firms’ owners (otherwise cash would be left
undistributed in perpetuity → value destruction). In such an assumption, the form of payout is totally secondary
(even to whom these are paid out is not a relevant assumption when it comes to steady state modelling.
Nonetheless, the assumption of perpetual share repurchases plan is very hard to be realistic).

The Impact of Payout Policy on Economic Steady State

WITH “NORMAL DIVIDENDS”

When forecasting pro-formas, the usual

assumption is to treat the computed
dividends to shareholders as if they were
actually paid out in full. The usual
assumption is, indeed, that the firm
manages cash balance optimally and, as a
consequence, does not engage in cash
hoarding practices (→ holding large
amount of cash on its balance sheet that
is not being used for investment or other
purposes).
Mechanical Steady State The set of pro-form financial statements is essentially a system of difference equations
(Example: Retained Earning s t=Retained Earning st −1+ Net Incom e t−Dividend s t ). These are mathematical
conditions that must hold for such a system to be in, or enter into, steady state. These mathematical conditions have direct
economic meaning: they must hold for economic ratios and for the relations between balance sheet and income statement.
The intuition behind the necessity for those equations to hold is the following:

( 1+g )∗FCFU T FCFU is growing at a growth rate (g) → as a consequence, all components of FCFU
T VT= should theoretically grow at g. This means:
r WACC−g 1. All components of CFO (sales, net income, depreciation / % change in
receivables, accounts payables,…)
2. % change in required cash must be g;
3. Interest expense must grow at g;
4. Capital expenditures must grow at g.

r WACC is assumed to be constant in perpetuity. As a consequence, also the underlying capital structure is assumed to be
kept constant from one year on (D/E and D/V ratio need to be kept constant). Other financing ratios also need to be
assumed as being constant.

This implies that in the last two years of explicit forecast period (that is, year T and year T-1), the valuation attribute
should have the same growth rate as revenues and value-creating profitability ratios should also be kept constant (ROE
and ROIC, as to allow Abnormal Earnings model to be kept constant, as well). The capital structure should be constant (in
market value terms and in book value terms, as well) and discount rates should also be kept the same. But, what if the
diagnostics show some severe steady state violations? At this point, the most efficient way in order to check whether in the
Terminal Value Year steady state has actually been reached, is to add years to the explicit forecast period, keeping all inputs
constant. This will often stabilize the system.
Nonetheless, most valuations actually violate steady state conditions in the terminal value year. What are the
consequences?
Whatever mistakes/inconsistency we make in the last explicitly forecasted year (year T), will be continued in perpetuity.
For instance, there will be a perpetually-changing capital structure, a perpetually-underestimated capital expenditure,… →
the terminal value will contain internal inconsistencies!
Nonetheless, it is important to understand that different valuation models are more or less sensitive to steady state
violations. Those valuation models, indeed, which are less affected by the terminal value impact on the final result are – by
definition- less sensitive to steady state problems. For instance, on FCFU models, the impact of the terminal value is
estimated to be around 82% (82% of the final result comes out from the terminal value assumption), whereas the
Abnormal Earnings model puts a weight on the TV of just 21%. Already from this assessment, we can understand that the
use of accruals down tones the cash mistake (in case of cash hoarding).
Once the steady state violation is spotted, it is important to identify the main problem area with steady state. In order to do
so, it is important to choose the valuation model whose attribute is least susceptible to such valuation problems (CapEx is,
for instance, among the most difficult things to model: how does a $1- mistake in the terminal value affect a FCF model or
an abnormal earnings model? Well, in the FCFE model, you are basically blowing out the error, whereas the Abnormal
Earnings model is not even directly affected by the error in CapEx. Depreciation, indeed, goes into the model, which is
usually only a fraction of the whole CapEx → accrual-based models are, then, by definition, less impacted by the terminal
value assumption).

Example Value Estimate Comparisons – Dell Inc.

The fact that there is a difference between these two models,

implies that there is a steady state violation (→ the value of a
company should not and does not depend on the model we
use). At this point, we need to question the pro-formas: there
could be an error in the capital structure consideration (if the
difference to the “real price” is greater with respect to levered
models) or maybe there could be an error in the investment
prediction for the company (especially if a huge delta is
spotted with respect to the FCFU model)

LEVERED MODELS UNLEVERED MODELS

STEP 1: UNDERSTAND WHERE THE PROBLEM IS = DE-EMPHASIZING THE TERMINAL VALUE

Even if the pro-formas are assumed to be correct, we can check their validity by extending the forecasts beyond the
terminal value years, so as to understand where the steady state violation occurred. If we had forecasted well both the
terminal value year and the growth measures which should influence it, then we should obtain the following result:

Face Value 2027 + CF (2028 – 2045)

TERMINAL VALUE 2027 = +

PV at 2022 of TV (2045 - …)

If your original assumptions about steady state reached in 2027 were correct, then this means that the above cited
numbers (with the addition of forecasting years) should all be equal and provide you with the correct valuation for
your firm. Conversely, should they not yield the same number, then forecasting for additional years could potentially
allow you to find the problem in your proformas.

Consequence 1: as a consequence, growth rates for all components of FCFU should stabilize around the same growth rate
value without variation much as to respect the steady state requirement.

Consequence 2: changes in the model will help you identify where the problem with the steady state assumption was:

V = 40.56 $ We see that the difference for the two models of evaluation is
around 25% when confronting the Total Dividend Model before
and after iteration of forecasts. As a consequence, we can deduce
that the steady state violation problem highly likely resided in
the capital structure forecasting → the model is, indeed, a levered
model

V = 52.99 $
Issues with the Statement of Cash Flows As we already pointed out when looking at the pro-forma statements, the
Statement of Cash Flow is a required document also under IFRS and not only when performing accounting under US GAAP.
For the most part, the structure and the line items of the SCF under IFRS and US GAAP are equivalent, with one important
difference.
Under IFRS, Cash Interest Paid (and cash dividends) may be classified as operating, investing or financing cashflows,
provided that they are classified consistently from period to period. This brings about a clear inconsistency across firms,
but at least revels some kind of conceptual correctness. Under US GAAP, differently, Cash Interest Paid is simply disclosed
and is not considered to be part of the Statement of Cashflow. This treatment is conceptually incorrect (interest paid,
indeed, effectively represents a cash outflow), but at least signals some consistency across all firms.
Under IFRS, then, Statements of Cash Flows need to be carefully inspected in order to be able to assess the FCF metrics
correctly:
o If cash interest paid has been deducted in the operating cashflow, you need to add it back to arrive at the true
operating cashflow;
o If cash interest paid has not been deducted in the CFO but rather in the financing cash flow, you do not need to
explicitly adjust CFO for it.

Example Daimler AG – Cash Flow Statement Consolidated

Daimler’s CFO calculation

starts off with Net Income
Before Taxes (meaning a
measure which already
deducts Interest Expense)

Nonetheless, in order to adjust and make the statement somehow compliant with US GAAP,
Daimler decides to subtract the amount of Cash Interest Paid in the CFO such that the FCFU
computation needs to take into account the adjustment for Cash Interest Paid → CFO + Cash
Interest Paid – TS on Cash Interest Paid +… = FCFU
BMW Group – Consolidated Statement of Cash Flows

Operating Lease Capitalization Before IFRS 16 was published, Operating Leases were considered some off-balance sheet
As we No
liability. cantransfer
see, BMW decides
of asset to classify
ownership to theCash Interest
lessee formallyPaid in the and,
happened CFF as
calculation, meaning
a consequence, that thesheet
the balance amount
was not
required to recognize the acquisition of an asset and the income statement included the rental expense, but often(ifas an
theoretically does not need to be added back in the FCFU calculation → CFO – TS on Cash Interest Paid +… =FCFU
we look
hidden at the
item CFO Calculation
(aggregated forwith
together BMW, we see
other that expenses
general the company alsostatement).
in the starts fromThe
Netmandatory
Income BT footnote
and thenwas
undoes
the only
the Interestsource
information Expense deduction
regarding theother the Other
presence non-cash
of operating expenses/incomes
leases, since it needed to report the rental expense in the current
fiscal year, the explicit minimum rental payments for the next 5 years and the obligations thereafter aggregated to one sum.
When IFRS 16 was introduced, lease expenses were required to be treated as debt. More specifically, the lease liability was
required to be recognized as the present value of the lease payment to be made over the lease term, using the lessee’s
incremental borrowing rate. The right-of-use asset was also required to be recognized at an amount equal to the lease
liability, adjusted for any lease payment made at or before the commencement date. The interest expense on the lease
liability needs to be computed using the effective interest rate method.

Example Note 10: SBUX’s Operating Leases

Those minimum lease payments are calculated based on

lease agreements which the company has already signed.
As a consequence, they are non-cancellable obligations
which act as priority claim on the firm. In order to
quantify the lease liability, the minimum required
payments for each year and “thereafter” need to be
discounted at PV.
The first step in such a process is to assume an average
useful life of the asset (in this case 30 years) and split
among those which you make explicit in determining the
minimum payment and those which are hidden in
“Thereafter”.
The second step is to determine a discount rate: you can
assume it to be equal to cost of debt or you can use the CONTRACTUAL LIABILITY =
finance lease rate. COMPONENT OF TOTAL
DEBT

In order to determine the implied CapEx, then, you

need to identify the commitment which was
referred to the previous year in order to
understand the amount of lease liability which was
taken up during the current year.

PV (rental payments 2019) =7,961.71

PV (rental payments 2018) = 7,335.00

= Hidden increase in asset = 606.71

Digression : S&P Approach for Lease Recognition

In practice, also the S&P approach is frequently used. The latter computes the lease expenses as follows:

Rental Expense * 8 = Overall Lease Obligation

In such a case, you are assuming the rental expense to be 12.5% of lease obligation, which implies that the portion
allocated to depreciation implies a depreciation rate of 9.2%.
This assumption implies, in its turn, a useful life assumption of 11 years. Given this derived assumption, you can adjust the
amount by which you multiply the rental expense (you derive whether the n number by which you multiply it is too high or
too low based on whether the depreciation assumption derived is of a too high or low depreciation assumption).

Components of Rental Expense When a firm is involved in a leasing contract, from an accounting perspective, we are
making the firm look as if it had acquired an asset by taking up a loan. In such as case, indeed, will would record the
increase in assets in the BS and – at the same time- also record its depreciation expense. Since the acquisition has been
made by taking up debt, also an interest expense would be recorded.

RENTAL EXPENSE

INTEREST EXPENSE COMPONENT DEPRECIATION EXPENSE COMPONENT

Cost of debt *avg. operating lease obligation The remainder is assigned to depreciation
component

Example Starbucks’s WACC (Operating Asset View)

EQUITY DEBT NCI

o r f =2 % ; o r f =¿ 3.283% o r NCI =5.42 %

o r M −r f =4.75 % o Short term borrowings =0 o NCI = 1.2
o LT-debt = 11,167.0
o SBUX’s β = 0.72
o FV Adjustment = (+) 866
o r E=r f + β ( r M −r f )=5.42 %
o Shares outstanding = 1,184.42 + OPERATING LEASE OBLIGATION = 7961.7
o Obs. Price, 9/27/2919 = $88.42
o Market Value of Equity = 104,742.3 = TOTAL DEBT 19,984

ENTERPRISE VALUE = 124,739.2

w E =83.970 % w D =16.029 % w NCI =0.001 %

r WACC =4.97 %
Changes to FCFU

ADJUSTMENT 1)
Interest Expense is added back
because it is a Financial Expense
which should not affect FCFU
Depreciation Expense because it is a
non-cash expense

ADJUSTMENT 2)
We add back a tax shield on the
interest expense derived from the
lease obligation

Why not a tax shield on

depreciation?
Well, because it was originally
registered as rental expense,
meaning it already implied a tax
Will shield
there be any
(thechanges
wholeto FCFCE?
Income
NO! Operating leases have been capitalized, meaning that we have transferred the amount
Statementreferred
result istonot
them from
affected)
operations to financing. Nonetheless, Operating Leases are considered NON-COMMON EQUITY FINANCING (DEBT) and
consequently do not affect FCFCE.

ADJUSTMENT 1)
We are undoing what we did in the
FCFU calculation in order to account
for the cashflows going to Common
Equity holders

ADJUSTMENT 2)
This is a pure changes in the lease
liability, which is actually given by
two components:
- The inflow of CapEX (1.797);
- The outflow of depreciation
(1.190,3)

What changes in the Economic Value Model?

1. Debt Level changes because it now takes into account also the Operating Lease Liability. Therefore, both Invested
Capital and WACC appear to be affected by such an adjustment: WACC needs to be re-computed usually yielding a
slightly lower value;
2. NOPAT is affected in terms of the newly recorder Interest Expense which needs to be taken into account. The
needed adjustments are two: + INTEREST EXPENSE FOR OL – TS ON INTEREST EXPENSE.

The Impact of the New Operating Leases Standard

This has an impact when performing MULTIPLES VALUATION. As a matter of fact, when choosing comparable companies
and performing a valuation based on multiples, it is important to check how the firms reported their Operating Leases in
the Income Statement → if the comparable company is reporting under ASC 842, then some multiples cannot be used for
comparison: EBITDA, for instance, will be affected by Lease Expenses in the OLD reporting standard whereas is not
affected under IFRS 16. A multiple involving EBITDA will therefore not provide a correct valuation for the firm.

Also in the case of the Cash Interest

Paid for Operating Leases, the item
can be classified either under CFO or
under CFF (meaning it can be
interpreted both as a financing or as
an operating cash outflow)

Needed Adjustments when accounting for Operating Leases in FCFU and FCFCE Calculations

Adjustment US GAAP IFRS

A. FCFU
+ Depreciation Expense in RoU Asset YES DONE
+ Interest Expense on Lease Obligation YES MAYBE
- TS on Interest Expense YES YES
- CapEx implied in Leases YES YES
B. FCFCE
- Interest Expense on Lease Obligation YES YES
+ TS on Interest Expense YES YES
+/- Change in Lease Obligation YES YES / NO

+ INFLOW IN THE CFF → TO DO

- REPAYMENT PART IS DONE
Example Starbucks’s 2020 Lease Accounting

In the calculation, we have

made the assumption that
ASSET = OBLIGATIONS , but
there is a difference between
BV of the asset and the value of
the obligation itself → the
difference amount IS PAID BY
EQUITY

8,910.50 $

Consequences on the Pro-Forma Models

1. Operating Leases = a part of NPP&E and a part of debt

2. If necessary, capitalize all the line items only ONCE AT T=0 and forecast on that basis (leases are a liability of the
present and consequently all needed adjustments need to be made in the present)
- Balance Sheet of T=0: if not already capitalized, capitalized asset and liability related to the OL. In that case,
usually assume OL Lease Obligation (debt)= OL Lease Right-of-Use (NPP&E);
 - Income Statement of T=0 (only for comparability needs): if US GAAP, replace lease expenses with
Depreciation and Interest Expense (if under IFRS, the replacement should be done already);
- Statement of CF of T=0 (only for comparability needs): show depreciation expense, implied CapEx and net
lease repayments instead of rental expense

IS AND SCF SHOULD BE DERIVED MECHANICALLY IN T= 1+ (they should already be adjusted and corrected for the
OpLease items)