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contents Overview.........................................................................................................................................1 9.1. What does “value of the firm” mean?.....................................................................................3 9.2. Using the DCF valuation—summary......................................................................................9 9.3. Projecting the FCFs and doing the DCF valuation with a financial planning model...........15 9.4. Advanced section: What’s the theory behind the model?....................................................20 Summary.......................................................................................................................................23 Exercises.......................................................................................................................................24 Overview In Chapter 8 we learned how to use accounting concepts to build a financial planning model of a company. In this chapter we use financial planning models to value a company. This is something that almost every finance specialist has to do occasionally. The valuation technique we employ—called discounted cash flow (DCF) valuation—is the valuation technique universally favored by the finance profession. DCF valuations are often based on the financial planning models discussed in Chapter 8. When these models are used to do a DCF valuation, they are also used to do much of the sensitivity analysis which helps determine if the valuation is reasonable. Valuation is not intrinsically difficulty, but because there are several competing definitions of what constitutes the “value of a firm,” people often get confused. To shed some light on this issue, Section 9.1 discusses the different concepts of firm value. As you will see in Section 9.1, finance specialists often identify the value of the firm with the present value of its future cash flows. We will use the financial planning models of Chapter 8 to determine these cash flows. After discussing the concept of firm value in Section 9.1, we summarize the steps involved in a DCF valuation in Section 9.2. We then go on to show you how to value a company by building a full-blown DCF valuation model (Section 9.3). Finance concepts used Present value Free cash flow Gordon model (Chapter 6) Terminal value Mid-year valuation Excel functions used - NPV - Data tables 9.1. What does “value of the firm” mean? The terms “value of a company” or “value of a firm” are often used interchangeably by finance professionals. Even finance professionals, however, can use a confusing variety of meanings for these terms. Here are a few of the meanings which are often intended: In finance the definition most often used for “firm value” is the following: The value of a firm is the market value of the firm’s equity plus the market value of the firm’s financial debt. This section illustrates two methods of computing the firm value. o The simplest method is to value the firm’s equity (its shares) using the firm’s share price in the market, and to add to this the value of the firm’s debt. o A second method, the DCF method, is based on discounted cash flows. In a DCF valuation firm value equals the present value of the firm’s futures FCFs plus the value of its currently available liquid assets. Often when individuals discuss the firm value, they really mean the value of its shares. It is better to use the term equity value for the value of a company’s shares and to use the term firm value (or company value) to denote the market value of the firm’s equity plus its debt. In our calculations we also show you how to compute the
value of a firm’s shares. Sometimes the term firm value is used to denote the accounting value of the firm. Also known as the book value, this value is based on the firm’s balance sheets. Because accounting statements are based on historical values, people in finance generally prefer not to use this definition. At the end of this section we illustrate why we do not like this valuation method. Motherboard Shoes: What’s it worth? To illustrate the different concepts of firm value, we’ll tell the story of Motherboard Shoes. Motherboard is listed on the Chicago Stock Exchange, but the majority of the stock is owned by the Motherboard family, which founded the company and still runs it. The current date is 1 January 2005, and the Motherboards have received an offer for their shares from Century Shoe International. They would like to know if the offer is a fair one. Their investment advisor, John Mba has advised them that there are two plausible ways to value the company (John just finished business school and liked it so much that he changed his last name to reflect his new status). Each of the two methods has advantages and disadvantages. The share price valuation: Valuing a Motherboard by using current share price The simplest way to value Motherboard is look at the value of its share. Motherboard Shoes has one million shares, which were trading on 31 December 2004 at $50 per share. Thus the market value of the firm’s equity is $50 million. In addition the company’s balance sheet shows that it has short-term debt of $2.5 million and long-term debt of $7.5 million; John Mba uses these balance sheet values (also called book values) of the debt as an approximation to the 1 debt’s market value.
The discounted cash flow (DCF) valuation: Valuing Motherboard by discounting its future free cash flows The advantage of the share-price valuation method illustrated above is that it is very simple: The firm value equals the market value of the firm’s shares plus the book value of its debt. Valuing the company at its current price of $50 per share is perfectly acceptable for someone considering buying a few shares of the company, but it makes less sense if Motherboard Shoes is selling a controlling block of shares. In this case the purchaser would probably expect to pay more for the following reasons: If the purchaser tried to buy a big block of shares of Motherboard shares on the open market, he would probably have to offer more than the current market price per share. As he bought more and more shares, the price would go up; in addition, the 1 This is common practice. Most company debt is not traded on financial markets, and therefore there is no easilyavailable market value for the debt. As a first approximation, most finance professionals use the book value of a firm’s debt as a proxy for the debt’s market value.
since the controlling shareholder can actually decide what the company will do. John comes up with the following valuation: There are a few things to explain about this valuation: John has projected 5 years of future FCFs and has also projected a terminal value at the end of the 5 years. and so is the feeling of ownership—a psychological benefit. the value of Motherboard at the end of year 5: .) After some work to estimate the future free cash flows. In general the value of a controlling block of shares is larger than the market value. which defines the value of the firm as the present value of the firm’s future free cash flows (FCF).announcement that someone was trying to take over Motherboard Shoes would—in many cases—force the share price up. To deal with these problems. The market price of a share reflects the value of a company’s future dividends to a passive shareholder who has no control over the company. plus the firm’s initial cash and marketable securities. John Mba proposes to use the discounted cash flow (DCF) valuation method to value the shares. he’s estimated 5 years of FCFs and then estimated the terminal value. Instead of estimating all future FCFs. Section 9. The big car with a driver that the company gives its president is a private benefit of ownership. There are benefits to controlling a company that are not priced in the market price per share. perhaps. (Notice that the present value of the firm’s future FCFs is often called the firm’s enterprise value. but nonetheless valuable. DCF valuations are a standard finance methodology. but for the moment we skip all the theory and simply present the formula: 2 Economists use the term private benefits to discuss all kinds of financial and non-financial benefits associated with firm ownership. discounted at the weighted average cost of capital (WACC).4 discusses the theory behind this method of valuation. However. discountedatWACC he thinks this is too much guesswork. He can also derive considerable private benefits from running the company. He explains that the finance methodology requires him to estimate the allfutureFCFs present value of all the future free cash flows: PV .
the present value of 3 the FCFs and the terminal value.000. the value of the firm’s debt and equity as listed in the firm’s balance sheet.2.407 (cell B15).16 (cell B18). The firm’s book value—a definition we’d rather not use There’s another valuation method which John explains to the Motherboard family—the accounting definition of firm value uses the balance sheet to arrive at the value of the firm. which is based on historical values.If the weighted average cost of capital is 20%. is a backward looking definition. 9. Adding current balances of cash and marketable securities to the present value of the FCFs and subtracting out the value of the firm’s debts gives an equity valuation of $59. this values each share at $59. John Mba thinks that the accounting definition gives an inappropriate valuation. The finance definition of firm value is a forward looking definition (it discounts the future anticipated values of the cash flows).407.657. Recall from Chapter 7 that the accounting definition. Since there are one million shares outstanding. the forward-looking DCF valuation of the firm is $68.407 whereas the backward-looking accounting definition is $14. In the case of Motherboard Shoes. is $68. the enterprise value. For the case of Motherboard Shoes. and he’s right. the balance sheets at the end of 2004 look like: The accounting definition of firm value relies on book values.157.657.000. Using the DCF valuation—summary .
and in the next section we illustrate a DCF valuation using a financial planning model we learned in Chapter 8. Step 1: Estimate the weighted average cost of capital The WACC is the discount rate for the future FCFs.The DCF valuation of a firm is based on discounting the firm’s future expected free cash flows (FCFs).4). using the weighted average cost of capital (WACC) as the discount rate. 5 Later in the book. A solution to this problem is to define the firm’s terminal value as the firm value at the end of year 5. We discussed the WACC in Chapter 5 In this chapter we will not go into the details of 6 and gave an example of how to estimate it. For this example. . estimating the WACC. Step 3: Project the long-term FCF growth rate and the terminal value Valuation using the DCF method in principle requires us to project an infinite number of future FCFs. but in a standard financial planning model we project only a limited number of FCFs. we assume that John Mba’s estimate of a 20% WACC is correct. Step 2: Project a reasonable number of FCFs A financial planning model’s predictions of future FCFs are based on the assumption that the parameters of the model will not change by too much. a fact that is usually addressed by doing sensitivity analysis (see section 9. 9. John has assumed that he can reasonably project the next 5 years of cash flows. calculating the WACC entails many assumptions and in many cases the calculation itself becomes a topic of controversy among the parties involved in the valuation. The definition John uses is contained in Figure 1. Everyone recognizes that a firm’s environment is dynamic and that the model parameters will change over time. In this section we summarize the steps for implementing this valuation. Most financial analysts define 6 “reasonable” to mean number of periods over which this basic assumption is not too silly. In Section 4 Not to disparage accounting (very important) or accountants (most of whom would readily agree). 6 The author defines “not too silly” as something he can explain to his mother with a straight face (and that she won’t laugh at him). Chapter 15 gives another approach to estimating the WACC.3 we will perform some sensitivity analysis (using an Excel Data Table) to show how changes in the WACC affect the valuation.
3).S. and that this rate is also the long-term rate for Motherboard Shoes.029. As you will see in Section 9. economy is 5 percent. Instead of projecting the present value of each of the cash flows in years 6. Using the WACC of 20 percent and the long-term FCF growth rate of 5 percent. John Mba estimates that Motherboard’s year-5 FCF is $13. In Section 9. the company’s terminal value is $91. John has chosen to summarize them in the present value of the terminal value.110. 7. Line 3 gives the value of the cash and marketable securities.773: . For now we assume that John’s prediction of Motherboard’s terminal value is correct. …. using a financial planning model (details to come in Section 9. this long-term growth rate is different from the sales growth rate projected for the company’s next five years. The terminal value formula requires us to estimate the long-term FCF growth rate. He estimates that the long-term growth of the U.203.4 we explain how this expression for the terminal value is derived. Terminal value is what we project the firm to be worth at the end of projection horizon. In the financial planning model for the Motherboard Shoes FCFs. John has projected these cash flows one-by-one. John’s criterion for choosing the long-term FCF growth rate of the company is that a company’s cash flows cannot grow forever at a rate greater than the economy in which it operates. John projects a relatively high growth rate of sales of 10% for Motherboard over the 5 year horizon of the planning model.As you can see. infinity. Using his model.3. there are 3 parts to this valuation equation: Line 1 is the present value of the first 5 years of free cash flows. 8.
Step 6: Adding mid-year valuation In Chapter 4 (page000) we discussed mid-year valuation of cash flows. We are often interested in valuing only the firm’s equity—our estimate of the market value of the firm’s shares. They then compare this estimated per-share value to the current market price to come up with a buy or sell recommendation for the stock. the estimated market value per share is This share valuation is higher than the current market value per share of $50. Stock market analysts often use the estimate of a firm’s equity value to arrive at a pershare valuation of the firm.Step 4: Determine the value of the firm At this point all the elements of the firm valuation formula are in place: -WACC: the discount rate for the FCFs and the terminal value .407 (cell B9). In cells B15 and B18 we’ve added two more steps: Step 5: Value the firm’s equity by subtracting the value of the firm’s debt today from the firm value The firm value is the value of the firm’s debt + equity.157.Five years of FCFs projected from the financial planning model . we should .000. Since Motherboard Shoes has 1. The idea was that when cash flows occur over the course of the year and not at the end of the year. we would expect the analyst would make a “buy” recommendation for the Motherboard Shoes.000 shares outstanding. In this case the analysis is used by John Mba to recommend that Motherboard be taken over for more than its current price per share.The terminal value of the firm -The firm’s initial (year 0) balances of cash and marketable securities We can now value the firm: The value of the firm is $69. If the DCF valuation analysis were being used to make recommendations about the stock.
3. In cell B18 you can see that the projected share value increases to $65. with the mid-year valuation discussed in the previous section: . We leave our demonstrations of sensitivity analysis for the next section. The model looks a lot like those discussed in Chapter 8. In the spreadsheet below you can see how mid-year valuation affects the value of the firm and projected share valuation: Cell B8 shows that the present value of future cash flows and terminal value firm value increases from $69 million to $75 million. For Motherboard Shoes.71. Our “weapon of choice” for sensitivity analysis is the Data Table feature of Excel (see Chapter 30). but we haven’t shown the financial planning model which produces the free cash flows. we evaluate the effect of changing values of the main variables on the value of the firm. since the company’s sales occur throughout the year and not just at year-end. 9. Here it is. mid-year valuation makes sense.0. Step 7: Don’t trust anything! Do a sensitivity analysis Valuations are based on a formidable number of assumptions! When we do sensitivity analysis. Projecting the FCFs and doing the DCF valuation with a financial planning model So far we’ve shown how John Mba performs his valuation.5 take the standard present value formula and multiply it by 1 WACC .
there are obviously many sensitivity analyses we can perform. that in the FCF calculations lines 45 (depreciation) and 48 (capital expenses) cancel out.Several features of the model used by John Mba to value Motherboard Shoes are: Net fixed assets are assumed constant. John assumes that—as long as depreciation is invested back into fixed assets—Motherboard Shoes will need no more fixed assets. Below we show two data tables. John Mba has . Given the full-blown financial planning model. Motherboard Shoes will repay $1 million of its $10 million debt. As you can see in row 30 of the model this does not mean that fixed assets at cost are constant. John assumes that in each of the next five years. It does mean. The first table analyzes the effect of the sales growth assumption (cell B2 of the model) on the share valuation. however. Cash is the plug. Another way of thinking about this assumption is that the major expenses incurred for fixed assets are equal to the depreciation expenses.
The greater the sales growth (cell B2). the greater the valuation of Motherboard’s shares: Excel Note: Data tables This may be the appropriate place to review Data Tables.estimated sales growth of 10% annually for the next 5 years. As you can see. John builds a two-dimensional data table: The results produced by this sensitivity analysis are not surprising: . Notice that these two parameters affect the valuation in two ways: To examine the effect of these two parameters.71” in cell B74. This is a reference to the share price calculation in the initial model The data table asks Excel to redo this calculation for the sales growths in cells A75:A84. the effect of this assumption is quite dramatic. What may be confusing in the previous data table is the “65. which are covered in Chapter000. A second sensitivity analysis performed by John Mba is the effect of the weighted average cost of capital and the long-term growth rate (cells B55 and B56) on the per-share valuation.
the value per share decreases. the more the shares are worth. Advanced section: What’s the theory behind the model? In this section we explain some theoretical points about the valuation model illustrated in the previous section.4. When this assumption is not true (meaning: the long-term WACC). Since a larger WACC means that the present value of a future cash flow is less. and you may (understandably) want to skip this 1 section. As noted in the box below. The growth >technique for doing this is explained below.Going across rows shows that as the WACC increases. since larger long-term growth rates mean higher FCFs after the year-5 model horizon. Why is the firm’s value related to the PV of the future FCFs? Our basic valuation formula is: . this is to be expected. we’ve had Excel write “nmf” (“no meaningful figure”). 9. this is not a surprise. our terminal value model only works when the long-term growth rate is less than the WACC. Again. Going down columns shows that the larger the long-term growth rate expected from Motherboard Shoes. Not all of this is easy.
The enterprise value of the firm is defined to be the value of the firm’s operations. We rewrite the balance sheet by moving the current liabilities from the liabilities/equity side to the asset side of the balance sheet: 1 Why would an author put a section like this in this book? Our experience is that ultimately almost all finance professionals are called upon to do valuations. That’s the time to come back to this section. but using market values. At some point in every valuation. . In this section we explain these concepts. In financial theory. the enterprise value is the present value of the firm’s future anticipated cash flows. someone is going to question your techniques and theory. The valuation process One way of viewing valuation is through the use of the accounting paradigm.
the Year-5 Terminal Value is a proxy for the present value of all FCFs from year 6 onwards.3 Terminal value In determining the terminal value we use a version of the Gordon model described in Chapter 6.Note that this means that we can write the enterprise balance sheet in a slightly different form: We can use the FCF projections and a cost of capital to determine the enterprise value of the firm. This gives the terminal value as: .2 FCFs plus its terminal value: In this formula. We have assumed that—after the year 5 projection horizon—the cash flows will grow at a rate of growth equal to the sales growth of 10%. Suppose we have determined that the firm’s weighted average cost of capital (WACC) Then the enterprise value of the firm is the discounted value of the firm’s projected is 20%.
How to compute the cost of capital.2 In Chapter 6 we introduced the topic of the WACC and showed you how to calculate this using the Gordon dividend model. In this chapter we have not discussed its computation (Chapters 6 and 15 give different aspects of the WACC computation). How to use Excel to do the relevant computations. . In this chapter we have described how to do a discounted cash flow (DCF) valuation using the financial planning models of Chapter 8. Summary The valuation of a business (“how much is it worth”) is one of the most important activities of a financial analyst. We determine the terminal value based on year-5 FCF. In this chapter we simply assume a value for the WACC. The last equality is derived in a manner similar to the dividend valuation of shares (the Gordon model) discussed in Chapter 6. The weighted average cost of capital (WACC) is the discount rate used to value the future FCFs of the firm. The composition of the firm’s current assets and current liabilities (meaning: its net working capital needed to do its business) and the amount of fixed assets (buildings and equipment and land) needed to do this business—all of these factors affect a firm’s valuation. In Chapter 14 we show an alternative calculation of the WACC which uses the security market line. To do a DCF valuation you have to understand almost all facets of the business: How the business works—this affects the financial parameters used in the financial planning model. 3 We don’t actually project these cash flows.
The company has also borrowed .1.Transport has a tax rate of TC The company thinks its shareholders want an annual return on their investment of 20%. the current market price per share is $10. What does the firm’s WACC mean? The weighted average cost of capital (WACC) is the average return that the company has to pay to its equity and debt investors. has 3 million shares outstanding.6. Another way of putting this is that the WACC is the 2 average return shareholders and debtholders expect to receive from the company.To compute United Transport’s WACC we use the formula: 2 In finance the expected return. this is the company’s cost of debt r D = 40%. the required rate of return are all synonyms. the cost of capital (be it cost of equity or cost of debt). the required return. this 20% return is the company’s cost of equity r . They all represent the market-adjusted rate that investors get (or demand) on various investments or securities. The definition of the WACC is: Here’s a simple example to show what we mean: United Transport Inc. United $10 million from its banks at a rate of 8%. .
The United Transport WACC computation shows you that the WACC depends on five critical variables. r is the return required by the firm’s shareholders.4 for an example. the cost of equity. Most often we calculate T by computing the average tax rate of CC the firm. the firm’s tax rate. r is the most difficult to calculate. 4 How did United Transport come to the conclusion that its shareholders want a 20% return? This is the question in the computation of the WACC. and we will spend a lot of this chapter discussing the answer. the market value of a firm’s equity. The Gordon dividend model: discounting anticipated dividends to derive the firm’s cost of equity r . A model for calculating r is given in Section 6. Of the five parameters in the WACC calculation. 6. In most cases we will take D to be the total value of the firm’s financial obligations.2.4. r is the cost of borrowing for the firm. the market value of the firm’s debt. In most cases we will take D D r to be the firm’s marginal interest rate—the interest rate at which the firm could borrow D additional funds from its banks or by selling bonds.4.3 We use the symbol T to indicate the corporate tax rate. • T . We will usually take E to equal the number of shares of the firm times the market price per share. An actual example of a calculation for D is given below in Section 6. D • D.2. the cost of debt. A detailed example of the calculation of r for an actual firm is given in Section 6. r . see Section 6. So be patient! • E. • r .
5 The model is sometimes simply called the Gordon model. Summing up In this chapter we have calculated the firm’s weighted-average cost of capital (WACC). The WACC is defined as: In the table below we summarize how we derived each of the elements of this formula: . We will call the formula the Gordon dividend model. and it is also used to derive the value of the firm. It is often used to value projects whose riskiness is similar to the riskiness of the firm’s existing activities. Both of these uses have been illustrated in this chapter. in honor of Myron Gordon who first set out the 5 model in 1959. others call it the dividend discount model.In this section we present a formula for computing the firm’s cost of equity r . The WACC is the risk-adjusted discount rate for the firm’s free cash flows. This section has two subsections: In the first subsection we derive a model for calculating the value of a firm’s shares based on their future anticipated dividends.
.A final warning Cost of capital calculations are critical for valuations and controversial. In Chapter 14 we will show you how to use this model to calculate the cost of equity. given the variation in plausible assumptions. Almost every number in the WACC calculation above can be determined in several ways.An important competing model to the Gordon model is the capital asset pricing model (CAPM). In many cases professionals do extensive sensitivity analysis on the WACC and the FCF growth to establish a price range—the range of valuations which appears to be reasonable. They involve a mixture of theory and judgment. The most important modification you might want to make to the WACC calculation above involves the cost of equity r.