Firm Valuation: A Summary

P.V. Viswanath

Class Notes for Corporate Finance and

Equity Valuation
 Discounted Cashflow Valuation

t = n CF
Value =  t
t
t = 1 (1 + r)

where,
 n = life of the asset
 CFt = cashflow in period t
 r = discount rate reflecting the riskiness of the
estimated cashflows

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 Two Measures of Discount Rates

 Cost of Equity: This is the rate of return required

by equity investors on an investment. It will
incorporate a premium for equity risk -the greater
the risk, the greater the premium. This is used to
value equity.
 Cost of capital: This is a composite cost of all of
the capital invested in an asset or business. It will
be a weighted average of the cost of equity and the
after-tax cost of borrowing. This is used to value
the entire firm.

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 Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

Free Cash Flow to Equity = Net Income – Net Reinvestment (capex as well as
change in working capital) – Net Debt Paid (or + Net Debt Issued)

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 Firm Valuation
Figure 5.6: Firm Valuation
Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
prior to any debt payments
but after firm has
reinvested to create growth
assets
Discount rate reflects the cost
of raising both debt and equity
financing, in proportion to their
use
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) – Net
Reinvestment
Net Reinvestment is defined as actual expenditures on short-term and long-term assets less
depreciation.
The tax benefits of debt are not included in FCFF because they are taken into account in the firm’s
cost of capital.
P.V. Viswanath 5
 Valuation with Infinite Life
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
cash flows Grows at constant rate
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Equity: Value of Equity
Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

P.V. Viswanath 6
 Valuing the Home Depot’s Equity
 Assume that we expect the free cash flows to equity at Home
Depot to grow for the next 10 years at rates much higher than the
growth rate for the economy. To estimate the free cash flows to
equity for the next 10 years, we make the following assumptions:
 The net income of $1,614 million will grow 15% a year each year for the
next 10 years.
 The firm will reinvest 75% of the net income back into new investments
each year, and its net debt issued each year will be 10% of the reinvestment.
 To estimate the terminal price, we assume that net income will grow 6% a
year forever after year 10. Since lower growth will require less reinvestment,
we will assume that the reinvestment rate after year 10 will be 40% of net
income; net debt issued will remain 10% of reinvestment.

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Estimating cash flows to equity: The
Home Depot

Year Net Income Reinvestment Needs Net Debt Paid FCFE PV of FCFE
1 $ 1,856 $ 1,392 $ (139) $ 603 $ 549
2 $ 2,135 $ 1,601 $ (160) $ 694 $ 576
3 $ 2,455 $ 1,841 $ (184) $ 798 $ 603
4 $ 2,823 $ 2,117 $ (212) $ 917 $ 632
5 $ 3,246 $ 2,435 $ (243) $ 1,055 $ 662
6 $ 3,733 $ 2,800 $ (280) $ 1,213 $ 693
7 $ 4,293 $ 3,220 $ (322) $ 1,395 $ 726
8 $ 4,937 $ 3,703 $ (370) $ 1,605 $ 761
9 $ 5,678 $ 4,258 $ (426) $ 1,845 $ 797
10 $ 6,530 $ 4,897 $ (490) $ 2,122 $ 835
Sum of PV of FCFE = $6,833

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 Terminal Value and Value of Equity
today
 FCFE11 = Net Income11 – Reinvestment11 – Net Debt Paid
(Issued)11
= $6,530 (1.06) – $6,530 (1.06) (0.40) – (-277) = $ 4,430 million
 Terminal Price10 = FCFE11/(ke – g)
= $ 4,430 / (.0978 - .06) = $117,186 million
 The value per share today can be computed as the sum of the
present values of the free cash flows to equity during the next 10
years and the present value of the terminal value at the end of
the 10th year.
Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978)10
= $52,927 million

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 Valuing Boeing as a firm

 Assume that you are valuing Boeing as a firm, and

that Boeing has cash flows before debt payments
but after reinvestment needs and taxes of $ 850
million in the current year.
 Assume that these cash flows will grow at 15% a
year for the next 5 years and at 5% thereafter.
 Boeing has a cost of capital of 9.17%.

P.V. Viswanath 10
 Expected Cash Flows and Firm Value

 Terminal Value = $ 1710 (1.05)/(.0917-.05) = $ 43,049

million
Year Cash Flow Terminal Present
Value Value
1 $978 $895
2 $1,124 $943
3 $1,293 $994
4 $1,487 $1,047
5 $1,710 $43,049 $28,864
Value of Boeing as a firm = $32,743
P.V. Viswanath 11
 What discount rate to use?
 Since financial resources are finite, there is a hurdle that projects
have to cross before being deemed acceptable.
 This hurdle will be higher for riskier projects than for safer
projects.
 A simple representation of the hurdle rate is as follows:
Hurdle rate = Return for postponing consumption +
Return for bearing risk
Hurdle rate = Riskless Rate + Risk Premium
 The two basic questions that every risk and return model in finance
tries to answer are:
 How do you measure risk?
 How do you translate this risk measure into a risk premium?

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 The Capital Asset Pricing Model

 Uses variance as a measure of risk

 Specifies that a portion of variance can be diversified away,
and that is only the non-diversifiable portion that is
rewarded.
 Measures the non-diversifiable risk with beta, which is
standardized around one.
 Relates beta to hurdle rate or the required rate of return:
Reqd. ROR = Riskfree rate +  (Risk Premium)
 Works as well as the next best alternative in most cases.

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 From Cost of Equity to Cost of Capital

 The cost of capital is a composite cost to the firm of

raising financing to fund its projects.
 In addition to equity, firms can raise capital from
debt

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 Estimating the Cost of Debt
 If the firm has bonds outstanding, and the bonds are traded, the
yield to maturity on a long-term, straight (no special features)
bond can be used as the interest rate.
 If the firm is rated, use the rating and a typical default spread on
bonds with that rating to estimate the cost of debt.
 If the firm is not rated,
 and it has recently borrowed long term from a bank, use the interest rate on
the borrowing or
 estimate a synthetic rating for the company, and use the synthetic rating to
arrive at a default spread and a cost of debt
 The cost of debt has to be estimated in the same currency as the
cost of equity and the cash flows in the valuation.

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 Estimating Cost of Capital: Boeing

 Equity
 Cost of Equity = 5% + 1.01 (5.5%) = 10.58%
 Market Value of Equity = $32.60 Billion
 Equity/(Debt+Equity ) = 82%
 Debt
 After-tax Cost of debt = 5.50% (1-.35) = 3.58%
 Market Value of Debt = $ 8.2 Billion
 Debt/(Debt +Equity) = 18%
 Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%

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 Estimating the Expected Growth Rate
Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)

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 Expected Growth in EPS

gEPS = (Retained Earningst-1/ NIt-1) * ROE

= Retention Ratio * ROE
= b * ROE
• ROE = (Net Income)/ (BV: Common Equity)
• This is the right growth rate for FCFE
• Proposition: The expected growth rate in earnings
for a company cannot exceed its return on equity in
the long term.

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 Expected Growth in EBIT And
Fundamentals
 Reinvestment Rate and Return on Capital
gEBIT = (Net Capex + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
 Return on Capital =
(EBIT(1-tax rate)) / (BV: Debt + BV: Equity)

 This is the right growth rate for FCFF

 Proposition: No firm can expect its operating income to
grow over time without reinvesting some of the operating
income in net capital expenditures and/or working capital.

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 Getting Closure in Valuation

 A publicly traded firm potentially has an infinite

life. The value is therefore the present value of cash
t =  CFt
flows forever. Value = 
t = 1 (1+ r)
t

 Since we cannot estimate cash flows forever, we

estimate cash flows for a “growth period” and then
estimate a terminal value, to capture the value at the
end of the period: Value = t =N CFt t  Terminal Value
N
t = 1 (1 + r) (1 + r)

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 Stable Growth and Terminal Value
 When a firm’s cash flows grow at a “constant” rate forever, the present
value of those cash flows can be written as:
Value = (Expected Cash Flow Next Period) / (r - g) where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
 This “constant” growth rate is called a stable growth rate and cannot be
higher than the growth rate of the economy in which the firm operates.
 While companies can maintain high growth rates for extended periods,
they will all approach “stable growth” at some point in time.
 When they do approach stable growth, the valuation formula above can
be used to estimate the “terminal value” of all cash flows beyond.

P.V. Viswanath 21
 Relative Valuation

 In relative valuation, the value of an asset is derived from

the pricing of 'comparable' assets, standardized using a
common variable such as earnings, cashflows, book value or
revenues. Examples include --
• Price/Earnings (P/E) ratios
 and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios
 and variants (Tobin's Q)
• Price/Sales ratios

P.V. Viswanath 22
 Multiples and DCF Valuation
 Gordon Growth Model: P0 
DPS1
r  gn
 Dividing both sides by the earnings,
P0 Payout Ratio * (1  g n )
 PE =
EPS 0 r-gn
 Dividing both sides by the book value of equity,

 If the return on equity

P0
isPBV
ROE * Payout Ratio * (1  g n )
written
= in terms of the retention ratio and the
BV 0 r-g n
expected growth rate

 Dividing by the Sales per Pshare,

0 ROE - gn
 PBV =
BV 0 r-gn

P0 Profit Margin * Payout Ratio * (1  g n )

 PS =
Sales 0 r-g n

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