Valuation of Corporation

Drivers of value creation

Two versions of DDM
  
 The First Version:
Two versions of DDM
  

 THE SECOND VERSION:

Seven Drivers of Value creation
1. fair value of a share increases if DPS increases; it makes sense
because any asset which is expected to give high cash flows in
future is more valuable in your eyes today, and that is true for
shares also
2. Fair value of a share increases if Beta decreases; it makes sense
because beta is relevant risk of share, and low risk makes the
share attractive
3. Fair value of a share increases if interest rates in the economy
decline thus causing both Rf (frisk free rate of return) and (Rm –
Rf ) called market risk premium, to decline
4. Fair value of a share increases if net profit margin increases (NI /S
ratio); it makes sense because higher profit margin on sales means
higher profitability
Seven Drivers of Value creation
5. Fair value of a share increases if turnover of TA
increases (S / TA ratio); it makes sense because higher
asset productivity means that more is produced and sold
by using given resources called assets
6. Fair value of a share increases if financial leverage
increases (TA / OE ratio). Here you need to be careful
because effect of financial leverage on ROE is not
always positive.
7. Dividend payout ratio decreases (‘d‘)
Using the First version: Example
 Last year a company gave cash dividends of Rs 10 per
share, expected ROR from stock market as a whole is
20% and one-year maturity t-bills of the government of
Pakistan are yielding 10% interest rate, beta of this
levered Co’s share is 1.5. Last year its net profit
margin was 3% on sales, its turnover of total assets was
4 times, and its financial leverage was 4 times, and it
gave 80% of its profits as cash dividends. You estimate
that these policies are expected to remain the same in
this year. It is currently trading in the market at Rs 97
per share. Would you buy this share?
Using the First version: Example
ROE = NI/S * S/TA * TA/OE
= 3% * 4 * 4 = 48%
g = ROE (1 - d)
= 48% (1 - 0.8) = 9.6%
Using the First version: Example
ROE = NI/S * S/TA * TA/OE
= 3% * 4 * 4 = 48%
g = ROE (1 - d)
= 48% (1 - 0.8) = 9.6%
DPS1 = DPS0 (1 + g)
= 10 (1 + 0.096) = 10.96 Rs per share
Kc = Rf + (Rm - Rf) Beta
= 10% + ( 20% - 10%)1.5
= 25%
Using the First version: Example
Fair value of share today = (10.96)/((0.25- 0.096) )
= 71.16 Rs per share

As actual price in the market = 97 Rs

Estimated fair value = 71.16 Rs

Therefore in your view it is overvalued by 25.8 Rs at 97

Rs, and you won’t buy it; rather you would expect its
price to fall by 25.8 Rs and only then you would feel it is
fairly priced and would buy it.
Using the First version: Example

Now suppose this co’s management has decided and

announced publically that during this year financial
leverage (TA/OE ratio) would be brought down to 3 times
from existing 4 times, causing its beta to reduce to 1.2
from 1.5, and profit margin would be increased from 3% of
sales to 3.5% of sales, and dividend policy would be
changed to giving 50% as cash dividends from NI instead of
80%, while asset productivity would be maintained at 4 .
Would you buy this share?
Using the first version: Example

ROE = NI/S * S/TA * TA/OE

= 3.5% * 4 * 3 = 42%
g = ROE (1 - d)
= 42% (1 - 0.5) = 21%
Using the first version: Example

ROE = NI/S * S/TA * TA/OE

= 3.5% * 4 * 3 = 42%
g = ROE (1 - d)
= 42% (1 - 0.5) = 21%
DPS1 = DPS0 (1 + g)
= 10 (1 + 0.21) = 12.1 Rs per share
Kc = Rf + (Rm - Rf) Beta
= 10% + ( 20% - 10%)1.2 = 22%
Using the first version: Example

  
Using the second version: Example

Suppose ROIC is 20%, Ki is 23%, D/OE ratio is 3 .

Then fair value = ?
Using the second version: Example
  
ROE = ROIC + (ROIC – Ki)D/OE
=20 + (20 - 23)3 = 11%
The resulting ‘g’ = ROE (1 – d)
= 11% (1 – 0.5) = 5.5%

= 63.93 Rs per share

Using the second version: Example

 If this company increases its D/E Ratio 5 times & as a

result BL increases to 1.7
Using the second version: Example
ROE = ROIC + (ROIC – Ki)D/OE
=20 + (20 - 23)5 = 5%
The resulting ‘g’ = ROE (1 – d)
= 5% (1 – 0.5) = 2.5%.
Using the second version: Example
ROE = ROIC + (ROIC – Ki)D/OE
=20 + (20 - 23)5 = 5%
The resulting ‘g’ = ROE (1 – d)
= 5% (1 – 0.5) = 2.5%.
Please note when ROIC – Ki was negative, then increasing
financial leverage (D/OE ratio) from 3 to 5 resulted in
shrinkage of ROE from 11% to 5%. Consequently growth
rate estimate came down to 2.5% from 5.5%
Kc = Rf + (Rm - Rf) Beta
= 10% + ( 20% - 10%)1.7 = 27%
Using the second version: Example

  

 
= 41.83 Rs per share

Ultimately fair value estimate of its share was down to

41.83 rupees from 63.93 Rs.
Implications:
Therefore if in a co after tax percentage cost of debt is higher than
its ROIC then its :
a) ROE is less than its ROIC. This shown value destroying impact of
financial leverage where debt financing was acquired at too high
an interest rate.
b) If such a co increases its financial leverage, then its ROE shrinks
further. On the other hand higher financial leverage causes its
cost of equity (Kc) to increase because as per Hamda’s equation
higher D/OE ratio leads to higher beta levered; which in turn
causes Kc to increase as per CAPM.
c) Such shrinkage in ROE results in lower growth rate and lower share
value estimates.
 Free Cash Flow Model
1) Estimating annual free cash flows, FCF, for next few years , such as next
4 or 5 year ; and beyond that a constant growth rate in FCF per year is
assumed.
2) Annual FCF are discounted at the company’s weighted average cost of
capital (WACC) of that operation to estimate the VALUE OF OPERATIONS
or in other words the fair value of its operating assets. Then the value of
non-operating assets is added to the value of operations to arrive at the
value of TA, and this is also called value of firm. From the value of TA,
the value of Debt capital is subtracted to arrive at the value of equity.
But if that Co has issued preferred shares as well then value of preferred
shareholders capital is subtracted from the value of equity to arrive at
the value of common equity.
 Free Cash Flow Model
3) If debt is composed of bank loans only then BV of debt from balance
sheet is used, but if market tradable bonds issued by this Co are also
part of its debt capital then based on prevailing market price of those
bonds the MV of debt is estimated.
4) For preferred share capital also the MV should be used if they are
listed and traded, or conversion value would be used if they are
convertible in common shares, or call value is used if preferred shares
are callable; otherwise book value of preferred shareholders capital
from the most recent balance sheet is used as estimate for value of
preferred share capital. The value of debt capital and value of preferred
shareholders’ capital is subtracted from the value of TA to arrive at an
estimate of the value of common equity capital.
 Free Cash Flow Model
5) Then this estimated fair value of common equity is divided by number
of common shares outstanding to arrive at the estimated fair value of
a common share.
6) But if a Co has no non-operating assets, then you can directly find
value of total assets as PV of FCFs; and subtract values of debt and
preferred share capital to arrive at value of common equity and finally
fair value per common share.
 Free Cash Flow Model
 The starting point is to estimate next four or five years’ income
statements and balance sheets. From these projected income statements
and balance sheets you extract annual NOPAT (net operating profit after
tax) as:

 NOPAT per year = EBIT ( 1 - T)

 Free Cash Flow Model
 The starting point is to estimate next four or five years’ income
statements and balance sheets. From these projected income statements
and balance sheets you extract annual NOPAT (net operating profit after
tax) as:

 NOPAT per year = EBIT ( 1 - T)

Then free cash flows per year are estimated as:

Free Cash Flows per year (FCF)
= NOPAT - Increase in total operating capital
 Free Cash Flow Model
Total Operating Capital = Operating NWC + Operating FA (net)
FA(net) = BV of FA minus accumulated depreciation of those FA

 First Method:
 Increase in total operating capital
= Total Operating Capital (next year) – Total Operating Capital (last year )

 Increase in total operating capital

= (Operating NWC + Operating Net FA (next year) ) – ( Operating NWC +
Operating Net FA (last year) )
 Free Cash Flow Model
 Total Operating Capital = Operating NWC + Operating FA (net)
 FA(net) = BV of FA minus accumulated depreciation of those FA

Second Method:
 Increase in total operating capital
= increase in operating NWC + increase in operating net FA
 Increase in operating NWC
= operating NWC (next year) - Operating NWC (last year ) .
 Increase in operating net FA
= Operating net FA (next year) - Operating FA (last year)
 Free Cash Flow Model – Operating Net
Working Capital
 Operating NWC = Operating WC – Operating CL
 Operating WC are Operating CA. The Operating WC can be viewed as
those CA which are used in normal business operations to generate
sales such as cash, account receivables from sales, and inventory;
this means investment in marketable securities, though a CA, do not
qualify as operating CA because they have no such role.
Therefore:
 Operating WC = Operating CA
= CA – non operating CA
 Operating CL = CL – ST bank loans
Free Cash Flow Model – Operating Net
Working Capital
 ST bank loan should be counted as part of debt capital
in this context along with long term interest bearing
loans, long term bonds payable and long term lease
contracts.
 Typically operating NWC is composed of only those CA
which are financed by long term debt and OE, and in
this context debt includes short term bank loan as well.
Free Cash Flow Model – Operating Net
Working Capital
Operating NWC
= (Cash + R/A + Inventory) – (Acc P/A + Accruals)
Or,
=(non interest or dividend earning CA) – (non interest paying CL)
Or,
= (CA excluding investment in marketable securities) – (CL excluding
ST bank loans)
= CA financed by investors.
Free Cash Flow Model – Operating Net
FA
 Operating net FA = Net FA – Non Operating FA .
 Non operating FA include those long term assets which
are not used in day to day business operations such as
investment in land for future use, investment in bonds
and stocks for long term purposes, also investments in
Subsidiary Co’s shares.
 Net FA = FA – Accumulated Depreciation.
Free Cash Flow Model - Example

 Cash = 100, R/As = 200, Inventory = 300, marketable

securities = 100, Op FA (net) = 500, Govt Bonds and
land = 200, P/As = 50, accruals = 150, ST bank loan =
300, LT Loan = 500, OE = 40.
 Calculate Op CA, Op CL, Op NWC, Total Operating
Capital, Non Operating Assets, Debt Capital, Equity
Capital
Free Cash Flow Model - Example

 Op CA
= cash + R/As + Inventory = 100 + 200 + 300 = 600
 Op CL
= P/As + accruals = 50 + 150 = 200
Free Cash Flow Model - Example

 Op CA
= cash + R/As + Inventory = 100 + 200 + 300 = 600
 Op CL
= P/As + accruals = 50 + 150 = 200
 Op NWC
= Op CA – Op CL = 600 -200 = 400
 Total Op capital (op assets)
= Op NWC +OP FA (net) = 400 + 500 = 900.
Free Cash Flow Model - Example

 Non op assets
= investment in Govt bonds & in land + investment in
marketable securities
= 200+100 = 300
Free Cash Flow Model - Analysis
 Debt Capital = ST bank loan + LT loan = 300 + 500 = 800.
 operating capital (900) is always financed by investors (that is debt
capital and equity capital = 800 + 400).
 In this case available capital provided by financiers is 1,200 while
investment of these funds in operating assets is only 900 therefore the
remaining 300 has been invested in non-operating assets.
 In this Co management has forced capital providers (also called
investors or financiers) to do over investment in the form of financing
non operating assets of 300. Also note that in this case all the non
operating assets were 300 and short term bank loan was also 300; so
one can say that all the non –operating assets were financed by short
term loan; which means ST bank loan could have been avoided if
management had not invested in non operating assets.
Free Cash Flow Model - Practice

 Cash = 200, R/As = 400, Inventory = 400, marketable

securities = 100, Op FA (net) = 500, Govt Bonds and
land = 200, P/As = 50, accruals = 250, ST bank loan =
400, LT Loan = 700, OE = 40.
 Calculate Op CA, Op CL, Op NWC, Total Operating
Capital, Non Operating Assets, Debt Capital, Equity
Capital
 Do this company need all the funding provided by its
investors?
Free Cash Flow Model - Practice

 Cash = 500, R/As = 400, Inventory = 700, marketable

securities = 100, Op FA (net) = 500, Govt Bonds and
land = 200, P/As = 50, accruals = 350, ST bank loan =
400, LT Loan = 800, OE =440.
 Calculate Op CA, Op CL, Op NWC, Total Operating
Capital, Non Operating Assets, Debt Capital, Equity
Capital
 Do this company need all the funding provided by its
investors?
Free Cash Flow Model - Practice

 Cash = 350, R/As = 400, Inventory = 700, marketable

securities = 400, Op FA (net) = 700, Govt Bonds and
land = 200, P/As = 350, accruals = 200, ST bank loan =
400, LT Loan = 1000, OE =440.
 Calculate Op CA, Op CL, Op NWC, Total Operating
Capital, Non Operating Assets, Debt Capital, Equity
Capital
 Do this company need all the funding provided by its
investors?
FCF per year through operating Cash
flows
 Operating CFs per year (OCFs) = NOPAT + Depreciation Expense
= EBIT (1 – T) + Dep Exp
FCF per year through operating Cash
flows
 Operating CFs per year (OCFs) = NOPAT + Depreciation Expense
= EBIT (1 – T) + Dep Exp
 Gross investment in total OP Capital
= increase in Total Operating Capital + Depreciation
 FCF = Operating CF – Gross investment in Total Op Capital
FCF per year through operating Cash
flows
 Operating CFs per year (OCFs) = NOPAT + Depreciation Expense
= EBIT (1 – T) + Dep Exp
 Gross investment in total OP Capital
= increase in Total Operating Capital + Depreciation
 FCF = Operating CF – Gross investment in Total Op Capital
= (NOPAT + Dep) – (increase in Total Operating Capital + Dep)
= NOPAT – Increase in Total Operating Capital
= [EBIT(1 - T)] - (Increase in Total Operating Capital)
 So, if you are given OCFs per year and gross investments per year you can
find FCF per year.
Value of operations

  Value of operations = PV of FCFs of all future years

 Terminal value at the end of year 5 is PV of all FCFs beyond year 5

till infinity, and it is estimated assuming a constant growth rate of
FCFs after year 5.
 Terminal value in year 5 = FCF5(1 + g) / (WACC – g).
 Income Statements
Actual Projected Projected Projected Projected
2009 2010 2011 2012 2013
Sales 700 850 1000 1100 1155
Costs (CGS + Op Expenses) 599 734 911 935 982
Depreciation Expense 28 31 34 36 38
Total Operating Costs 627 765 945 971 1020
EBIT 73 85 55 129 135
Interest Expense 13 15 16 17 19
EBT 60 70 39 112 116
Tax 40% 24 28 15.6 44.8 46.4
NI before preferred divid 36 42 23.4 67.2 69.6
Preferred dividends 6 7 7.4 8 8.3
NI available for com Divd 30 35 16 59.2 61.3
Common Dividends 0 0 0 44.2 45.3
Addition to RE 30 35 16 15 16
Nimber of shares outstand 100 100 100 100 100
DPS common 0 0 0 0.442 0.453
 Balance Sheets
Actual Projected Projected Projected Projected
2009 2010 2011 2012 2013
cash 17 20 22 23 24
marketable securities 63 70 80 84 88
account recievables 85 100 110 116 121
inventory 170 200 220 231 243
CA 335 390 432 454 476
Operating FA (net) 279 310 341 358 376
TA 614 700 773 812 852

accounts payable 17 20 22 23 24
short term bank loan 123 140 160 168 176
accrued expenses payable 43 50 55 58 61
CL 183 210 237 249 261
long term bonds payable 124 140 160 168 176
TL 307 350 397 417 437
preferred stock 62 70 80 84 88
common stock 200 200 200 200 200
retained earnings 45 80 96 111 127
common equity 245 280 296 311 327
OE 307 350 376 395 415
TL & OE 614 700 773 812 852
FCF - Example

2009 Actual

Operating NWC =(Cash+R/A+Inventory)–(P/A+Accruals)

=(17+85+170) – (17+43)
=212
Total Operating Capital = Operating NWC + Operating net
FA
=212 + 279
=491
 2010 Estimated
Operating NWC =(Cash + R/A + Inventory ) – (P/A + Accruals)
=(20 + 100 +200) – (20 + 50)
=250
Total Operating Capital = Operating NWC + Operating net FA
= 250 + 310
=560
 2010 Estimated
Operating NWC =(Cash + R/A + Inventory ) – (P/A + Accruals)
=(20 + 100 +200) – (20 + 50)
=250
Total Operating Capital = Operating NWC + Operating net FA
= 250 + 310
=560
Increase in Total Operating Capital2010
= Total Operating Capital 2010 - Total Operating Capital 2009
= 560 – 491 = 69
 2010 Estimated
Operating NWC =(Cash + R/A + Inventory ) – (P/A + Accruals)
=(20 + 100 +200) – (20 + 50)
=250
Total Operating Capital = Operating NWC + Operating net FA
= 250 + 310
=560
Increase in Total Operating Capital2010
= Total Operating Capital 2010 - Total Operating Capital 2009
= 560 – 491 = 69

NOPAT 2010 = EBIT( 1 - T) = 85 ( 1 – 0.4) = 51 million Rs

Free Cash Flows (FCF) 2010 = NOPAT – Increase in Total Operating Capital
=51 – 69 = - 18 m Rs.
 Free Cash Flows
Actual Projected Projected Projected Projected
2009 2010 2011 2012 2013
Operating CA 272 320 352 370 388
Operating CL 60 70 77 81 85
Operating NWC 212 250 275 289 303
Operating FA (net) 279 310 341 358 376
Total Operating Capital 491 560 616 647 679
Increase in Oper Capital 69 56 31 32

EBIT 73 85 55 129 135

NOPAT=EBIT (1 - T) 43.8 51 33 77.4 81

FCF= NOPAT - incr in op Cap -18 -23 46.4 49

growth rate 0.05

WACC 0.1084
terminal value of FCF in yr 4 881
PV of FCFs (16) (19) 34 616
value of ops now in 2009 615
non operating assets 63
Value of TA or value of Firm 678
short term debt 123
long term debt 124
total debt 247
Value of equity= TA-Debt 431
Preferred equity 62
Value of common equity 369
number of shares 100
fair value per share 3.69
Terminal Value

Terminal Value at the end of year 4 (that is end of in

2013) of all the FCF beyond 2013:
= {FCF 2013( 1 + g) }/ ( WACC - g)
= 49(1 + 0.05) / ( 0.1084 - 0.05)
= 881
Value of Operations
Value of operations
=FCF2010/(1+WACC)1+FCF2011/(1+WACC)2 + FCF2012/(1+WACC)3 +
( FCF2013 + Terminal value of year 2013 )/(1+WACC)4

= (-18) / ( 1 + 0.1084) 1 + (-23) / ( 1 + 0.1084) 2 + 46 . 4 / (1 + 0.1084) 3 +

(49 + 881) / ( 1 + 0.1084) 4

= 615 million Rs
 Value of Firm

Value of TA ( Value of Firm)

= Value of Operations + Value of non operating assets
= 615 + 63
= 678
Note : Only non operating assets in this co now (that is
end of 2009) are marketable securities of Rs 63
 Value of Equity

Value of Equity = Value of TA - Debt

= 678 - 247
= 431 million Rs
Note: operating CL (accounts payables and accruals) are
not included in debt, because those were already used in
estimating FCF.
The remaining liabilities are short term bank loan of 123
and LT Bonds payable of Rs 124 , adding up these interest
paying Debts you get 123 + 124 = 247 million Rs
 Fair Value per share
Value of Common Equity
= Value of Equity - Preferred equity capital
= 431 - 62 = 369 million Rs
(preferred share capital was taken from balance sheet of 2009)
 Fair Value per share

Fair Price per share

= Value of common equity / number of shares outstanding
= 369 / 100 million = 3.69 Rs per share

This is the maximum price you are willing to pay per share based
on your forecast and analysis; usually it is termed fair value or
intrinsic value, or justified value , or theoretical value of share
 Market Value Added
MVA is a life-covering idea and it is different from EVA which is per
year concept.
Market value added ( MVA)
= Present Value of owners’ wealth - original investment by owners
= Value of common equity - BV of common equity
= 369 - 245
= 124 m Rs
(BV of OE is from balance sheet of 2009, and it is common share
capital + RE)
This increase in wealth of shareholders has occurred over the whole
life of the company , not in one year.
Value of Total Assets & MVA

Value of TA
= Debt + BV of preferred stock + BV of common Equity + MVA
Value of Total Assets & MVA

Value of TA
= Debt + BV of preferred stock + BV of common Equity + MVA
678 = 247 + 62 + 245 + MVA
678 = 554 + MVA
678 – 554 = MVA
124 = MVA