VALUATIONS

RT
Approaches to valuation
• Income oriented approach
• Income oriented approach is based on the principle of future
benefits, which states that the value of any business equals the net
present value of all future economic benefits attained as a result of
the ownership of the business.

• To arrive at the net present value we require a discount factor that

considers the risk-return assessment of the market to finally derive
the value of equity.

• The three commonly used valuation methods under this approach

are the cash flow method, dividend discount method, and residual
income method.
• Market oriented approach
• Market-oriented approach is based on the principle of quick
valuation of companies (see, Fernandez, 2002).

• It is a simple, economic and less time consuming approach to

compute value.

• It is used to measure the relative performance of the firms by

practitioners as a control mechanism to assess whether the
intrinsic value is in line with the market view of the comparable.

• The two commonly used valuation methods under this approach

Equity multiples and Value multiples.
• Cost oriented approach
• The Cost Oriented Approach, also known as the Asset-based
Approach, involves methods of determining a company’s value by
analysing the market value of a company’s assets.

• This valuation approach often serves as a valuation floor since most

companies have greater value as a going concern than they would if
liquidated, i.e., the present value of future cash flows generated by the
assets usually far exceed the liquidation value of those assets.

• This difference between the asset value and going concern value is
commonly referred to as “goodwill”. Therefore asset based approach
or cost oriented approach measures only a part of firm’s value.
• It does not assign any value for future growth.

• The cost oriented or asset based value approach assumes the

liquidation of the firm and therefore violates the principle of going-
concern.

• Nevertheless, the Cost oriented approach is only meaningful for

the valuation of individual financial investments and valuation of
assets in case of liquidation.
Income oriented approach
• Free cash flow model:-
• Residual income model:-
• Dividend discount model:-
Forecast horizon
• Forecast horizon means the length of forecast period.

• Five to ten years forecast period is very much in line with

the literature in this area.

• Forecast horizon is divided into three phases: growth

phase; transition phase and maturity phase.
Estimating growth rate
• One is to look at the growth in a firm’s past earnings – its
historical growth rate.

• The second is to estimate the growth from a firm’s

fundamentals. A firm’s growth ultimately is determined by
how much is reinvested into new assets.

• The third is to trust the equity research analysts that

follow the firm to come up with the right estimate of
growth for the firm, and to use that growth rate in
valuation.
 Free Cash Flow
Free Cash Flow to the Free Cash Flow to
Firm Equity

= Cash flow available = Cash flow available to

to

Common stockholders Common stockholders

Debtholders

Preferred stockholders
 FCFF vs. FCFE Approaches to
Firm & Equity Valuation

Equity Value

FCFE Discounted FCFF Discounted

at Required at WACC – Debt
Equity Return Value
Calculating FCFF & FCFE from Net Income
FCFF and FCFE from net income (NI):

FCFF = EBIT (1-Tax) + Dep. – CAPEX – WC

FCFE = NI + Dep. – CAPEX – WC + Net

borrowing
Example: Calculating FCFF & FCFE
EBITDA $1,000
Depreciation expense $400
Interest expense $150
Tax rate 30%
Purchases of fixed assets $500
Change in working capital $50
Net borrowing $80
 FCFF vs. FCFE Approaches to
Equity Valuation

FCFFt
Firm value   t
t 1  1  WACC 

Equity value  Firm value  Debt value


FCFEt
Equity value   t
t 1  1  r 
Single-Stage Free Cash Flow Models
FCFF1
Firm value 
WACC  g
Equity value  Firm value  Debt value

FCFE1
Equity value 
rg
Example: Single-Stage FCFF Model
Current FCFF $6,000,000
Target debt to capital 0.25
Market value to debt $30,000,000
Shares outstanding 2,900,000
Required return on equity 12%
Cost of debt 7%
Long-term growth in FCFF 5%
Tax rate 30%

Calculate Equity Value?

Example: Single-Stage FCFF Model
 MV(Debt)  
WACC     rd  (1  Tax rate) 
 MV(Equity)  MV(Debt)  
 MV(Equity)  
   r
 MV(Equity)  MV(Debt)  

WACC   0.25  7%  (1  0.30)    0.75 12%   10.23%

Example: Single-Stage FCFF Model
Firm
  value =

Firm
  value = = $120.5 million

Equity value = $120.5 million – $30 million = $90.5 million

Equity value per share = $90.5 million/2.9 million = $31.21

 Simple Two-Stage FCF Models
n
FCFFt FCFFn 1 1
Firm value   +
 
t 1   
t n
1  WACC WACC g (1  WACC)

n
FCFE t FCFE n 1 1
Equity value   +
 r  g  (1  r )n
t =1 1 r  t
Example: Two-Stage FCF Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for Years 1 to 3 10%
FCFF growth for Year 4 and thereafter 5%
WACC 10%
Example: Three-Stage FCF Models
Current FCFF in millions $100 .00

Shares outstanding in millions 300 .00

Long-term debt value in millions $400.00
FCFF growth for Years 1 to 3 30%
FCFF growth for Year 4 24%
FCFF growth for Year 5 12%
FCFF growth for Year 6 and thereafter 5%
WACC 10%
Example: Three-Stage FCF Models
Year

1 2 3 4 5 6

FCFF growth rate 30% 30% 30% 24% 12% 5%

FCFF $130.0 $169.0 $219.7 $272.4 $305.1 $320.4

PV of FCFF $118.2 $139.7 $165.1 $186.1 $189.5

Example: Three-Stage FCF Models

FCFFn 1 1
Terminal value 
 WACC  g  (1  WACC)n

$320.4 1
Terminal value   $3979
 0.10  0.05  (1  0.10) 5

Note : The above formula shows the present value of perpetual stream at t = 0
 Example: Three-Stage FCF Models
n
FCFFt FCFFn 1 1
Firm value   +
 WACC  g  (1  WACC)n
t =1  1  WACC  t

Firm value  $118.2  $139.7  $165.1  $186.1  $189.5  $3,979  $4,777

Equity value  Firm value  Debt value

Equity value  $4777  $400  $4377

Equity value per share  $4377/300  $14.59

 Summary
FCFF vs. FCFE

• FCFF = Cash flow available to all firm capital

providers
• FCFE = Cash flow available to common
equity holders
• FCFF is preferred when FCFE is negative

Equity Valuation with FCFF and FCFE

• Discount FCFF with WACC

• Discount FCFE with required return on equity
• Equity value = FCFF – Debt value
Thank you