Lecture 2 – January 28, 2021

VALUING FIRMS USING THE

ENTERPRISE DCF METHOD
Discounted cash flows – general approach
 Also called Enterprise DCF or WACC DCF approach

 Under the DCF approach, the value of a firm depends

on:
 The free cash flows from operations that the firm
generates over time
 The riskiness of these CFs

N
FCFt
Value =

t 1 (1  r ) t
t

 Must define FCF and r consistently

 Steps in the enterprise DCF method

 Estimate free cash flows (FCFs)

 These are cash flows generated by company’s operations,
less reinvestments back into the business
 Cash flows to all capital providers (independent of capital
structure)
 Which items from the financial statements do we use?
 How do we forecast future FCFs?

 Calculate company’s weighted average cost of capital

(WACC)
 Should reflect the cost of all claims used to finance the firm

 Discount FCFs by WACC to get the value of the

operations of the firm
 How many time periods?
 Steps in the enterprise DCF method

 Calculate the value of the nonoperating assets and

add to value of operations to get the enterprise (or
total) firm value
 Excess cash and marketable securities
 Investments in other companies (nonconsolidated
subsidiaries)
 Overfunded pension funds, etc.

 Calculate the value of debt and other nonequity claims

 Convertible and straight debt
 Preferred equity, operating leases
 Employee options (currently outstanding, future ones are
included in FCFs), unfunded retirement liabilities
 Minority interests (when a third party owns some % in one
of the company’s consolidated subsidiaries)
 Steps in the enterprise DCF method

 Calculate market value of common equity by

subtracting the value of all nonequity claims from the
company’s enterprise value

 Calculate the price per share by dividing market value

of equity by the undiluted number of shares
outstanding
 Using diluted shares will double count options and convertible
debt
 Enterprise value definition

 Many investment professionals define enterprise value

as:
Enterprise value = Value of Equity + Debt – Cash

 We define enterprise value as total firm value

 The investment professional’s definition of enterprise value
most closely resembles our definition of Value of firm’s
operations
 Enterprise value definition

Practitioner definition of enterprise value

 Calculating free cash flows

 Financial statements do not directly estimate FCFs

and ROIC
 Need to reorganize them to get NOPLAT and Invested
Capital. Recall that:

FCF = NOPLAT – Net Increase in Invested capital

= NOPLAT + Noncash Operating Expenses –
Investments in Invested capital,

Invested capital = Operating Assets – Operating Liabilities

= Debt + Equity
 Calculating free cash flows – NOPLAT

 How do we estimate NOPLAT?

 After tax, operating profit

 Excludes gains or income from nonoperating assets

(consistently defined w.r.t. Invested Capital)

 Profit available to all investors (interest expense is NOT

subtracted from operating profit)

 Need to calculate operating taxes, which are different from

reported taxes (have to add back tax shields from interest
and remove taxes paid on nonoperating income)
 Aren’t we underestimating firm value by ignoring the tax shields
from interest payments?
 Calculating free cash flows – NOPLAT
 Start with the EBIT from the Income Statement
 Depreciation is an operating expense and hence must be
subtracted

Home Depot, Inc.

Historical Income Statement ($ million) NOPLAT Calculation ($ million)
  2006 2007 2008 2006 2007 2008
Net sales 90,837 77,349 71,288 Net sales 90,837 77,349 71,288
Cost of goods sold (61,054) (51,352) (47,298) Cost of goods sold (61,054) (51,352) (47,298)
Selling, general, and administrative (18,348) (17,053) (17,846) Selling, general, and administrative (18,348) (17,053) (17,846)
Depreciation (1,645) (1,693) (1,785) Depreciation (1,645) (1,693) (1,785)
Amortization (117) (9)   EBIT 9,673 7,242 4,359
EBIT 9,673 7,242 4,359
Add: Operating lease implied interest 441 536 486
Interest and investment income 27 74 18 Adjusted EBITA 10,114 7,778 4,845
Interest expense (392) (696) (624)
Nonrecurring change     (163) Operating cash taxes (3,986) (3,331) (1,811)
Earnings before taxes 9,308 6,620 3,590 NOPLAT 6,128 4,447 3,034

Income taxes (3,547) (2,410) (1,278)

Earnings from continuing operations 5,761 4,210 2,312

Discontinued operations   185 (52)

Net income 5,761 4,395 2,260
 Calculating free cash flows – NOPLAT
 Adjustments to EBIT
 The goal is to weed out nonoperating items and to
recognize certain off-balance-sheet items that are used in
operations

 Exclude nonoperating gains and expenses (restructuring

charges, gains/losses from pensions, etc.) – have to dig
through the notes in the 10-K!

 Most common adjustments to EBIT

 Operating leases

 Operating taxes

 Pensions

 Restructuring charges
 Calculating free cash flows – NOPLAT
 Adjustments to EBIT – Operating leases
 When a company borrows money to purchase an asset, the asset and
the debt are recorded on the company’s balance sheet and interest
payments are recorded on the company’s income statement.

 When a company leases an asset from the lessor, and if the lease
meets certain criteria, it usually records rental expenses and future
commitments reported in the notes of the 10-K.

 A company that chooses to lease its assets will have artificially low
operating profits (rental expenses include an implicit interest expense)
and artificially high capital productivity (the assets do not appear on the
balance sheet). Usually, the net effect is an artificial boost in ROIC.

 To properly account for operating leases, we need to include them in

the balance sheet as operating assets and a debt financing item (i.e.,
to capitalize them), and to adjust EBIT by adding back the implied
lease interest.
 Since rental expenses are subtracted from Revenues, we have to estimate the
 Calculating free cash flows – NOPLAT
 Adjustments to EBIT – Operating leases
 Step1: Capitalize the operating leases (Kd = cost of debt)

 
 
 Re ntal Expenset 
Lease Value t 1   1 
k
 d  
 Asset Life 

 Step 2: Add the implied interest expense back to the EBIT

Implied interest expenset = Lease valuet-1 * Cost of (secure) debt

o This is not equal to the rental expense reported in the financials, it is
just the implicit interest. The remaining rental expense is usually
renamed lease depreciation (it is a cash charge for the lessee).

 Step 3: Adjust the operating taxes by adding back the tax shields created
by rental expenses
o Tax shield = tax rate * Implied interest expense
Calculating free cash flows – NOPLAT

Operating lease example:

Suppose Home Depot reported rental expense of $846 million
for 2008. Assume asset life of 20 years and cost of secured
debt (kd) of 5.2%. How do we calculate the implied interest
expense for the operating lease?

Value of operating leases2007 = $846/(5.2% + 1/20) = $8.3 billion

Implied interest expense2008 = 8.3 bil * 5.2% = 486 million

We then add the 486 million to Home Depot’s EBIT for 2008.
Calculating free cash flows – NOPLAT
 Calculating free cash flows – NOPLAT

 Adjustments to EBIT – Operating cash taxes

 Reported taxes must be adjusted by eliminating the effect
of nonoperating items

 Have to estimate the marginal tax rate

 Use the tax reconciliation table in the footnotes of the 10-K
 Usually, marginal tax rate = statutory rate + state/local taxes

 EBIT * tm = operating taxes

 Adjust the operating taxes calculated this way for other

operating taxes (mainly foreign country differences)

 (if info available) Adjust for cash taxes by subtracting

(adding) the increase (decrease) in Net Operating Deferred
Tax Liabilities

 Calculating free cash flows – NOPLAT
 Adjustments to EBIT – Other items
 Pension expenses: Only service cost (the PV of retirement promises
given to employees in a given year) and amortization of prior service
cost are considered operating expenses. The other pension expense
items – interest cost, expected return on plan assets, and
amortization of loss – are nonoperating and should be excluded from
cost of sales. Any overfunded or underfunded pension funds should
be treated as nonoperating assets or debt equivalents, respectively.

 Ongoing operating provisions (e.g., product warranties) should be

deducted from revenue when determining NOPLAT, and the
corresponding reserve should be deducted from operating assets.

 Long-term operating provisions (e.g., expected plant

decommissioning costs): deduct the operating portion from revenue
when determining NOPLAT and treat interest portion as nonoperating.
Treat the corresponding reserve as debt equivalent.

 One-time restructuring provisions (e.g., expected severance during a

 Calculating free cash flows – Invested
Capital

 Use balance sheet information to calculate Invested

Capital

Invested Capital = Operating Assets – Operating Liabilities =

= Debt + Equity

 For most companies the balance sheet is more

complex
 Nonoperating assets (e.g., marketable securities)
 Debt equivalents (e.g., unfunded pension liabilities)
 Equity equivalents (e.g., deferred taxes)

Invested Capital + Nonoperating Assets = Total Funds

= (Debt + Its Equivalents) + (Equity + Its Equivalents)
 Calculating free cash flows – Invested
Capital

Invested capital is the sum of the following:

 Operating working capital
 Excludes nonoperating cash and marketable securities
 Interest-bearing liabilities are nonoperating

OWC = Operating Current Assets – Operating Current Liabilities

 Net PP&E
 Other LT operating assets – other LT operating
liabilities
 If large, need to disaggregate into operating and
nonoperating; if small – assume they are operating.
 Calculating free cash flows – Invested
Capital

Invested capital is the sum of the following:

 Goodwill and acquired intangibles
 Goodwill is not amortized, it is periodically written down; need
to add cumulative amortization to it.
 Acquired intangibles are amortized (internally generated
intangibles are expensed).
Total Funds Invested = Invested Capital + Nonoperating Assets (NOA)
 Excess cash and marketable securities
 Financial subsidiaries
 Nonconsolidated subsidiaries and equity investments

 Prepaid pension assets

 Tax loss carry-forwards
 Other nonoperating assets (excess real estate, discont. oper.)
 Calculating free cash flows – Invested
Capital

Total Funds Invested = Debt + Debt equivalents + Hybrid securities +

Minority interest + Equity + Equity equivalents

 Debt equivalents: retirement liabilities and restructuring

charges
 Hybrid securities: convertible debt, preferred equity, stock
options
 Equity equivalents: mainly deferred taxes
 Calculating Invested Capital
Historical Balance Sheet ($ million) Invested Capital Calculations ($ million)
  2006 2007 2008   2006 2007 2008
Assets Total funds invested: Uses
Cash and cash equivalents 614 457 525 Operating cash 614 457 525
Receivables, net 3,223 1,259 972 Receivables, net 3,223 1,259 972
Inventories 12,822 11,731 10,673 Inventories 12,822 11,731 10,673
Short-term deferred tax assets 561 535 491 Other current assets 780 692 701
Other current assets 780 692 701 Operating current assets 17,439 14,139 12,871
Total current assets 18,000 14,674 13,362

Net property, plant and equipment 26,605 27,476 26,234 Accounts payable (7,356) (5,732) (4,822)
Goodwill 6,314 1,209 1,134 Accrued salaries (1,295) (1,094) (1,129)
Notes receivable 343 342 36 Deferred revenue (1,634) (1,474) (1,165)

Other assets: Equity investments 325 325 Other accrued expenses (2,598) (2,349) (2,265)
Other assets: Acquired intangibles 778 100 Operating current liabilities (12,883) (10,649) (9,381)
Other assets: Long-term deferred tax assets 7 4
Other assets: Undisclosed 216 198 69 Operating working capital 4,556 3,490 3,490
Total assets 52,263 44,324 41,164 Net property, plant and equipment 26,605 27,476 26,234

Liabilities and equity Capitalized operating leases 9,141 7,878 8,298

Short-term debt 18 2,047 1,767 Other long-term assets, net of liabilities (1,027) (1,635) (2,129)
Invested capital (excluding goodwill and
Accounts payable 7,356 5,732 4,822 acquired intangibles 39,275 37,209 35,893
Accrued salaries 1,295 1,094 1,129
Deferred revenue 1,634 1,474 1,165 Goodwill and acquired intangibles 7,092 1,309 1,134
Cummulative amortization and
Short-term deferred tax liabilities 30 10 5 unrecorded goodwill 177 49 49
Other accrued expenses 2,598 2,349 2,265 Invested capital 46,544 38,567 37,076
Total current liabilities 12,931 12,706 11,153

Long-term debt 11,643 11,383 9,667 Excess cash

Deferred income taxes 1,416 688 369 Nonconsolidated investments 343 667 361
Other long-term liabilities 1,243 1,833 2,198 Tax loss carry-forwards 66 101 124
     
Common stock and paid-in capital 8,051 5,885 6,133 Total funds invested 46,953 39,335 37,561
Retained earnings 33,052 11,388 12,093
Accumulated other comprehensive income 310 755 (77)
Treasury stock (16,383) (314) (372)
Total liabilities and shareholders' equity 52,263 44,324 41,164
 Calculating free cash flows

 Free cash flow is independent of financing and

nonoperating items
FCF = NOPLAT + Noncash Operating Expenses
- Investments in Invested Capital

where Noncash Operating Expenses = Depreciation + Amortization

OR
FCF = NOPLAT + Noncash Operating Expenses
– CAPEX – Δ(OWC) – Δ(Capitalized Operating Leases)
– Δ(Goodwill and Acquired Intangibles + cumulative amortization)
– Δ(Other Net LT Operating Assets) – Δ(FX translation effect)

where CAPEX = Δ(Net property, plant and equipment) + Depreciation

 Calculating free cash flows
 Enterprise value
 The total cash flow available to investors

EV = PV(FCFs) + Value of Nonoperating Assets

Calculating free cash flows – Analyzing
Performance

 To forecast FCFs, we need to have an idea how the

company is expected to perform in the future
 What are the ROIC and revenue growth rate that it
generates?
 What are the drivers of ROIC and growth?
 Industry competition forces
 Look as far back as possible
 If a dramatic change occurs, identify the source

 Does the financial health of the company play a role?

 What fraction of operations is financed through debt?
 Is the leverage sustainable?
 How much is the company paying out to shareholders
 Can the company survive an industry downturn?
Calculating free cash flows – Analyzing
Performance

 What is the ROIC that the company generates?

 Recall that ROIC = NOPLAT / Invested Capital
 Estimate with and without goodwill and acquired tangibles
 Compare to industry peers!!!
 Could decompose it to get a better idea what is behind it

ROIC = (1 – tM) * (EBIT/Revenues) * (Revenues/Invested Capital)

 What is the company’s revenue growth rate?

 With stable profitability and reinvestment rates, the growth
in FCFs is directly related to revenue growth
 Recall that g = ROIC * IR
 Effects of M&A activity on growth
 Effects of accounting changes and irregularities
Calculating free cash flows – Forecasting
Performance
 What should the length of the forecast be?
 Use an explicit forecast period to forecast the CFs during a
higher-growth stage (5-10 years)
 Detailed forecast (item by item) initially, then forecast only
important variables (ROIC, g, profit margins, capital
expenditures, etc.)
 Explicit forecast should be long enough for the company to
reach a steady state – low constant g, constant ROIC

 Prepare and analyze historical financials

 Data sources: COMPUSTAT, Capital IQ, Thomson ONE Banker,
www.sec.gov
 Beware: sometimes commercial datasets lack enough detail on the
company’s financial statements. Have to dig through those
documents yourself.
Calculating free cash flows – Forecasting
Performance
 Build the revenue forecast
 IMPORTANT!!!!!!!!
 Could use a top-down approach: total market size,
company’s market share, prices
 Competitors, product/services mix,
 Over the short term – plans and capabilities for growth
 More challenging for new-product markets
 Could also use a bottom-up approach: use company’s own
forecasts of demand from current customers, customer
turnover, potential for new customers
 Forecasts become imprecise over the long run
 Might have to use scenario analysis (e.g., normal,
optimistic, pessimistic scenarios and a weighted average)
Calculating free cash flows – Forecasting
Performance
 Forecast the Income Statement
 Most items tied directly to revenues, some to specific
assets or liabilities
 Estimate forecast ratios (for operating expenses – exclude
nonoperating items)
 Depreciation: % of Revenues, % of net PP&E, or based on
purchases and depreciation schedules
 Interest expense/income: % of prior year value of
liability/asset
 Operating taxes: % of EBIT (nonoperating taxes as % of
respective nonoperating items)
 Calculating free cash flows – Forecasting
Performance

Typical forecast drivers for the Income Statement  

  Line item Typical forecast driver Typical forecast ratio

Operating Cost of goods sold Revenue COGS/revenue
SG&A expenses Revenue SG&A/revenue

Depreciation Prior-year net PP&E Depreciationt/net PP&Et-1

       

Nonoperating
Nonoperating Nonoperating income Appropriate nonoperating asset income/Nonoperating asset

Interest expense Prior-year total debt Interest expenset/total debtt-1

  Interest income Prior-year excess cash Interest incomet/Excess casht-1

 Calculating free cash flows – Forecasting
Performance

Forecast of the Income Statement        

Forecast worksheet Income Statement

Forecast Forecast
% 2014 2015 $ million 2014 2015
Revenue growth 20.0 20.0 Revenues 240.0 288.0
COGS/revenue 37.5 37.5 COGS (90.0) (108.0)
SG&A/revenue 18.8 18.8 SG&A (45.1) (54.1)

Depreciationt/net PP&Et-1 9.5 9.5 Depreciation (19.0) (23.8)

EBITA 85.9 102.1

Net PP&Et-1 200.0 250.0        

Calculating free cash flows – Forecasting
Performance
 Forecast the Balance Sheet
 Forecast items directly, not its change
 Operating working capital: % of Revenues, Accts payable
and Inventories as % of COGS
 PP&E: % of Revenues
 Goodwill and acquired tangibles: keep constant
 Deferred taxes: % of taxes likely to be deferred (use
historical ratios)
 Forecasting nonoperating assets, debt and equity
equivalents: usually valued by other methods
 Calculating free cash flows – Forecasting
Performance

Typical forecast drivers for the Balance Sheet  

  Line item Typical forecast driver Typical forecast ratio
Operating Accounts receivable Revenue Accounts receivable/revenue
Inventories Cost of goods sold Inventories/COGS
Accounts payable Cost of goods sold Accounts payable/COGS
Accrued expenses Revenue Accrued expenses/revenue
Net PP&E Revenue Net PP&E/revenue

Goodwill and acquired tangibles Acquired revenues Goodwill/acquired revenue

       
Nonoperating Nonoperating assets none Growth in nonoperating assets
Pension assets or liabilities none Tend toward zero

Change in operating taxes/operating

  Deferred taxes Operating taxes taxes