Valuation 3 3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value.

EMBA Finance II

The Va lue- Ba sed M a na gem ent Fra m ework

Va lue

Figure 1. The Va lue- Ba sedM a na gem ent Fra m ew ork

Stra teg ic

Fina ncia l

Corpora teG overna nce

Valuation

EMBA Finance II 3

3 Valuation Frameworks

Discounted Cash Flow (DCF)

Comparables

Option Value

EMBA Finance II 4



Comparables

Option Value

DCF Valuation

Spreadsheet Approach

EMBA Finance II

Economic Valuation

PV =

C

1+ k ... +

C

1+k1 n

12

21

C

kn .

0 1 2 nk

C1 Cn C2Value

...

+ ++

Capital Projects AsCash Flow Tradeoffs

Initial

Outlay

Net

Benefits

Additional

Outlay

Capital

Recovery

TIME

Match initial investment with the combined PV of all future cash flows

EMBA Finance II

Capital Project Valuation

Annual cash flow

Investment $100

NPV = $13

$20 $20 $20 $20 $20 $20 $20

1

2 3 4 5 6 10k

Discounting Example

Cash Discount P.V.Cumul.

Yr Flow Factor* Cash Flow P.V. 1 $ 20 .9091 $ 18.18 $ 18.182 20 .8264 16.53 34.713 20 .7513 15.03 49.74

10 20 .3855 7.71 113.00

* Discount Factor = 1/(1+.10)n

Corporate Value

infinity

Value = Cash Flowt

t=0 (1 + Cost of Capital)t

Free cash flow is the basis of value!

Investors watch this pattern……

….which is “cash in and cash out”

Free cash flow = NOPAT adjusted for depreciation and other accounting elementsLess net investment in working capital, fixed assets, capitalized R&D, etc.

Trend

Time

PLEASE DO NOT DISTURB

Working on A big project !!!

STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

Corporate Business Unit PV of Business Strategy

beyond2001 2002 2003 2004 2005 2005

Planned cash flows $570 $630 $700 $800 $850 $850Discount factor (12%) 0.893 0.797 0.712 0.636 0.567 4.729

2000 Present Value $509 $502 $498 $508 $482 $4,019

TOTAL PV $6,519


XYZ Corp Business Unit2005 FV of Business Strategy

POST-PLANNING

beyond2001 2002 2003 2004 2005 2005

Planned cash flows $570 $630 $700 $800 $850 $850Discount factor 1.574 1.405 1.254 1.120 1.000 8.333

2005 Future Value $897 $885 $878 $896 $850 $7,083

TOTAL FV $11,489


PRE-PLANNING

2000 pre-planning $600cash flow

beyond2001 2002 2003 2004 2005 2005

Planned cash flows $600 $600 $600 $600 $600 $600Discount factor 1.574 1.405 1.254 1.120 1.000 8.333

2005 Future Value $944 $843 $753 $672 $600 $5,000

TOTAL PRE-PLAN $8,812FUTURE VALUE


RANGE OF PERFORMANCE COMPENSATION

BusinessPerformance Value

Target $11,489Threshold $8,812

Example:

if business value equals threshold, bonus = 40%

if business value equals target, bonus = 100%

Portal.com Example

Table 1 Portal.com Financial Statements Balance Sheet

2001 2000 ChangeCash $250 $100 $150Receivables $2,600 $1,500 $1,100Inventory $2,600 $1,500 $1,100Property, plant, & eqpt $6,000 $4,000 $2,000 Accum deprec $750 $500 $250Net Property, plant, & eqpt $5,250 $3,500 $1,750

----------- ----------- ----------- Total Assets $10,700 $6,600 $4,100

Accounts Payables $3,570 $2,560 $1,010Long-Term Debt $2,000 $2,000 $0Common Equity $5,130 $2,040 $3,090

----------- ----------- ----------- Total Liabilities & Owners Equity $10,700 $6,600 $4,100

Income Statement

2001Sales $12,000 Cost of Sales $3,500 Selling, general, admin $3,000 Depreciation $250

------------ Total Expense $6,750

Interest $100------------

Income Before tax $5,150 Taxes (40%) $2,060

------------Net Income $3,090

Free Cash Flows

2001Cash Flows - Operations

Revenue $12,000

Cash Expenses $6,500Taxes* $2,100

------------ Total $3,400

Cash Flows - Investments

Working Capital $1,340Fixed Assets $2,000

------------ Total $3,340

------------Net Cash Flows $60

ASSUMPTIONS:

Revenue growth 25%Expense growth 25%Working capital growth 25%Taxes growth 25%Capital Investments growth 20%

Table 2 Portal.com Free Cash Flows Projections and Valuation

2001 2002 2003 2004 2005

Sales $12,000 $15,000 $18,750 $23,438 $29,297Oper costs excl. deprec. $6,500 $8,125 $10,156 $12,695 $15,869Earnings bef. deprec, interest, tax (EBDIT) $5,500 $6,875 $8,594 $10,742 $13,428Depreciation (Dep) $250 $300 $360 $432 $518Earnings bef interest & tax (EBIT) $5,250 $6,575 $8,234 $10,310 $12,909Less Taxes on EBIT $2,100 $2,630 $3,294 $4,124 $5,164Plus Depreciation $250 $300 $360 $432 $518Less Capital Expenditures $2,000 $2,400 $2,880 $3,456 $4,147Less Additions to Working Capital $1,340 $1,675 $2,094 $2,617 $3,271Free Cash Flow $60 $170 $327 $545 $845Terminal Value (Note 1) $7,044Total Free Cash Flow $60 $170 $327 $545 $7,890

NPV at 12% $5,245less Debt $2,000Equity Value $3,245Shares outstanding $100Intrincic Value per share $32Recent Share Price $29Discount of Value from Price 11%

Portal.com2001 Valuation Cash Flows

Customers$12,000 Revenue

Customers$12,000 Revenue

Cash ExpenseCOGS 3,500SG&A 3,000 ------- $6,500

Cash ExpenseCOGS 3,500SG&A 3,000 ------- $6,500

Investment$2,000

Investment$2,000

Working CapitalCash 150Receivables 1,100Inventory 1,100Payables -1,010 -------- $1,340

Working CapitalCash 150Receivables 1,100Inventory 1,100Payables -1,010 -------- $1,340

Taxes$2,100Taxes$2,100

Available toShareholders andDebt Suppliers

$60

Available toShareholders andDebt Suppliers

$60

EMBA Finance II

Company Valuation

Annual cash flow

1 2 3 4 5

7,044

Terminal Value

k

0

60170

327 545

845

Free Cash Flow Valuation

$5,245

$0 $5,245 $2,000

$3,245

Value of

Operating

Cash Flows

Marketable

Securities &

Non-operating

Cash Flows

Market Value

of Entity

Market Value of

Debt and other

Liabilities

Market Value

of

Equity

Adjusted Present Value (APV)

Value of the project as ifit were financed with equity

Interest tax shields

Costs of financial distress

Subsidies

Hedges

Issue costs

+APV =

Base-case value

Value of financing side effects

APV =

Higher growth

Asset sales

Working capital improvem

Margin improvement

Interest tax shields

Baseline business value

So

urc

e o

f valu

e

$0 $500 $1,000 $1,500 $2,000

Value created

APV Is Rich in Information

DCF Valuation

Formula Approaches

Company ValuationFree Cash Flow Formulas

NOPAT0 = initial after-tax earnings before interest and taxes (EBIT)

b = rate of investment per period divided by NOPAT g = growth in free cash flows. The subscripts s and c refer to the supernormal growth rate and the constant growth rate. n = number of periods of supernormal growth k = the company’s weighted average cost of capital WACC

No growth:

NOPAT0

V = ------------------ k

Constant growth:

NOPAT0(1 - b)(1 + g)

V = -------------------------------- k - g

Company Valuation

Free Cash Flow Formulas

NOPAT0 = initial after-tax earnings before interest and taxes (EBIT)

b = rate of investment per period divided by NOPAT

g = growth in free cash flows. The subscripts s and c refer to the

supernormal growth rate and the constant growth rate.

n = number of periods of supernormal growth

k = the company’s weighted average cost of capital WACC

Temporary supernormal growth, then no growth:

n (1 + g)t NOPAT0(1 + g)n+1

V = NOPAT0 (1 - b) ----------------- + ---------------------------

t=1 (1 + k)t k (1 + k)n

Temporary supernormal growth, then constant growth:

n (1 + gs)t NOPAT0 (1 - bs) (1 + gs)

n+1

V = NOPAT0 (1 - b) ----------------- + --------------------- x -------------

t=1 (1 + k)t k - g (1 + k)n

DCF Approaches to Estimate Continuing Value

g = 0 In a perfectly competitive market, in the long-term companies earn their cost of capital, resulting in zero economic profit and hence zero cash flow growth rate

g = industry average

Zero growth rates may be too conservative in the cases of some industries. In that case, it is reasonable to assume that companies’ cash flow will grow at the average industry rate

g = Forecasted long-term inflation growth rate

Usually, both revenues and costs are equally affected by inflation and hence inflation has no or little effect on a firm’s growth rate. In some cases, especially in certain consumer industries, inflation affects the revenues more than the costs. In this case, the forecasted perpetual inflation growth rate is a good proxy for the firm’s revenue growth rate and consequently its cash flow growth rate.

g = Forecasted long-term GDP growth rate

It is reasonable that in the long-term the growth rate of companies will fade to that of the growth rate of the overall economy. If a company grows at a sustained rate higher than that of the economy, eventually it will become larger than the economy itself, which of course is not possible.

Valuation Framework

NOPAT R - K V = ------------- + ------------ * I * T K K

WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX K = COST OF CAPITAL R = RETURN ON CAPITAL I = ANNUAL INCREMENTAL INVESTMENT T = NO. OF YEARS THAT I CAN BE INVESTED AT R > K

V = AS IS VALUE + VALUE GROWTH OPPORTUNITIES

3 Factors in Value Creation

ROI > WACCAmount of InvestmentInterval of Competitive Advantage

Note:– Forward-looking– Expected cash flows

Value Creation - Another View

Value Created = (Return On Investment - Cost of Capital) X Capital employed

Dependent Upon: Cost of Capital Spread Duration of Spread Amount of Capital Employed

Economic Profit (EP)(R - K) x capitalNOPAT - K x capitalOperating profits - a capital charge

EP ties directly to NPV:NPV = market value - capitalNPV = the present value of projected EP Market value = Capital + PV of projected EP

K = WACC R = NOPAT / Capital

Economic Profit

Discounted Cash Flow Approach:

Yr. 0 Yr. 1 Yr. 2

NOPAT $250 $250...

P.V. Perpetuity $2,500

Investment ($1,000)

NPV @ 10% $1,500

Economic Profit

Discounted EP Approach:

Yr. 0 Yr. 1 Yr. 2Nopat $250 $250...Investment $1,000Capital Charge $100 $100...

EP $150 $150...

NPV @ 10% $1,500

NPV and the Regulatory Process

Remember:

NPV = Cash Inflow - Cash Outflow

where Cash Inflow = Revenues - Costs

But in a regulated environment,

Revenues = Costs + Return x Investment

Therefore, the NPV is always zero

NPV and the Regulatory Process

but R = C + KI

= 0

t=1

n

NPV = - I(R - C)t

(1 + K)t

t=1

n(C + KI - C)t

(1 + K)t- I=

t=1

n(KI)t

(1 + K)t- I= =

(KI)

K- I

EMBA Finance II 40



Comparables

Option Value

Comparables: An Example

MULTIPLIER COMPANY COMPANY

DATA VALUE

1.5 x book value $23.2 $34.8

9 x cash flow $3.6 $32.4

7 x EBIT $4.3 $30.1

25 x 2000 earnings $1.5 $37.5

20 x 2001 earnings $1.7 $33.0

------------------

Average Estimate $33.6

Valuation 3 3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value.

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