DCF Valuation:DCF Valuation:FCF and EVA ModelsFCF and EVA Models

James L. Grant, Ph.D.

JLG Research

jim@jlgresearch.com

FCF and EVA ValuationFCF and EVA Valuation

Free Cash Flow Formula

Generating Cash Flow Estimates

Valuation of Cash Flows

Cost of Capital Variation

EVA Valuation

Free Cash Flow Forecasting Equation (NOPAT Approach )

FCFt = St-1(1+g)p(1-tu) - (w+f)(St -St-1) = EBITt(1-tu) - (w+f)(St -St-1) = NOPATt - NET INVESTMENTt

Sales Base = 100Sales growth rate (g) = 15%; Pretax Operating Margin (p) = 20%Net capital investment (f) at 20% increased salesWorking capital additions (w) at 10% increased salesUnlevered tax rate = 35%

Source: JLG Research

Free Cash Flow Estimation: NOPAT Approach

Period 1 2 3 4 5 6 7 8 9 10

Sales 115.00 132.25 152.09 174.90 201.14 231.31 266.00 305.90 351.79 404.56

Op. Exp. 92.00 105.80 121.67 139.92 160.91 185.04 212.80 244.72 281.43 323.64EBIT 23.00 26.45 30.42 34.98 40.23 46.26 53.20 61.18 70.36 80.91Taxes 8.05 9.26 10.65 12.24 14.08 16.19 18.62 21.41 24.63 28.32NOPAT 14.95 17.19 19.77 22.74 26.15 30.07 34.58 39.77 45.73 52.59

NCapInv. 3.00 3.45 3.97 4.56 5.25 6.03 6.94 7.98 9.18 10.55Work Cap 1.50 1.73 1.98 2.28 2.62 3.02 3.47 3.99 4.59 5.28Net Inv. 4.50 5.18 5.95 6.84 7.87 9.05 10.41 11.97 13.77 15.83

FCF 10.45 12.02 13.82 15.89 18.28 21.02 24.17 27.80 31.97 36.76

Source: JLG Research

Free Cash Flow Estimation: GOPAT Approach

Period 1 2 3 4 5 6 7 8 9 10

Sales 115.00 132.25 152.09 174.90 201.14 231.31 266.00 305.90 351.79 404.56

Op. Exp. 92.00 105.80 121.67 139.92 160.91 185.04 212.80 244.72 281.43 323.64EBIT 23.00 26.45 30.42 34.98 40.23 46.26 53.20 61.18 70.36 80.91Taxes 8.05 9.26 10.65 12.24 14.08 16.19 18.62 21.41 24.63 28.32NOPAT 14.95 17.19 19.77 22.74 26.15 30.07 34.58 39.77 45.73 52.59Deprec. 0.90 1.04 1.19 1.37 1.57 1.81 2.08 2.39 2.75 3.17GOPAT 15.85 18.23 20.96 24.11 27.72 31.88 36.66 42.16 48.49 55.76

G.CapInv. 3.90 4.49 5.16 5.93 6.82 7.84 9.02 10.37 11.93 13.72Work Cap 1.50 1.73 1.98 2.28 2.62 3.02 3.47 3.99 4.59 5.28Gross Inv 5.40 6.21 7.14 8.21 9.44 10.86 12.49 14.36 16.52 19.00

FCF 10.45 12.02 13.82 15.89 18.28 21.02 24.17 27.80 31.97 36.76

Source: JLG Research

Free Cash Flow Valuation

Net Pres.Val. Cum. PVYear NOPAT Invest FCF 10% 0.00

1 14.95 4.5 10.45 9.50 9.502 17.19 5.18 12.01 9.93 19.433 19.77 5.95 13.82 10.38 29.814 22.74 6.84 15.9 10.86 40.675 26.15 7.87 18.28 11.35 52.026 30.07 9.05 21.02 11.87 63.887 34.58 10.41 24.17 12.40 76.298 39.77 11.97 27.8 12.97 89.269 45.73 13.77 31.96 13.55 102.81

10 52.59 15.83 36.76 14.17 116.9811 Plus 52.59

Residual Value 525.9 202.76

Corporate Value 319.74

LT Debt 12.00Equity 307.74Share OS 5.00Price 61.55

Source: JLG Research

Cost of Capital Sensitivity Analysis

Free Cash Flow Model

Basis Pt. % ChangeRate % Change Horiz.Val. Resid.Val. Corp.Val. Corp.Val.

8 -200 130.46 304.49 434.95 36.038.5 -150 126.89 273.65 400.54 25.27

9 -100 123.46 246.83 370.29 15.819.5 -50 120.16 223.38 343.54 7.4410 0 116.98 202.76 319.74 0

10.5 50 113.92 184.54 298.46 -6.6611 100 110.97 168.38 279.35 -12.63

11.5 150 108.13 153.98 262.11 -18.0312 200 105.39 141.11 246.50 -22.91

Source: JLG Research

JLG ResearchEnterprise Valuation and the Cost of Capital: Free Cash Flow Model

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Change in Basis Points

Va

lue

Corporate Value

Residual Value

Horizon Value

Enterprise Value

Residual Value

Horizon Value

EVA Valuation Model

Economic Profit FormulaForecasting Economic ProfitNPV Valuation of EPCost of Capital VariationStandard Accounting Adjustments

Forecasting Economic Profit

Cost of Capital = 10%

Yearly Total Net Capital EconomicYear Net Inv. Capital NOPAT Charge Profit

0 401 4.5 44.5 14.95 4.00 10.952 5.18 49.68 17.19 4.45 12.743 5.95 55.63 19.77 4.97 14.804 6.84 62.47 22.74 5.56 17.185 7.87 70.34 26.15 6.25 19.906 9.05 79.39 30.07 7.03 23.047 10.41 89.8 34.58 7.94 26.648 11.97 101.77 39.77 8.98 30.799 13.77 115.54 45.73 10.18 35.55

10 15.83 131.37 52.59 11.55 41.0411 Plus 52.59 13.14 39.45

Source: JLG Research

Valuation of Economic Profit

Cum. PVYear EVA Pres.Val. 0

1 10.95 9.95 9.952 12.74 10.53 20.483 14.80 11.12 31.604 17.18 11.73 43.345 19.90 12.36 55.696 23.04 13.00 68.707 26.64 13.67 82.378 30.79 14.36 96.739 35.55 15.08 111.81

10 41.04 15.82 127.63

Residual 394.53 152.11Value

NPV 279.74Capital 40.00Corp.Val 319.74

LT Debt 12.00Equity 307.74Share OS 5.00Price 61.55

Source: JLG Research

Cost of Capital Sensitivity Analysis

Economic Profit Model

Basis Pt. % ChangeRate % Change NPV Tot. Cap. Corp.Val. Corp.Val.

8 -200 394.95 40.00 434.95 36.038.5 -150 360.54 40.00 400.54 25.27

9 -100 330.29 40.00 370.29 15.819.5 -50 303.54 40.00 343.54 7.4410 0 279.74 40.00 319.74 0.00

10.5 50 258.46 40.00 298.46 -6.6611 100 239.35 40.00 279.35 -12.63

11.5 150 222.11 40.00 262.11 -18.0312 200 206.50 40.00 246.50 -22.91

Source: JLG Research

JLG ResearchEnterprise Valuation and the Cost of Capital: Economic Profit Model

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Change in Basis Points

Va

lue

Corporate Value

Net Present Value

Economic Capital

Enterprise Value

NPV

Invested Capital

Standard EVA Accounting Standard EVA Accounting AdjustmentsAdjustments

Operating leasesLIFO ReserveResearch and DevelopmentGoodwill AmortizationSpecial items (restructuring costs)(typically cited in CFA program)

JLG Research JLG Research Disclosed versus Basic EVADisclosed versus Basic EVA

Dow Jones IndustrialsDow Jones Industrials

Amount ($ mill.) %

Basic EVA 46,964.50 100.00

Effect of Operating Leases 127.54 0.27

Effect of R&D Expenses (4,094.55) (8.72)

Effect of LIFO Reserves (917.69) (1.95)

Disclosed EVA 42,079.80 89.60

*Equity betas in this analysis were set equal to 1.0

Illustration of Multiple Illustration of Multiple Regression AnalysisRegression Analysis

Top 50 US Wealth Creators

(And Destroyers)

JLG ResearchNPV/Capital versus EVA/Capital Ratio: 50 Largest Wealth Creators

y = 26.525x + 1.7762

R2 = 0.9269

y = -6.0078x2 + 36.573x + 1.3024

R2 = 0.9373

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-0.2 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2

EVA to Capital Ratio

MV

A to C

apital R

atio

Series1

Linear (Series1)

Poly. (Series1)

JLG Research

Dell

MSFT

KO

CSCO

INTC

MDT

JLG ResearchNPV-to-Capital versus EVA-to-Capital Ratio: 50 Largest Wealth Destroyers

-0.5

-0.45

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-0.35

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-0.3 -0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15

EVA to Capital Ratio

MV

A to C

apital R

atio

Series1

JLG Research

AAPLDEC

SEG

TRANAV

IHS

NPV/Cap=a + b times EVA/Cap

Decile b (slope) R-Squared

1 18.57 67.37% 5 11.72 39.74% 6 2.99 10.57% 10 0.46 7.47%

Source: J. Grant, Foundations of Economic Value Added

Thank you!Thank you!