Post on 26-Dec-2015
DES Chapter 2 1
Chapter 2
A Complete Corporate Valuation for a Simple
Company
DES Chapter 2 2
Three types of value
Book value: the company’s historical value as shown on its financial statements.
Market value: the current price at which an asset can be bought or sold.
Intrinsic value: estimate of the value an individual buyer places on an asset.
DES Chapter 2 3
Objective:
Objective is to provide a sound basis for estimating the intrinsic value of a stock.This intrinsic value is also called its fundamental value.The process is known as fundamental valuation—Warren Buffet is very successful at identifying a company’s fundamental value!
DES Chapter 2 4
The three basic concepts of valuation
Investors can only spend cash so "Cash is good and more cash is better."Cash today is worth more than cash tomorrow.Risky cash flows are worth less than safe cash flows.These three imply the value of a company depends on the size, timing, and riskiness of its cash flows.
DES Chapter 2 5
Valuation of a Simple Company: Mayberry Personal
Receivers, Inc. (MPR)Investors are:DebtholdersStockholders
DES Chapter 2 6
Debtholders and the value of debt
Consider a bond that pays $90 per year for 10 years, and $1,000 at the end of 10th year.
$90 is the coupon payment
$1,000 is the face value, or maturity value.
$90/$1000 = 9% is the coupon rate
DES Chapter 2 7
What do investors require?
MPR’s bonds compete in the market with other bonds. If investors can earn 9% on similar investments, then MPR has to offer at least 9% on its bonds to attract investors. The required rate of return is 9%.
rD = 9%
DES Chapter 2 8
More investors…
MPR’s shares of stock also compete in the market for investors.
Stockholders are the owners of the firm, and the value of ownership is the value of the asset, less any debt that is owed.
For example: Suppose MPR is worth $501 million. It owes $150 million to debtholders. So MPR’s equity is worth $501 – 150 = $351 million.
DES Chapter 2 9
Cash flows that equity holders receive
Dividends:Not fixed—usually growNo maturity dateRiskier than bond payments The required return on equity, rS,
compensates investors for this risk. MPR’s rS is 12%.
DES Chapter 2 10
Discounted dividend valuation
MPR’s last dividend, D0,was $2.34 per share, and is expected to grow at 5% per year.
The present value of these at 12% is:
10.35$....12.1
)05.1(34.2$
12.1
)05.1(34.2$
12.1
)05.1(34.2$3
3
2
2
=+++
Of course, this method becomes difficult to apply if the company doesn’t pay dividends!
DES Chapter 2 11
The Corporate Valuation Model
PV of cash flows available to all investors—called free cash flows (FCFs).
Discount free cash flows at the average rate of return required by all investors—called the weighted average cost of capital (WACC)
DES Chapter 2 12
Steps in the corporate value model
Determine weighted average cost of capital
Estimate expected future free cash flows
Find value of company
DES Chapter 2 13
Estimating the Weighted Average Cost of Capital (WACC)
Company has two types of investorsDebtholdersStockholders
Each type of investor expects to receive a return for their investmentThe return an investor receives is a “cost of capital” from company’s viewpoint.
DES Chapter 2 14
Cost of Debt
MPR’s cost of debt: rD = 9%.
But MPR can deduct interest, so cost to MPR is after-tax rate on debt.
If tax rate is 40%, then after-tax cost of debt is:After-tax rD = 9%(1-0.4) = 5.4%.
DES Chapter 2 15
Cost of Equity
Cost of equity, rs, is higher than cost of
debt because stock is riskier.MPR: rs = 12%
DES Chapter 2 16
Weighted Average Cost of Capital
WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type.
For MPR, target percent financed by equity: wS = 70%
For MPR, target percent financed by debt: wD = 30%
(More….)
DES Chapter 2 17
WACC (Continued)
WACC = wD rD (1-T) + wS rS
= 0.3(9%)(1 - 0.4) + 0.7(12%)
= 10.02%
DES Chapter 2 18
Free Cash Flow (FCF)
FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.
A company’s value depends upon the amount of FCF it can generate.
DES Chapter 2 19
Calculating FCF
FCF = net operating profit after taxes minus investment in operating capital
DES Chapter 2 20
Financial Statements
Balance sheetAssets (all of MPR’s assets are used in
operations)Operating assets
Operating current assets Property, plant, and equipment (PPE)
DES Chapter 2 21
Operating Current Assets
Operating current assets are the CA needed to support operations.Op CA include: cash, inventory,
receivables.Op CA exclude: short-term investments,
because these are not a part of operations.
DES Chapter 2 22
Operating Current Liabilities
Operating current liabilities are the CL resulting as a normal part of operations.Op CL include: accounts payable and
accruals.Op CA exclude: notes payable, because
this is a source of financing, not a part of operations.
DES Chapter 2 23
Balance Sheet: Assets
2001 2002 2003
Op. CA 162,000.0 168,000.0 176,400.0
Total CA162,000.0 168,000.0 176,400.0
Net PPE 199,000.0 210,042.0 220,500.0
Tot. Assets 361,000.0 378,042.0 396,900.0
DES Chapter 2 24
Balance Sheet: Claims
2001 2002 2003
Op. CL 57,911.5 62,999.7 66,150.0
Total CL 57,911.5 62,999.7 66,150.0
L-T Debt 136,253.0 143,061.0 150,223.0
Total Liab.194,164.5 206,060.7 216,373.0
Equity 166,835.5 171,981.3 180,527.0
TL & Eq. 361,000.0 378,042.0 396,900.0
DES Chapter 2 25
Income Statement2001 2002 2003
Sales 400,000.0 420,000.0 441,000.0Costs 344,000.0 361,994.2 374,881.6 Op. prof. 56,000.0 58,005.8 66,118.4Interest 11,678.7 12,262.8 12,875.5 EBT 44,321.3 45,743.0 53,242.9Taxes (40%) 17,728.4 18,297.2 21,297.2 NI 26,592.7 27,445.8 31,945.7Dividends 21,200.0 22,300.0 23,400.0Add. RE 5,392.7 5,145.8 8,545.7
DES Chapter 2 26
NOPAT (Net Operating Profit After Taxes)
NOPAT is the amount of after-tax profit generated by operations.NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have.
NOPAT = (Operating profit) (1-T)
= EBIT (1-T)
DES Chapter 2 27
Calculating NOPAT
NOPAT = (Operating profit) (1-T)
= EBIT (1-T)
NOPAT03 = 66.1184 (1-0.4) = 39.67104
million.
DES Chapter 2 28
Calculating Operating Capital
Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations. The short-term component is net operating
working capital (NOWC). The long-term component is factories,
land, equipment.
DES Chapter 2 29
Net Operating Working Capital
NOWC = Operating current assets
– Operating current liabilities
This is the net amount tied up in the
“things” needed to run the company on a
day-to-day basis.
DES Chapter 2 30
Net Operating Working Capital
NOWC = Operating CA – Operating CL
NOWC03 = $176.4 – $66.15
= $110.25 million
DES Chapter 2 31
Operating Capital
Operating capital = Net operating working capital
(NOWC) plusLong-term capital, such as factories,
land, equipment.
DES Chapter 2 32
Operating Capital = NOWC + LT Op. Capital
Capital03 = $110.25 + $220.50
= $330.75 million
This means in 2003 MPR had $330.75
million tied up in capital needed to support
its operations. Investors supplied this
money. It isn’t available for distribution.
DES Chapter 2 33
Investment in operating capital
Operating capital in 2002 was $315.0423 million
Operating capital in 2003 was $330.75 million
MPR had to make a net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2003.
DES Chapter 2 34
Calculating FCF
FCF = NOPAT – Investment in operating
capital
FCF03 = $39.67104 – (330.75 – 315.0423)
= $39.67104 – $15.7077
= $23.96334 million
DES Chapter 2 35
There are five ways for a company to use FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)
DES Chapter 2 36ReinvestmentBucket
Free Cash FlowBucket
DES Chapter 2 37
How Did MPR use its FCF?
Paid dividends: $23.4 millionPaid after-tax interest of: $12,875.5 (1-0.4) = $7.7253 millionFor a total of $31.1253 million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from?
MPR increased its borrowing by $150.223 – $143.061) = $7.162 million to make up the difference.
DES Chapter 2 38
Corporate Valuation
Forecast financial statements and use them to project FCF.
Discount the FCFs at the WACC
This gives the value of operations
DES Chapter 2 39
Value of Operations:
( )∑∞
= +=
1 1tt
tOp
WACC
FCFV
Of course, this requires projecting free cash flows out forever.
DES Chapter 2 40
Constant growth
If free cash flows are expected to grow at a constant rate of 5%, then this is easy:
2003 2004 2005 2006 2007 2008
FCF 23.963 25.161 26.419 27.740 29.12730.584
There is an easy formula for the present value of free cash flows that grow forever at a constant rate…
DES Chapter 2 41
Constant Growth Formula
The summation can be replaced by a single formula:
( )
( )gWACC
)g1(FCF
gWACC
FCFV
0
1Op
−
+=
−=
DES Chapter 2 42
The value of operations
( )
( )million 225.501$
05.01002.0
)05.01(96334.23$
)1(0
=
−
+=
−
+=
Op
Op
V
gWACC
gFCFV
DES Chapter 2 43
Value of EquitySources of Corporate ValueValue of operations = $501.225 millionValue of non-operating assets = $0 (in this
case)
Claims on Corporate ValueValue of Debt = $150.223 million
Value of Equity = ? Value of Equity = $501.225 - $150.223 = $351.002 million, or just $351 million.
DES Chapter 2 44
Value of EquityPrice per share
= Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share
DES Chapter 2 45
A picture of the breakdown of MPR’s value
Equity
Debt
DES Chapter 2 46
Return on Invested Capital (ROIC)
ROIC can be used to evaluate MPR’s performance:
ROIC = NOPAT / Total operating capital in place at the beginning of the year
DES Chapter 2 47
ROIC calculation
ROIC03 = NOPAT03 / Capital02
ROIC03 = 39.67104 / 315.0423 = 12.6%.
This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So MPR added value during 2003.
DES Chapter 2 48
Economic Value Added (EVATM) (also called Economic Profit)
EVA is another key measure of operating performance.EVA is trademarked by Stern Stewart, Inc.It measures the amount of profit the company earned, over and above the amount of profit that investors required.
EP = NOPATt – WACC(Capitalt-1)
DES Chapter 2 49
Calculating EVA
EVA = NOPAT- (WACC)(Begng. Capital)
EVA03 = NOPAT03 – (0.1002)(Capital02)
EVA03 = $39.67104 – (0.1002)(315.0423)
= $39.67104 – $31.56742
= $8.1038 million
(More…)
DES Chapter 2 50
Economic profit…
This shows that in 2003 MPR earned about $8 million more than its investors required.
Another way to calculate EP is
EPt = (ROIC – WACC)Capitalt-1
= (0.125923 – 0.1002)$315.0423
= $8.1038 million
DES Chapter 2 51
Intuition behind EP
If the ROIC – WACC spread is positive, then the firm is generating more than enough “profit,” and is increasing value. But, if the ROIC – WACC spread is negative, then the firm is destroying value, in the sense that investors would be better off taking their money and investing it elsewhere.
DES Chapter 2 52
Applications of the corporate valuation model
Mergers and acquisitions Evaluate how much a target is worth under various
operating scenarios
Value-based management Make decisions with the goal of increasing the
company’s value
Fundamental investing Identify firms that are worth more than the current
stock price