Frameworks for Valuation

Frameworks for ValuationChapter 8 Summary . Erik Lloyd . April 23, 2007

OverviewPart 1:

What drives value & how to create value

value driven by ability to generate cash flows

long term growth returns on invested capital relative to

cost of capitalPart 2:Step by step guide to analyzing and

valuing a company First step (ch. 8)- Using DCF approach

to value a company

Valuing a company:DCF approach

Discounted Cash Flow models

1. Enterprise DCF model2. Economic Profit Model3. Adjusted Present Value (APV) Model4. Equity DCF Model

There are many ways to apply DCF approach

Enterprise and Economic discussed in detail

Both models provide the same value

Enterprise DCF Model

Most widely used model in practice Formula: Single-Business Company

Equity Value = Operating Value - Debt Value

Operating and Debt values are calculated by taking their respective cash flows and discounting at rates that reflect riskiness of these cash flows

Free cash flow from operations

Cash flow to debtholders

Cash flow to equity owners

Year 1 2 3 4 5

Discounted by WACC

Op

era

tin

g V

alu

e

De

bt

Va

lue

Eq

uit

y V

alu

e +

=

5064

6787 90

5043

332620

7090

100130

140


Or

Equity Value + Debt Value = Operating Value


Formula: Multi-business Company Equity value = Sum of the values of the individual

operating units + Marketable securities - Corporate overhead - Value of company debt and preferred stock

1,750150 250

Unit D 2001,500

Unit C 300 300

P/ S 100

Unit B 400

1,100Unit A 700

Marketable securities

Value distribution

Value of operating units

Deb

tCom

mon

Equ

ity

Val

ue

Corporate Overhead

Enterprise Value

Equity value = sum of units + securities - overhead - debt and pref. stock

EXAMPLE: GM spinning off bus. lines or selling bus. Segments. They need to valuate how much four segments are worth.

Saturn

Saab

Insurance division

Residential mort. services

Value of operations Equals the discounted value of expected future

free cash flow Free cash flow =

after tax operating earnings + non-cash charges (deprec. etc.)

- investments in operating working capital, property, plant, and equipment, and other assets

Free cash flow = sum of the cash flows paid to or

received from all the capital providers



Value of operations

The discount rate applied to the free cash flow should reflect the opportunity cost to all the capital providers weighted by their relative contribution to the company’s total capital, or WACC

opportunity cost is the rate of return the investors could expect to earn on other investments of equivalent risk


Value of operations

How to include indefinite life of a business? Separate the value of the business into two periods

during a precise forecast period after a precise forecast period

Value = present value of cash flow during precise forecast period + present value of cash flow after precise forecast period

The value after the precise forecast period is the continuing value

Continuing value = NOPLAT (1-g/ROICi)

WACC-g {page 136}


Value of debt Equals the present value of the cash flow

to debt holders discounted at a rate that reflects the riskiness of that flow

Value of equity Equals the value of the operations plus

non-operating assets, less the value of its debt and any non-operating liabilities


WACC Summary Hershey Foods

Debt 12.1% 5.5% 39.0% 3.4% 0.4%Equity 87.9% 8.1% 8.1% 7.1%

WACC 7.5%

Contribution to weighted average

Proportion of total capital

Source of

CapitalOpportunity

cost Tax rateAfter-tax

cost

Free Cash Flow Valuation Summary

Year Free cash flow (FCF) Discount Present Value of FCFFactor

($ million) -7.50% ($ million)1999 331 0.93 3082000 349 0.865 3022001 364 0.805 2932008 485 0.485 235

Continuing value 14,710 0.485 7,1389,855

Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385

Drivers of Free Cash Flow and Value(evaluate FCF used for valuation)

1. The rate at which the company is growing revenues Growth Rate = ROIC x Investment rate

2. Return on invested capital (relative to the cost of capital, or WACC) ROIC = NOPLAT / Invested capital

If ROIC > WACC , then value is greater If ROIC = WACC, then value is neutral If ROIC <WACC, then value is destroyed


Drivers To increase value, a company must do one

or more of the following1. Earn a higher return on invested capital 2. Ensure that ROIC (new) exceeds WACC3. Increase the growth rate (keeping ROIC

above WACC)4. Reduce WACC


Growth Rate & Free Cash Flow

5% Growth rate ($ millions)

Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 105 110 116 122 128 134 141 148 155 163 171Net Investment 25 26 27 29 31 32 33 35 37 39 41 43Free cash flow 75 79 83 87 91 96 101 106 111 116 122 128

8% Growth rate ($ millions)

Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 108 117 126 136 147 159 171 185 200 216 233Net Investment 40 43 47 50 54 59 64 68 74 80 86 93Free cash flow 60 65 70 76 82 88 95 103 111 120 130 140

Invested 20% operating profits

Invested 40% operating profits

How ROIC and Growth Drive Value

DCF Value

Operating profit ROIC(annual growth) 7.50% 10.00% 12.50% 15.00% 12.00%

3% $887 $1,000 $1,058 $1,113 $1,1706% $708 $1,000 $1,117 $1,295 $1,4429% $410 $1,000 $1,354 $1,591 $1,886

Value Value Value Destruction neutral creation

Assumes starting NOP LAT = 100, WACC = 10%, and a 25-year horizon after which ROIC = WACC

Reasons for recommending the enterprise DCF model:

1. The model values the components of the business (each operating unit) that add up to the enterprise value

2. The approach helps to identify key leverage areas

3. It can be applied consistently to the company as a whole or to individual business units

4. It is sophisticated enough to deal with the complexity of most situations, yet easy to carry out with personal computer tools


Enterprise DCF ModelEnterprise DCF model: Single-Business Co.

*Equity Value = Operating Value (minus) Debt Value

Operating Value: Value of Debt:

Discounted Value of exp. future Free Cash Flow PV of the cash flow to debt holders discounted at rate that

reflects riskiness of that flow WACC Free cash flow = after tax operating earnings

+ non-cash charges (deprec. etc.) - investments in operating working capital,

Debt % * cost property, plant, and equipment, and other assets Equity % * cost OR

wacc sum Free cash flow = sum of the cash flows paid to or received from all the capital providers

* Equity Value: Equals the value of the operations plus non-operating assets, less the value of its debt and any non-operating liabilities

Economic Profit Model Value equals the amount of capital invested plus a

premium equal to the PV of the value created each year.

Useful measure for understanding a company’s performance in any single year.

Economic Profit equals the spread between ROIC and the cost of capital times the amount of invested capital

Economic profit = Invested capital x (ROIC - WACC)

Translates the two value drivers (growth and ROIC) into a single dollar figure

Example: Economic profit = $1000 * (10%-8%)= $1000 * 2%= $20

Economic Profit Model Economic Profit is the after-tax operating profits less a charge

for the capital used by the company

Economic Profit = NOPLAT - Capital charge = NOPLAT - (invested capital x WACC)

The approach says that the value of a company equals the amount of capital invested plus a premium or discount equal to the present value of its projected economic profit

Value = Invested capital + present value of projected economic profit

Economic Profit Calculation

Forecast Forecast Forecast$ million 1997 1998 1999 2000 2001Return on invested capital 24.30% 23.0$ 23.00% 22.70% 22.60%WACC 8.30% 7.50% 7.50% 7.50% 7.50%Spread 16.00% 15.50% 15.50% 15.20% 15.10%Invested capital (beginning of year) 1,815 1,885 1,830 1,919 2,005Economic profit 291 293 283 292 304NOPLAT 442 434 420 436 454Capital charge (151) (141) (137) (144) (150)Economic profit 291 293 283 292 304

Economic profit = Invested capital x (ROIC - WACC)

Economic Profit = NOPLAT - Capital charge = NOPLAT - (invested capital x WACC)

YearEconomic Profit

Discount Factor

Present Value of Economic Profit

($ million) (7.5%) ($ million)

1999 283 0.930 2632000 292 0.865 252

2008 403 0.485 196Continuing value 11,858 0.485 5,754Present value of economic profit 8,024Invested capital (beginning of year) 1,830

9,857Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385

Economic Profit Valuation Summary

FCF Valuation SummaryEquity Value 9,385

Economic Profit Valuation Summary

Equity Value 9,385

Adjusted Present Value (APV) Model

The APV model discounts free cash flows to estimate the value of operations, and ultimately the enterprise value, where the value of debt is then deducted to arrive at an equity value.

This is very similar to the enterprise DCF model, except: APV model separates the value of operations

into two components The value of operations as if the company were

entirely equity-financed The value of the tax benefit arising from debt

financing


The APV model reflects the findings from the Modigliani-Miller propositions on capital structure

In a world with no taxes, the enterprise value of a company (the sum of debt plus equity) is independent of capital structure (or the amount of debt relative to equity)

The value of a company should not be affected by how you slice it up


“Mr. Berra, would you like your pizza cut into six or eight pieces?”

“Six please, I am not hungry enough to eat eight.”

The pizza is the same size no matter how many pieces you cut into it!


The implications of MM for valuation in a world without taxes are

the WACC must be constant regardless of the company’s capital structure

Capital structure can only affect value through taxes and other market imperfections and distortions


The APV model

1) values a company at the cost of capital as if the company had no debt in its capital structure (the unlevered cost of equity)

2) adds the impact of taxes from leverage.

APV Free Cash Flow Valuation Summary

Year Unlevered DiscountCost of Factor

($ million) Equity ($ million)

1999 331 7.80% 0.928 3072000 349 7.80% 0.860 301

2008 485 7.80% 0.472 229Continuing value13,526 7.80% 0.472 6,380

9,056Mid-year adjustment factor 1.037APV value of FCF 9,390

Free cash flow (FCF)

Present Value

APV Free Cash Flow Valuation Summary with Tax Impact

APV value of FCF 9,390

Value of debt tax shield 642

Non-operating assets 450

Total enterprise value 10,482

Less: value of debt 1,282

Equity Value 9,200

Page 149

APV FCF Valuation SummaryEquity Value 9,200

FCF Valuation Summary

Equity Value 9,385

Why is there a difference in the equity values?


Comparison…

In the enterprise DCF model, this tax benefit is taken into consideration in the calculations of the WACC by adjusting the cost of debt by its tax benefit

In the APV model, the tax benefit from the company’s interest payments is estimated by discounting the projected tax savings

The key to reconciling the two approaches is the calculation of the WACC


Relating WACC to the unlevered cost of equity assuming that the tax benefit of debt is discounted at the unlevered cost of equity

WACC = ku - kb (B/(B+S)) T

Where ku = unlevered cost of equitykb = Cost of debtT = Marginal tax rate on

interest expensesB = Market value of debtS = Market value of equity

Enterprise DCF Adjusted for Changing Capital Structure

The enterprise DCF model assumes that the capital structure and WACC would be constant every period However, the capital structure does change every year

A separate capital structure and WACC can be estimated for every year

Year WACC Discount(percent) Factor

($ million) (percent (7.5%) ($ million)1999 331 13.3 7.52 0.930 3082000 349 12.3 7.54 0.865 302

2008 485 13.1 7.52 0.483 234Continuing value 14,710 13.1 7.52 0.483 6,965

9,675Mid-year adjustment factor 1.037Value of operations 10,032Value of non-operating investments 450Total enterprise value 10,482Less: Value of debt 1,282WACC Equity Value 9,200

Free cash flow (FCF)

Debt/Total value

Present Value


Equity Value 9,200

Enterprise DCF Adjusted for Changing Capital Structure

Equity Value 9,200

The Equity DCF Model

The equity DCF model discounts the cash flows to the equity owners of the company at the cost of equity

Equity DCF Valuation Summary

Year DiscountFactor

($ million) ($ million)

1999 245 0.925 2272000 137 0.856 118

2008 193 0.460 89Continuing value 12,895 0.460 5,934Discounted equity cash flows 8,454Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,261

Equity cash flow

Present Value

The Equity DCF Model This model also needs to be adjusted

for the changing capital structure. It is necessary to recalculate the cost of equity every period using the following formula

ks = ku + (ku - kb)(B/S)

Where ks = levered cost of equity

Once the adjustment is made, the value using the equity DCF approach is the same as the APV approach and the enterprise DCF model with WACC adjusted every period

Equity DCF Valuation Summary

Year Levered Discountks Factor

($ million) (percent (percent) ($ million)

1999 245 13.3 8.16 0.925 2272000 137 12.3 8.13 0.855 117

2008 193 13.1 8.15 0.458 88Continuing value 12,838 13.1 8.15 0.458 5,880Discounted equity cash flows 8,393Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,200

Equity cash flow

Debt/Total value

Present Value


Once the adjustment is made, the value using the equity DCF approach is the same as the APV approach and the enterprise DCF model with WACC adjusted every period.


Equity Value 9,200

Adjusted Enterprise DCF Valuation SummaryEquity Value 9,200

Adjusted Equity DCF Valuation SummaryEquity Value 9,200


The equity DCF approach is not as useful as the enterprise model (except for financial institutions) because Discounting equity cash flow provides less

information about the sources of value creation It us not as useful for identifying value-creation

opportunities It requires careful adjustments to ensure that

changes in projected financing do not incorrectly affect the company’s value

It requires allocating debt and interest expense to each business unit, which creates extra work, yet provides no additional information.

Additional Models and Approaches

Option Valuation Models Models which adjust for management’s

ability to modify decisions as more information is made available.

DCF Approaches Using real instead of nominal cash

flows and discount rates Discounting pretax cash flow instead

of after-tax cash flow Formula-based DCF approaches

Summary of Models

Enterprise DCF

Economic Profit

APV

Equity DCF

Adjus

tmen

t Adjustment

Economic Profit Model

Advantage over DCF Model:

EP is a useful measure for understanding a

company’s performance in any single year, while

cash flow is notAPV ModelAdvantage over

Enterprise DCF Model:

APV is easier to use when the capital

structure is changing significantly over the

projection period

Equity DCF ModelAdvantage:

Simple and Straightfoward

Disadvantage:Provides less information

Requires careful adjustments

Enterprise DCF ModelAdvantage:

Values the componentsPinpoints key leverage

areasConsistent

Can handle complex situations

Easy to carry out

Frameworks for Valuation

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