Corporate Valuation Executive Masters Program Timothy A. Thompson
Corporate Valuation using Discounted Cash Flow Techniques • Lecture not about comparable transactions methods, or premiums paid analysis • Purpose here: outline principles of DCF valuation and discuss some implementation
Three key valuation components • The three key components of valuation are • Cash flow • You can’t eat earnings • Long term • Not a one year measure, but the PV of entire future stream of CF’s • Risk • via the “expected value” cash flows and via the opportunity cost of capital
Corporate valuation analysis is simply project DCF applied to the cash flows of the company • To value a project, we sum the discounted value (present value) of the project’s incremental cash flows (CFt), using a discount rate which is appropriate for the riskiness of the project’s cash flows • Value0 = [CF1/(1+r)1] + [CF2/(1+r)2] + … • The project value is the value of the “assets,” not the equity ownership of the project • remember, project cash flows are operating cash flows, omitting any financing cash flows • Corporate valuation analysis simply says, pretend the firm is a very large project: • The entire operating free cash flow of the firm is the annual cash flow to the assets of the firm, which we discount to the present by the cost of capital
Valuing the equity of the company: valuation by components • The value of the equity is the value of the assets minus the market value of the debt of the firm: • E = V - D • V is the present value of future operating free cash flow (t = 1,…,¥) to the assets of the firm; this amount is owned by both debtholders and equityholders (you have to add any non operating assets!) • Subtracting the market value of the debt gives the equity value
Shareholder value based on value drivers: links SHV to operating, investment and financing decisions
What is operating free cash flow? • Operating free cash flow is the cash flow that is left over after all investments (fixed and working capital investments) have been made, without taking out any impacts of financing on cash flow. • Also called unlevered free cash flow • Operating free cash flow is not required to fund the firm’s planned investments • Operating free cash flow is available to be paid out to • Debtholders in the form of interest and principal payments • Equityholders in the form of dividends or repurchases • When operating free cash flow is negative (which often happens in high growth firms), it means that they have to raise external funds.
Calculating operating free cash flow is the same as calculating project cash flow • Free cash flow is equal to • Sales • less cash operating expenses (no financing expenses) • less non-cash charges (e.g., depreciation) • Equals EBIT or pretax operating income • less Adjusted Taxes • Equals NOPLAT (net operating profit less adjusted taxes) • Plus non-cash charges • Equals operating cash flow (not operating free cash flow) • less Fixed Capital Investment (I.e., capex) • less Required Working Capital Investment
Why are interest expenses excluded? Why is the tax number different than the tax provision? • When we calculated operating free cash flow, it is the cash flow generated by the assets, ignoring financing effects • Interest cost is one source of the cost of capital. The cost of capital incorporates the costs of all the sources of capital (debt and equity). • Adjusted taxes are calculated to estimate what the tax of the company would be if it didn’t have the interest expense associated with the debt. • but doesn’t that ignore the tax shield associated with debt financing? • Yes! But where do we account for the tax shield associated with debt financing elsewhere? • In the WACC! • We don’t want to double count the value added by the tax shield of the debt financing, so if it is in the WACC, we must back it out of the cash flows. Later we will discuss different method for this: APV!
How do we forecast all the future operating free cash flows? • Difficult • Issue here is not theory, but implementation: general point --- if you have a better forecast method, use it! • Valuation consultants decide to break the free cash flow calculation down into a set of parameters • LEK/Alcar Partners refers to their breakdown as value drivers • We will look at a modified set of value drivers
What are the value drivers? • Sales growth (G) • Profit Margin (P) • Adjusted Taxes (T), Alcar calls “cash taxes” • Depreciation (D) • Fixed capital expenditures (F) • Required Working Capital Investment (W) • Two others, Value Growth Duration (N) and Cost of Capital (WACC)
Sales growth rate • Estimate the future sales of the company as today’s level times one plus a sales growth rate • Needn’t be constant each year • Can use historical CAGR, but careful about inflation assumptions • S t+1 = St (1+G), for each t
Sales in year one Sales1 = Sales0 (1 + G)
Operating Profit Margin • Forecast as a margin, i.e., ratio of operating profit to sales • Use historical estimate, peer group estimates, management estimates • P = (Sales - All operating (not financing) costs)/Sales • Excludes interest and non-operating items • Non cash operating expenses (e.g., depreciation) are subtracted out to calculate P, so you have to remember to add back depreciation after calculating NOPLAT (below) • Be careful with data sources (e.g., Value Line profit margins exclude depreciation when calculating their P
EBIT in year one EBIT1 = Sales1 P = Sales0 (1 + G) P
Adjusted Taxes • Idea is to estimate what the company would have paid in taxes if the firm were unlevered (had no financing expenses) • Valuing entire cash flow, so we want the effective tax rate. • Includes country, state, local and international income taxes • Advanced point: if a company is expected to have deferred taxes, forecast the deferred taxes separately, then adjust the tax amount in each period. • Forecast as a rate, I.e., adjusted taxes divided by EBIT
NOPLAT in year one NOPLAT1 = EBIT1 (1 - T)
Depreciation expenses • Once you have calculated NOPLAT, you must add back depreciation expense • In theory, if you have all past and forecasted capex and know the tax depreciation methods, you can calculate these amounts • In practice, often forecast depreciation to be a constant percentage of sales, or incremental sales, or fixed assets, etc.
Gross cash flow in year one Gross cash flow1 = NOPLAT1 + D (Sales1 - Sales0)
Fixed capital expenditures • Fixed capital expenditures should be calculated on a net basis: • Capital expenditures required for maintenance • plus Capital expenditures required for growth (in the strategy) • less proceed from asset sales • Net fixed capital expenditures can be modeled as percentage of sales, incremental sales, fixed assets, e.g., • F = (Net capital expenditures)/Incremental Sales • There is a logical connection here to the growth rate!!!
Required working capital investment • Net investment in working capital required to grow the sale of the firm at the rate assumed • Estimate W as a percentage of incremental sales: • W = (incremental working capital investment) / incremental sales • Use history to estimate W: better to use peer group of companies • Careful, working capital is defined as current operating assets minus current operating liabilities here. • Do not include the cash account in operating assets and do not include short-term debt as operating liabilities
Operating free cash flow in year one Op Free cash flow1 = NOPLAT1 + D (Incr. Sales1) - F (Incr. Sales1) - W (Incr. Sales1)
Operating free cash flows should be expected values • Should consider different potential outcomes and relative likelihoods • Should consider different possible macro conditions, competitor’s response and political and legal environment • Should not be what will happen if everything goes according to plan • contrast with venture capital methods
Value of operations is the present value of all the future operating free cash flows • Suppose we estimated op free cash flows for all t = 1,…, ¥ • Value of operations is the present value of all these free cash flows • Discounting at the WACC
It’s a lot of work to forecast out an infinite stream of cash flows • Usually a number of years are forecast explicitly, as we outlined above • Called the forecast period • The company generally has some value remaining after the forecast period: that value is often referred to as • Continuing value (McKinsey) • Residual value (Alcar) • Terminal value (usually implies liquidating) • Exit value (usually used in LBO deals, or interim financing deals)
Continuing value formula • Assume that the end of the forecast period is N years • If we can assume that the growth rate of FCF, g, is constant in years N+1 and beyond, then we can apply the Gordon Growth formula to value the continuing value of the business at time N as: • VN = FCF N+1 / (WACC - g), or • VN = FCF N (1 + g) / (WACC - g)
What is value growth duration? • One reason for using a continuing value method is that we would not expect the growth, profitability, etc., during the forecast period to be the same in perpetuity • industries probably become more competitive in the distant future • growth rate would diminish, profit margins erode • Alcar argues there is a date with destiny for any company, a time (which depends on the company and the strategy it follows) after which returns on new investments will equal only the cost of capital.
What is continuing value at the end of the value growth period? • Alcar says set your forecast period equal to the firm’s value growth duration, N. • All investments after time N are zero net present value, I.e., they return only the cost of capital. • In this instance, we have a simplification formula: • VN = NOPLATN/WACC • Remember, this is the continuing value at time N, have to discount it N more periods to time 0.
Back to valuation by components • Value of the operating assets is the PV of free cash flows in the forecast period plus the PV of the continuing value • operating assets are those forwhich you forecasted cash flows • Add to this amount the estimated value of non-operating assets • e.g., the excess cash on the balance sheet • e.g., value of undeveloped real estate for which you didn’t forecast cash flows • Total is value of the firm, V • Subtract the market value of financing obligations (value of the debt) • Result is the shareholder value, E • Divide by number of shares to get shareholder value per share, P0