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American Eagle Apparel Stores. Module 5: Valuation Using Cash Flows By: Nick Cecero. Free Cash Flow Valuation Method. This FCF valuation method is used to determine value which is based on expected future cash flows.
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American EagleApparel Stores Module 5: Valuation Using Cash Flows By: Nick Cecero
Free Cash Flow Valuation Method • This FCF valuation method is used to determine value which is based on expected future cash flows. • Investors and creditors do not concern themselves with where a company is or has been, but rather where the company they are valuing is going. • More importantly when deciding between investments its is always best to choose the investment in which future payoffs are the greatest with all other things being equal. • To arrive at our final formula it is imperative that one understands the breakdown of the formula and it is easier if shown one step at a time.
Finite-Life Project • This is an investment with a limited timeframe where the payoff over the entire life can be forecasted. • This type of valuation is usually done for such investments that are disposed of after a certain amount of years. • Essentially, the project or potential investment we are looking to undertake is not a going concern. • We can utilize the following formula to find the present value of expected cash flows represented as V0. • That formula continues on depending on the number of years that the project will continue to generate cash flow until it is disposed of and sold. • The V0 formula should yield a total present value of expected cash flows in which one must then subtract out the purchase price to arrive at a net present value and as long as the NPV of the project is > 0 the project or investment should be taken on.
Finite-Life Project Formula • V0 = CF1/(1+rp) + CF2/(1+rp)2…….. • V0 = intrinsic (or true economic) value • CFt = the cash flow from the project in period t. • rp = the required rate of return on the project. • Two things to remember are that the more payoffs in the future, the more value today. Secondly, if those payoffs occur sooner they are more valuable because they are discounted less.
American Eagle • To be able to value American Eagle we make the assumption that they are a going concern. This simply means that American Eagle is expected to have an infinite stream of future cash flows unlike our previous example which was a finite-life project which its cash flows end after a set amount of time. • American Eagle (enterprise) can be viewed as the sum of all the projects of the firm has undertaken or expects to undertake and the previous formula is changed slightly to account for them as a going concern:
Valuation of Enterprise Operations (Going Concern) Formula • Although the formula is still not complete here is the beginning of the new formula for a going concern: • V0 = FCF1/(1+rEnt) + FCF2/(1+rEnt)2………. • FCFt = is the cash flow generated by the enterprise that is distributable to debt and equity holders, that is the free cash flow at time t. • rent = is the required rate of return for the enterprise given its risk. • t = is the free cash flow at time t.
Free Cash Flow at Time t • FCFt = EPATt - NEAt • The reason as to why we use this formula instead of just looking at American Eagle’s statement of cash flows is because that equation takes into account non-cash items such as depreciation and other accruals that result in non cash transactions. • More Importantly, the free cash flow model uses the cash generated by the enterprise which is either available to pay debt holders or be distributed to equity holders in the form of dividends.
Within the Forecast Horizon • The previous formula will capture the first five years of American Eagle’s forecasted free cash flows which we did in the previous module. • The first five years are relatively accurate in terms of being able to forecast Sales, EPAT, & NEA. • Sales, EPAT, & NEA beyond those five years utilizing those same forecast would be more of speculation than anything else.
End of Forecast Horizon (Continuing Value) • As stated previously the forecasts within the horizon are explicit forecasts which were directly calculated utilizing reasonable and educated assumptions. • Beyond that horizon, a continuing value must be calculated that captures the expectations beyond the explicit forecast. • The second part of the equation located on the next slide will assume a constant growth rate for future cash flows represented by the letter (g). • This is referred to as the enterprise reaching a steady-state.
Continuing Value Formula • = 1/(1+rEnt)t X (FCFt/rEnt – g) • Important Notes: The growth rate as measured by (g) will normally and should always be a positive number as we use nominal payoffs which include the effect of inflation. Any (g) value between -1 and 0 captures the assumption that the payoffs decline over time better known as decaying. • Furthermore, the required rate of return as measured by r should always exceed the growth rate. • Lastly, (FCFt/rEnt – g) the time period t is the last year within the horizon and not the year after. So if we forecast 5 years out it is the 5th year FCF used and not the 6th year.
Final Formula • V0 = CF1/(1+rp) + CF2/(1+rp)2……..+ 1/(1+rEnt)t X (FCFt/rEnt – g) • As stated before we use nominal payoffs and rates because that is what all analysts use and is what is found on financial websites and reports issued. The payoffs and rates both have to be nominal. • You can use real rates and payoffs but you would have to make sure that both your payoff and rates have to be expressed in real terms. • Either one will give you the right present value but the latter requires an extra step of taking out the inflation premium.
Value of AEO’s enterprise operations • Assumptions: - Cost of Capital = 10% • Growth Rate = 6% • V0 = 166,670/1.10 + 269,426/1.21 + 277,509/1.331 + 285,834/1.4641 + 294,409/ 1.61051 + 1/1.61051 X ((294,409 X 1.03)/(.10 - .03)) • V0= $3,650,561 (Total Enterprise Value)
The End Any Questions?
