Essential Steps for Equity Valuation: A Comprehensive Guide

1. Chapter 12 Equity Valuation

2. The Basic Steps (1) • Gather Current and Historical data • Several years on financial statements • Firm level non-financial data • Industry data • Demographic data • Anything else that can help forecast the future

3. The Basic Steps (2) • Analyze the current data • Quality of earnings • Trend analysis • Ratio analysis • Common size statements

4. The Basic Steps (3) • Create Pro-forma statements • Three to five years minimum • Ten years maximum • A terminal year • Steady state

5. The Basic Steps (4) • Choose a valuation method • Discounted cash flows • Residual income • Comparable firms

6. The Basic Steps (5) • Apply your data to the valuation model • Determine appropriate discount rate

7. The Basic Steps (6) • Determine if your answer appears reasonable

8. Pro-forma statements (1) • Forecast future revenue • The single most important ingredient! • Most other items are a function of revenue

9. Pro-forma statements (2) • Forecast other income statement items that are a function of sales. • COGS • SG&A • Use common-size percentages if appropriate

10. Pro-forma statements (3) • Forecast balance sheet items that support the level of forecasted revenue • Inventory • Turnover ratio • A/R • Turnover ratio • A/P • Turnover ratio

11. Pro-forma statements (4) • Forecast balance sheet items that support the level of forecasted revenue • PP&E • Turnover • Forecast depreciation as a function of PP&E

12. Pro-forma statements (5) • Forecast the level of debt needed to finance operations and capital investments • Maintain a targeted capital structure • Forecast interest expense as a function of debt

13. Pro-forma statements (6) • Forecast any remaining income statement items. • Forecast income taxes

14. Pro-forma statements (7) • Forecast retained earnings based on net income and expected dividends

15. Pro-forma statements (8) • Make sure the balance sheet balances • It probably will not at this point • Choose a plug account • Something with few or no dependencies

16. Pro-forma statements (8) • Forecast the statement of cash flows from the forecasted balance sheets and income statements • Indirect method

17. Pro-forma statements (8) • Determine a terminal year growth rate for the terminal year. • Make sure it is realistic since it is assumed to be a perpetuity.

18. Pro-forma statements • Note that this is just one approach to forecasting financial statements. It is completely acceptable to use any other reasonable approach such as common-size percentages, etc. Just be sure the numbers appear to make sense.

19. Discounted Cash Flow • Any asset (e.g., a bond, a machine, a firm) is worth the present value of the future cash flows that come from the ownership of the asset. • Therefore the task is to extract the future cash flows from the pro-forma statements.

20. Discounted Cash Flow • Partition the future into two sections • The forecast period • The period thereafter • Continuing value or terminal value • Assumes a steady state perpetuity TV = FCF / (discount rate – growth rate)

21. Free Cash Flow • All capital providers • Equity holders only

22. Free Cash Flow to Common Equity • Dividends – Net Stock Issuance • CFFO – Increase in cash + CFFI + Increase in debt • Net income – Increase in common equity

23. Free Cash Flow to Common Equity • Discount FCF at the firm’s cost of equity • CAPM Rate = risk-free rate + (beta x risk premium)

24. Residual Income Model • Used earnings rather than cash flow • Based on theory that value comes from earning more than the opportunity cost of the investment. RI = NI – r(CE)

25. Comparable Firms • PE multiples • Trailing • Forward • More of a short-cut practical approach than a theory-based approach.