A General Valuation Model • The basic components of the valuation are: • An estimate of the future cash flow stream from owning the asset • The required rate of return for each period based upon the riskiness of the asset • The value is then found by discounting each cash flow by its respective discount rate and then summing the PV’s (Basically the PV of an Uneven Cash Flow Stream)
The Formal Model • The value of any asset should then be equal to:
Applying the general valuation formula to a firm • The only question is what to use as the future cash flows when valuing the firm. • Free Cash Flow • The cash flow from operations that is actually available for distribution to investors (stockholders, bondholders and preferred stockholders)
Free Cash Flow Net Operating Profit After Taxes + depreciation -Gross Capital Expenditure -Change in net operating working capital Free Cash Flow
NOPAT NOPAT = EBIT(1-Tax Rate) NOPAT is the amount of profit a firm would earn if it had no debt and held no financial assets.
FCF • Five good uses of FCF • Pay interest to debtholders (cost to firm is after tax interest expense) • Repay debt • Pay dividend to shareholders • Repurchase stock from shareholders • Buy marketable securities or other nonoperating assets.
Developing estimates of free cash flow • To develop the estimates of future cash flows you need to forecast the future income of the firm. • This will be a result of your financial plan and proforma financial statement.
Financial Planning • Establish an outline of the process by which the firms goals are to be realized
Goals of the Plan • Examining interactions • Exploring Options • Avoiding Surprises • Evaluating Feasibility
Elements of a Financial Plan • Forecasting: What future assets will be needed and how will they be obtained • Capital Structure Policy: How will the assets be financed • Dividend Policy: What portion of earnings will be returned to shareholders • Working Capital: The amount of liquidity needed for the firm to conduct daily operations
Main issues addressed • Corporate Purpose: Overview of long run mission of firm • Corporate Scope: Geographic location and main business line • Corporate Objectives: Specific Goals for the firm ( targets)
Main Issues • Corporate Strategy: A plan to obtain the firms objectives • Operating Plans: Five year horizon each year less specific
Steps in the process • Pro Forma Financial Statements • Determine the funds needed to support the plan • Forecast the funds available • Establish controls • Plan for other contingencies • Establish a performance based compensation plan
A simple model • Assume that all variables are directly tied to sales – If sales increases so do the other entries on the balance sheet and income statement (by the same %) • As sales increase so do assets – why? • (Assume total capacity utilization)
Sale 1,000 Costs 800 Net income 200 Sale 1,250 Costs 1,000 Net income 250 Simple Income Statement
Assets 500 Debt 250 Equity 250 500 500 Assets 625 Debt 325 Equity 325 625 625 Simple Balance Sheet
Percentage of Sales Approach • Two categories those that vary directly with sales and those that do not. Income Statement: • Costs – remain a set % of sales • Dividend Payout – Assume it remains constant Balance Sheet • Find % of sales for LHS, on the RHS not for L-T Debt or retained earnings or equity (only CL) • Retained Earnings – use dividend payout
Sales 1,000 Costs 800 Taxable income 200 Taxes 68 Net Income 132 Dividends 44 Addition to Ret E 88 RetRate=88/132=66.67% Sales 1,250 Costs 1,000 Taxable income 250 Taxes 85 Net Income 165 Addition to Ret Earn .6667(165) = 110 Income Statement
Assets Current Assets 160 16% Accts Rec 440 44% Inventory 600 60% Total 1200 120% Fixed Assets 1800 180% Total Assets 3000 300% Liabilities Current Liab 300 30% Notes Pay 500 na Total 400 na L-T debt 800 na Ret Earn 1000 na Total Liab 3000 300% Balance Sheet
Assets Current Assets 200 16% Accts Rec 550 44% Inventory 750 60% Total 1500 120% Fixed Assets 2250 180% Total Assets 3750 300% Laibilitess Current Liab 375 30% Accts Pay 500 na Total 875 na LT Debt 800 na Ret Earn 1110 na Total Liab 2785 300% Proforma Balance SheetSales increase by 25% They do not balance! The difference is the EFN EFN = 3750 –2785 = 965
External Financing Needed • Should be equal to Change in Assets – Change in Liabilities • Represents the amount of cash that needs to be raised to finance the assets.
Internal Growth Rate • The rate of growth where the amount of external financing needed is equal to zero. This would mean that the additional assets required are equal to the increase in retained earnings Internal Growth Rate = (ROA)b/[1-(ROA)b] b = retention rate
Sustainable Growth Rate • The firm wants to maintain a constant debt equity ratio (not increase its financial leverage). This implies that the firm will raise funds only in the form of debt, not external equity. sustainable growth rate = (ROE)b/[1-(ROE)b]
Problems • Financial Planning models that depend upon the financial statements leave out important financial relationships such as cash flows, risk ,and timing
The Formal Model Again • The value of any asset should be equal to:
Value of Operations • After forecasting the free cash flows it is then possible to find the value of operations for the firm. • Notice, this depends upon a forecast of future free cash flow which much like dividends are not certain.
Cost of Capital • What required return should be used in the formula? • Weighted average measure of the returns required by the providers of capital (debt, preferred stock, common stock) to the firm. • The weight corresponds to the amount of financing that comes from each source. • We will calculate it in more detail soon.
Weighted Average Cost of Capital (WACC) • Pacific corporation is considering a new project. It wants to issue debt for 75% of the funding, investors will require an 8% return on the debt. The other 25% would come from new equity, investors require a 12% return on the equity. • The WACC would then be: = (.75)(.08) + (.25)(.12) = .09
Constant Growth in FCF • Just like the constant growth in dividend model if constant growth in free cash flow is assumed you can shorten the equation.
This is the PV of the FCF from time N to time Infinity (think about the last part of a nonconstant dividend valuation) • We will call it the terminal value or horizon value or continuing value. • If the firm had constant growth forever N would be today.
Value of operations • Generally we will not assume that the firm has constant growth in Free Cash Flow. • Instead you want to forecast the future free cash flows for the firm over a reasonable period (5 to 10 years). • Then calculate the terminal value for the firm from the end of the forecast period to infinity. (the process is very similar to finding the PV of a nonconstant growth dividend stream.
Estimating price per share of stock • The PV of all the future free cash flows provides an estimate of the total value of the firm • We need to subtract the total amount of debt and claims by the owners of preferred stock. • Divide the remaining amount by the number of shares outstanding to get the value of one share of outstanding stock.