Frameworks for Valuation

Frameworks for ValuationFrameworks for Valuation

Chapter 8 SummaryChapter 8 SummaryPaula HeathcoatPaula Heathcoat

April 9, 2003April 9, 2003

Valuing a company using the Valuing a company using the discounted cash flow approachdiscounted cash flow approach

4 models4 models

Enterprise DCF modelEnterprise DCF modelEconomic Profit ModelEconomic Profit ModelAdjusted Present Value (APV) ModelAdjusted Present Value (APV) ModelEquity DCF ModelEquity DCF Model

All models provide the same resultsAll models provide the same results(demonstrated later in this presentation)(demonstrated later in this presentation)

Enterprise Discounted Enterprise Discounted Cash Flow ModelCash Flow Model

Formula: Single-Business CompanyFormula: Single-Business CompanyEquity Value = Operating Value - Debt ValueEquity Value = Operating Value - Debt Value

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


Formula: Multi-business CompanyFormula: Multi-business CompanyEquity value = Equity value =

Sum of the values of the individual Sum of the values of the individual operating unitsoperating units

+ Marketable securities+ Marketable securities

- Corporate overhead- Corporate overhead

- Value of company debt and preferred stock- 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

Reasons for recommending the Reasons for recommending the enterprise DCF model:enterprise DCF model:

The model values the components of the The model values the components of the business (each operating unit) that add up to business (each operating unit) that add up to the enterprise value the enterprise value The approach helps to identify key leverage The approach helps to identify key leverage areasareasIt can be applied consistently to the company It can be applied consistently to the company as a whole or to individual business unitsas a whole or to individual business unitsIt is sophisticated enough to deal with the It is sophisticated enough to deal with the complexity of most situations, yet easy to complexity of most situations, yet easy to carry out with personal computer toolscarry out with personal computer tools


Value of operationsValue of operationsEquals the discounted value of expected future Equals the discounted value of expected future free cash flowfree cash flow

Free cash flowFree cash flow = = after tax operating earningsafter tax operating earnings

+ non-cash charges+ non-cash charges- investments in operating working - investments in operating working

capital, capital, property, plant, property, plant, and equipment, and equipment, and other and other assetsassets

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

received received from all the capital providersfrom all the capital providers


Value of operationsValue of operations

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

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


Value of operationsValue of operations

Indefinite life of a businessIndefinite life of a businessSeparate the value of the business into two periodsSeparate the value of the business into two periods

duringduring a precise forecast period a precise forecast periodafterafter a precise forecast period a precise forecast period

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

The value after the precise forecast period is the The value after the precise forecast period is the continuing valuecontinuing value

Continuing value = NOPLAT (1-g/ROICContinuing value = NOPLAT (1-g/ROICii))

WACC-g WACC-g


Value of debtValue of debtEquals the present value of the cash flow to Equals the present value of the cash flow to debt holders discounted at a rate that debt holders discounted at a rate that reflects the riskiness of that flowreflects the riskiness of that flow

Value of equityValue of equityEquals the value of the operations plus non-Equals the value of the operations plus non-operating assets, less the value of its debt operating assets, less the value of its debt and any non-operating liabilitiesand any non-operating liabilities


WACC Summary WACC Summary Hershey FoodsHershey Foods

Tax rate

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

Opportunity cost

After-tax cost

Free Cash Flow Free Cash Flow Valuation SummaryValuation Summary

Year DiscountFactor

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

1999 331 0.930 3082000 349 0.865 302

2008 485 0.485 235Continuing value 14,710 0.485 7,138

9,855Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385Equity value per share 62.78

Free cash flow

Present Value Of FCF

Drivers of Free Cash Flow and ValueDrivers of Free Cash Flow and Value

The rate at which the company is growingThe rate at which the company is growingGrowth Rate = ROIC x Investment rateGrowth Rate = ROIC x Investment rate

Return on invested capital (relative to the Return on invested capital (relative to the cost of capital, or WACC)cost of capital, or WACC)

ROIC = NOPLAT / Invested capitalROIC = NOPLAT / Invested capital

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


DriversDriversTo increase value, a company must do one To increase value, a company must do one or more of the followingor more of the following

Earn a higher return on invested capital Earn a higher return on invested capital on legacy assetson legacy assets

Ensure that ROIC(new) exceeds WACCEnsure that ROIC(new) exceeds WACC

Increase the growth rate (keeping ROIC Increase the growth rate (keeping ROIC above WACC)above WACC)

Reduce WACCReduce WACC


Growth Rate & Free Cash Growth Rate & Free Cash FlowFlow

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

How ROCI and Growth Drive How ROCI and Growth Drive ValueValue

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

Economic Profit ModelEconomic Profit Model

Useful measure for understanding a Useful measure for understanding a company’s performance in any single yearcompany’s performance in any single yearEconomic Profit equals the spread Economic Profit equals the spread between the return on invested capital between the return on invested capital and the cost of capital times the amount and the cost of capital times the amount of invested capitalof invested capitalEconomic profit = Economic profit =

Invested capital x (ROIC - WACC)Invested capital x (ROIC - WACC)Translates the two value drivers (growth Translates the two value drivers (growth and ROIC) into a single dollar figureand ROIC) into a single dollar figure

Economic Profit ModelEconomic Profit Model

Economic Profit is the after-tax operating profits Economic Profit is the after-tax operating profits less a charge for the capital used by the less a charge for the capital used by the companycompanyEconomic Profit = NOPLAT - Capital chargeEconomic Profit = NOPLAT - Capital charge

= NOPLAT - (invested capital x WACC)= NOPLAT - (invested capital x WACC)

The approach says that the value of a company The approach says that the value of a company equals the amount of capital invested plus a equals the amount of capital invested plus a premium or discount equal to the present value premium or discount equal to the present value of its projected economic profitof its projected economic profitValue = Invested capital + present value of projected Value = Invested capital + present value of projected economic economic profitprofit

Economic Profit CalculationEconomic 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

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 Economic Profit Valuation SummaryValuation Summary

Free Cash Flow Valuation Free Cash Flow Valuation SummarySummary

Equity Value 9,385

Economic Profit Valuation Economic Profit Valuation SummarySummary

Equity Value 9,385

Adjusted Present Value (APV) Adjusted Present Value (APV) ModelModel

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

APV model separates the value of operations APV model separates the value of operations into two componentsinto two components

The value of operations as if the company were The value of operations as if the company were entirely equity-financedentirely equity-financedThe value of the tax benefit arising from debt The value of the tax benefit arising from debt financingfinancing


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

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

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

Remember these guys from Finance 602?


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

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

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


The implications of The implications of MMMM for valuation in for valuation in a world without taxes area world without taxes are

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

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


The APV model The APV model

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

2)2) adds the impact of taxes from adds the impact of taxes from leverage.leverage.

APV Free Cash Flow APV Free Cash Flow Valuation SummaryValuation 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 APV Free Cash Flow Valuation Summary with Tax ImpactSummary 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


Equity Value 9,200

Free Cash Flow Valuation Free Cash Flow Valuation SummarySummary

Equity Value 9,385

Why is there a difference in the equity values?


Comparison…Comparison…

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

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

The The keykey to reconciling the two approaches is the to reconciling the two approaches is the calculation of the calculation of the WACCWACC


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

WACC = kWACC = kuu - k - kbb (B/(B+S)) T (B/(B+S)) T

WhereWhere kkuu = unlevered cost of equity = unlevered cost of equitykkbb = Cost of debt = Cost of debtT = Marginal tax rate on T = Marginal tax rate on

interest interest expensesexpensesB = Market value of debtB = Market value of debtS = Market value of equityS = Market value of equity

Enterprise DCF Adjusted for Enterprise DCF Adjusted for Changing Capital StructureChanging Capital Structure

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

A separate capital A separate capital structure and WACC structure and WACC can be estimated for can be estimated for every yearevery 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 Enterprise DCF Adjusted for Changing Capital for Changing Capital

StructureStructureEquity Value 9,200

The Equity DCF ModelThe Equity DCF Model

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

Equity DCF Equity DCF Valuation SummaryValuation 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


This model also needs to be adjusted for This model also needs to be adjusted for the changing capital structure. It is the changing capital structure. It is necessary to recalculate the cost of equity necessary to recalculate the cost of equity every period using the following formulaevery period using the following formula

kkss = k = kuu + (k + (kuu - k - kbb)(B/S))(B/S)

WhereWhere k kss = levered cost of equity = levered cost of equity

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

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


Equity Value 9,200

Adjusted Enterprise DCF Adjusted Enterprise DCF Valuation SummaryValuation Summary

Equity Value 9,200

Adjusted Equity DCF Adjusted Equity DCF Valuation SummaryValuation Summary

Equity Value 9,200


The equity DCF approach is not as useful The equity DCF approach is not as useful as the enterprise model as the enterprise model (except for (except for financial institutions)financial institutions) because because

Discounting cash flow provides less Discounting cash flow provides less information about the sources of value creationinformation about the sources of value creationIt us not as useful for identifying value-creation It us not as useful for identifying value-creation opportunitiesopportunitiesIt requires careful adjustments to ensure that It requires careful adjustments to ensure that changes in projected financing do not changes in projected financing do not incorrectly affect the company’s valueincorrectly affect the company’s valueIt requires allocating debt and interest expense It requires allocating debt and interest expense to each business unit, which creates extra to each business unit, which creates extra work, yet provides no additional information.work, yet provides no additional information.

Additional Models and Additional Models and ApproachesApproaches

Option Valuation ModelsOption Valuation ModelsModels which adjust for management’s Models which adjust for management’s ability to modify decisions as more ability to modify decisions as more information is made available.information is made available.

DCF ApproachesDCF ApproachesUsing real instead of nominal cash Using real instead of nominal cash flows and discount ratesflows and discount ratesDiscounting pretax cash flow instead Discounting pretax cash flow instead of after-tax cash flowof after-tax cash flowFormula-based DCF approachesFormula-based DCF approaches

Summary of ModelsSummary 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 ValuationFrameworks for Valuation

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Frameworks for Valuation

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