11/2/2018 Nattawoot Koowattanatianchai 1 Investment Analysis & - - PowerPoint PPT Presentation

11/2/2018 Nattawoot Koowattanatianchai 1

11/2/2018 Nattawoot Koowattanatianchai 2

Investment Analysis & Portfolio Management

Assistant Professor Nattawoot Koowattanatianchai, DBA, CFA

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Email: :

 fbusn

snwk@k wk@ku. u.ac. c.th th

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• ot.htm

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Phone:

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• t. 1212

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Lecture 3

Stock Valuation: Free Cash Flow Model

Discussion topics

 Reviewing dividend discount

models

 free cash flow valuation

models

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Readings

 CFA Program Curriculum 2015 -

Level II – Volume 4: Equity.

 Readings 33-34

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Stock valuation

 Selecting the appropriate valuation model

 Absolute valuation model

 specifies an asset’s intrinsic value using present value

models.

 Dividend Discount Model  Free

ee Cas ash h Flow w Model del

 Residual Income model

 Relative valuation model

 estimates an asset’s value relative to that of another asset.  Price multiples  Enterprise value multiples

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Free cash flows (FCFs)

 Differences between FCF and dividends

 Whereas dividends are the cash flows actually paid

to stockholders, FCFs are the cash flows available for distribution to shareholders.

 Free cash flow to the firm: FCFF

 The cash flow available to the company’s suppliers

• f capital after all operating expenses (including

taxes) have been paid and necessary investments in working capital (e.g., inventory) and fixed capital (e.g., equipment) have been made.

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Free cash flows (FCFs)

 Free cash flow to equity: FCFE

 The cash flow available to the company’s holders

• f common equity after all operating expenses,

interest, and principal payments have been paid and necessary investments in working and fixed capital have been made.

 FCFE is the cash flow from operations minus

capital expenditures minus payments to (and plus receipts from) debtholders.

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Free cash flows (FCFs)

 Common equity valuation

 Common equity can be valued directly by using

FCFE or indirectly by first using a FCFF model to estimate the value of the firm and then subtracting the value of non-common-stock capital (usually debt) from FCFF to arrive at an estimate of the value of equity.

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Free cash flows (FCFs)

 Analysts like to use FCF as the return (either

FCFF or FCFE) whenever one or more of the following conditions is present:

 The company does not pay dividends.  The company pays dividends but the dividends

paid differ significantly from the company’s capacity to pay dividends.

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Free cash flows (FCFs)

 Analysts like to use FCF as the return (either

FCFF or FCFE) whenever one or more of the following conditions is present:

 FCFs align with profitability within a reasonable

forecast period with which the analyst is comfortable.

 The investor takes a “control” perspective. If an

investor can take control of the company (or expects another investor to do so), dividends may be changed substantially.

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Present value of FCF



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Present value of FCF



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Single-stage FCF models

 Constant-growth FCFF valuation model

 Firm value = FCFF1/(WACC – g)

 Firm value = [FCFF0(1+g)]/(WACC – g)



The model assumes that FCFF grows at a constant rate, g, such that FCFF in any period is equal to FCFF in the previous period multiplied by (1+g).

 Constant-growth FCFE valuation model

 Equity value = FCFE1/(r – g)

 Firm value = [FCFE0(1+g)]/(r – g)



The model assumes that FCFE grows at a constant rate, g. FCFE in any period is equal to FCFE in the preceding period multiplied by (1+g).

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Single-stage FCF models

 Example 1

 Cagiati Enterprices has FCFF of 700 million Swiss

frans (CHF) and FCFE of CHF620 million. Cagiati’s before-tax cost of debt is 5.7%, and its required rate of return for equity is 11.8%. The company expects a target capital structure consisting of 20% debt financing and 80% equity financing. The tax rate is 33.33%, and FCFF is expected to grow forever at 5%. Cagiati Enterprises has debt outstanding with a market value of CHF 2.2 billion and has 200 million

• utstanding common shares.

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Single-stage FCF models

 Example 1

 Computing WACC

 WACC = .20(5.7%)(1-.3333) + .80(11.8%) = 10.2%

 Computing equity value using FCFF

 Firm value = [700(1.05)]/(.102 - .05) = CHF14,134.6

million

 Equity value = 14,134.6 – 2,200 = CHF11,934.6 million

 Computing equity value per share

 V0 = CHF11,934.6/200 = CHF59.67

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Computing FCFF from net income

 FCFF = NI + NCC + Int× (1 – Tax rate) –

FCInv - WCInv

 NI = Net income available to common

shareholders

 NCC = Net noncash charges  Int = Interest expense  FCInv = Investment in fixed capital  WCInv = Investment in working capital

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Computing FCFF from net income

Cane ne Distribu ribution, ion, Inc. Inc ncom

• me Stat

atem ement ent (in n Thou

• usand

nds) Year ar Ending ding 31 Decem embe ber 2010 2011 2012 EBITDA $200.00 $220.00 $242.00 Deprec preciat iation ion expe pens nse 45.00 49.50 54.45 Oper erat ating ing income 155.00 170.50 187.55 Int nter eres est expen pense (at at 7%) 15.68 17.25 18.97 Inc ncom

• me bef

efor

• re

e tax axes es 139.32 153.25 168.58 Inc ncom

• me tax

axes (at at 30%) %) 41.80 45.97 50.58 Net inc ncom

• me

$97.52 $107.28 $118.00

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 Example 2

 Calculate the FCFF for Cane Distribution, Inc.

Computing FCFF from net income

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Cane ne Distribu ribution, ion, Inc. Balanc lance e Sheet eet (in n Thous

• usan

ands ds) Year ar Ending ding 31 Decem embe ber 2009 2010 2011 2012 Cash $0.00 $108.92 $228.74 $360.54 Account unts receiv ivable ble 0.00 100.00 110.00 121.00 Inv nven entory ry 60.00 66.00 72.60 79.86 Curr urren ent asset ets 60.00 274.92 411.34 561.40 Fixed ed assets 500.00 500.00 550.00 605.00 Les ess: Accum umulat lated ed deprec eprecia iatio ion 0.00 45.00 94.50 148.95 Tot

• tal

l asset ets $560.00 $729.92 $866.84 $1,017.4 5 Account unts payab able le $0.00 $50.00 $55.00 $60.50 Curren rrent port

• rtio

ion n of long ng-ter erm debt bt 0.00 0.00 0.00 0.00 Curr urren ent liabilit abilitie ies 0.00 50.00 55.00 60.50 Long ng-ter erm debt bt 224.00 246.40 271.04 298.14 Common n stoc

• ck

336.00 336.00 336.00 336.00 Retain ained ed earn rning ings 0.00 97.52 204.80 332.80 Tot

• tal

l liabilit abilities ies and nd equit uity $556.00 $729.92 $866.84 $1,017.4 5

Computing FCFF from net income

Cane ne Distribu ribution, ion, Inc. Work rking ing Capit ital al (in n Thou

• usand

nds) Year ar Ending ding 31 Decem embe ber 2009 2010 2011 2012 Curren rrent asset ets exclu luding ding cas ash Account unts receiv ivable ble $0.00 $100.00 $110.00 $121.00 Inv nven entory ry 60.00 66.00 72.60 79.86 Tot

• tal

l curre urrent nt assets exclu ludin ding g cash 60.00 166.00 182.60 200.86 Curren rrent liabilit abilities ies exclud luding ing short hort-term rm debt bt Account unts payab able le 0.00 50.00 $55.00 $60.50 Work rkin ing g capit pital al $60.00 $116.00 $127.60 $140.36 Inc ncre reas ase e in work rkin ing g capit pital al $56.00 $11.60 $12.76

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Computing FCFF from net income

Cane ne Distribu ribution, ion, Inc. FCFF (in n Thou

• usand

nds) Year ar Ending ding 31 Decem embe ber 2010 2011 2012 Net inc ncom

• me

$97.52 $107.28 $118.00 Noncas ncash h char arge ges - Depre precia iatio ion 45.00 49.50 54.45 Intere rest expe pens nse e × (1 (1-Tax rat ate) e) 10.98 12.08 13.28 Investment nt in fixed ed capit apital al (0.00) (50.00) (55.00) Investment nt in work rking ing capit apital (56.00) (11.60) (12.76) FCFF FCFF $97.50 $107.26 $117.87

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Computing FCFF from CFO

 FCFF = CFO + Int × (1 – Tax rate) – FCInv

 CFO = Cash flow from operations  Int = Interest expense  FCInv = Investment in fixed capital

 Example 3

 Calculate Cane Distribution’s FCFF from the

statement of cash flows

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Computing FCFF from CFO

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Cane ne Distribu ribution, ion, Inc. Stat atem ement nt of Cash h Flow

• ws: Indire

ndirect Metho hod d (in n Thous

• usand

ands) Year ar Ending ding 31 Decem embe ber 2010 2011 2012 Cash h flow

• w from

rom opera eratio ions ns Net inc ncom

• me

$97.52 $107.28 $118.00 Plus us: Depre precia iatio ion n 45.00 49.50 54.45 Incre ncreas ase e in accou

• unt

nts receiv eceivable able (100.00) (10.00) (11.00) Inc ncre reas ase e in inven entory

• ry

(6.00) (6.60) (7.26) Inc ncre reas ase e in accou

• unt

nts pay ayable able 50.00 5.00 5.50 Cash h flow

• w from

rom opera eratio ions ns 86.52 145.18 159.69 Cash h flow

• w from

rom inves estin ing g activ ivit ities ies Purc rchas ase e of PP&E 0.00 (50.00) (55.00) Cash h flow

• w from

rom finan nancin ing g activ ivit ities ies Borro rrowin ing g (rep epay aymen ent) 22.40 24.64 27.10 Total l cas ash flow

• w

$108.92 $119.82 $131.80 Beginn ginning ing cas ash 0.00 108.92 228.74 Ending ding cas ash $108.92 $228.74 $360.54 Notes es: Cash h paid id for r interes rest ($15.68) ($17.25) ($18.97) Cash h paid id for r tax axes es ($41.80) ($45.98) ($50.57)

Computing FCFF from CFO

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Cane ne Distribu ribution, ion, Inc. FCFF (in n Thou

• usand

nds) Year ar Ending ding 31 Decem embe ber 2010 2011 2012 Cash h flow

• w from

rom opera eratio ions ns $86.52 $145.18 $159.69 Int nter eres est expen pense×(1 (1 – Tax rate) 10.98 12.08 13.28 Inv nves estmen ent in fixed d capit pital al (0.00) (50.00) (55.00) FCFF FCFF $97.50 $107.26 $117.97

Noncash items and FCFF

Noncas ash h item Adjus ustment ment to NI t to arrive e at FCFF Depreci eciat ation

• n

Added back Amorti tizat ation

• n and impai

airment ent of intangi angibl bles es Added back Restruc uctur uring ng charges ges (expens pense) e) Added back Restruc uctur uring ng charges ges (incom

• me

e resulti ting ng from reversal rsal) Subtracted Losses es Added back Gains Subtracted Amorti tizat ation

• n of long-term

erm bond d discounts

• unts

Added back Amorti tizat ation

• n of long-term

erm bond d premiums ums Subtracted Deferred ed taxes es Added back but calls for special attention

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Computing FCFE from FCFF

 FCFE = FCFF - Int× (1 – Tax rate) + Net

borrowing

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Cane ne Distribu ribution, ion, Inc. FCFE E (in n Thous

• usan

ands ds) Year ar Ending ding 31 Decem embe ber 2010 2011 2012 FCFF FCFF $97.50 $107.26 $117.97 Inter nteres est expen pense×(1 (1 – Tax rate) ate) (10.98) (12.08) (13.28) New debt bt borr rrow

• wing

ing 22.40 24.64 27.10 Debt bt repa payment ent (0) (0) (0) FCFE FCFE 108.92 119.82 131.79

Computing FCFE from NI & CFO

 FCFF = NI + NCC + Int× (1 – Tax rate) –

FCInv – WCInv

 ∵ FCFE = FCFF - Int× (1 – Tax rate) + Net

borrowing

  FCFE = NI + NCC – FCInv – WCInv + Net

borrowing

 FCFF = CFO + Int × (1 – Tax rate) – FCInv

 ∵ FCFE = FCFF - Int× (1 – Tax rate) + Net

borrowing

  FCFE = CFO – FCInv + Net borrowing

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Computing FCFF from EBIT

 Assume that the only NCC is Depreciation

(Dep)

 FCFF = NI + Dep + Int× (1 – Tax rate) – FCInv –

WCInv

 ∵ NI = (EBIT – Int)×(1 – Tax rate) = EBIT(1 – Tax rate) –

Int(1 – Tax rate)

  FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv

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Computing FCFF from EBITDA

 Assume that the only NCC is Depreciation

(Dep)

 FCFF = NI + Dep + Int× (1 – Tax rate) – FCInv –

WCInv

 ∵ NI = (EBITDA – Dep – Int)×(1 – Tax rate) = EBITDA(1

– Tax rate) – Dep(1 – Tax rate) – Int(1 – Tax rate)

  FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) –

FCInv – WCInv

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Two-stage FCF models



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Two-stage FCF models

 Example 3

 Uwe Henschel is doing a valuation of

TechnoSchaft on the basis of the following information:

 Year 0 sales per share = €25  Sales growth rate = 20% annually for 3 years and 6%

annually thereafter.

 Net profit margin = 10% forever.  Net investment in fixed capital (net of depreciation) =

50% of the sales increase.

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Two-stage FCF models

 Example 3

 Uwe Henschel is doing a valuation of

TechnoSchaft on the basis of the following information:

 Annual increase in working capital = 20% of the sales

increase.

 Debt financing = 40% of the net investments in capital

equipment and working capital.

 TechnoSchaft beta = 1.2; the risk free rate of return =

7%; the equity risk premium = 4.5%.

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Two-stage FCF models

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 Example 3

 FCFE estimates for TechnoSchaft (in Euros)

yea ear 1 2 3 4 5 6 Sale les s growth wth rate te 20% 20% 20% 6% 6% 6% Sale les s per er sha hare 30.000 36.000 43.200 45.792 48.540 51.452 Net t profit fit margin rgin 10% 10% 10% 10% 10% 10% EPS EPS 3.000 3.600 4.320 4.579 4.854 5.145 Net t FCInv per r share re 2.500 3.000 3.600 1.296 1.374 1.456 WCInv v per r share re 1.000 1.200 1.440 0.518 0.550 0.582 Debt t financin cing per r share re 1.400 1.680 2.016 0.726 0.769 0.815 FCFE per r share re 0.900 1.080 1.296 3.491 3.700 3.922 Growth wth rate te of FCFE 20% 20% 169% 6% 6%

Two-stage FCF models

 Example 3

 Computing the rate of return for equity using

CAPM:

 r = E(Ri) = RF + βi × [E(RM) - RF] = 7% + 1.2(4.5%) =

12.4%

 The terminal value of FCFE from years 4 and

later:

 TV3 = FCFE4/(r – g) = 3.491/(0.124 – 0.06) = €54.55

 Present values:

 V0 = 0.900/1.124 + 1.080/(1.124)2 + 1.296/(1.124)3 +

54.55/(1.124)4 = €40.98

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Three-stage FCF models

 Example 4

 Charles Jones is evaluating Reliant Home

Furnishings by using a three-stage growth model. He has accumulated the following information:

 Current FCFF = $745 million.  Outstanding shares = 309.39 million.  Equity beta = 0.90; risk-free rate = 5.04%; equity risk

premium = 5.5%.

 Cost of debt = 7.1%

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Three-stage FCF models

 Example 4

 Charles Jones is evaluating Reliant Home

Furnishings by using a three-stage growth model. He has accumulated the following information:

 Marginal tax rate = 34%  Capital structure = 20% debt, 80% equity.  Long-term debt = $1.518 billion.  Growth rate of FCFF =  8.8% annually in stage 1, Years 1 – 4.  7.4% in Year 5, 6.0% in Year 6, 4.6% in Year 7.  3.2% in Year 8 and thereafter.

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Three-stage FCF models

 Example 4

 The require return for equity is

 r = E(Ri) = RF + βi × [E(RM) - RF] = 5.04% + 0.9(5.5%) =

9.99%

 WACC is

 WACC = 0.2(7.1%)(1 – 0.34) + 0.80(9.99%) = 8.93%

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Three-stage FCF models

 Example 4

 Forecasted FCFF for Reliant Home Furnishings

11/2/2018 Nattawoot Koowattanatianchai 39 year 1 2 3 4 5 6 7 8 Growth wth rate te 8.80% 8.80% 8.80% 8.80% 7.40% 6.00% 4.60% 3.20% FCFF 811 882 959 1,044 1,121 1,188 1,243 1,283 PV at 8.9 .93% 744 743 742 741 731 711 683

Three-stage FCF models

 Example 4

 The terminal value at the end of Year 7 is

 TV7 = FCFF8/(WACC – g) = 1,283/(0.0893 – 0.032) =

$22,391 million

 The present value of TV7 discounted at 8.93% for

7 years is

 PV of TV7 = 22,391/(1.0893)7 = $12,304 million

 The total present value of the first seven years of

FCFF is $5,097 million. The total value of the firm is therefore 12,304 + 5,097 = $17,401 million.

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Three-stage FCF models

 Example 4

 The value of the equity is the value of the firm

minus the market value of debt:

 17,401 – 1,518 = $15,833 million

 The value per share:

 $15,833/309.39 million = $51.34

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