Introduction Two important distinctions Javier Estrada Price v . - - PDF document

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Introduction Two important distinctions Javier Estrada Price v . - - PDF document

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Corporate Finance DCF Valuation Javier Estrada Spring, 2014 1. Introduction Price v . Value Absolute valuation v . Relative valuation 2. DCF Models The general DCF model Steps Versions: WACC, APV, and FTE Complementary issues

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  • 1. Introduction
  • Price v. Value
  • Absolute valuation v. Relative valuation
  • 2. DCF Models
  • The general DCF model
  • Steps
  • Versions: WACC, APV, and FTE
  • Complementary issues

Corporate Finance

DCF Valuation

Javier Estrada Spring, 2014

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Introduction

  • Two important distinctions
  • Price v. Value
  • Price is what you pay, value is what you get!
  • Absolute valuation v. Relative valuation
  • Absolute valuation

 DCF models: DDM, WACC, APV, FTE  Value is derived from fundamentals in a PV calculation (Cash flows, not earnings, and their risk)

Go

  • Relative valuation

 Multiples: P/E, P/B, P/CF, P/D, …  Value is derived from alignment to a benchmark

  • Remember a critical point
  • When valuing stocks, there is ample room for

reasonable disagreement

Go

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The General DCF Model

  • Two key variables
  • Expected cash flows
  • T depends on the asset
  • Often a terminal value plays a role in E(CFT)
  • Discount rate
  • R = Rf + RP

 Rf : Risk‐free rate (Compensates the expected loss of purchasing power)  RP: Risk premium (Compensates risk bearing)

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

DCF Model – Steps

  • Basic steps
  • 1. Choose a model
  • 2. Estimate the appropriate free cash flows (FCF) for

that model over the forecasting period (T)

  • 3. Estimate a terminal value (TV)
  • 4. Estimate the appropriate discount rate (DR) for

that model

  • 5. Calculate the present value of all FCFs discounted

at the DR

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 1 – Model

  • There are several versions of the DCF model
  • WACC model
  • Discounts unlevered FCFs at the cost of capital
  • APV model
  • Discounts unlevered FCFs at the unlevered cost of

equity

  • Adds the net present value of debt effects
  • FTE model
  • Discounts levered FCFs at the cost of equity
  • Recall
  • The DDM is just another version of the DCF model
  • Discounts dividends at the cost of equity

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 2 – Free Cash Flows

  • Remarks
  • FCFs can also be calculated beginning from EBIT
  • UFCF = (1–tc)⋅EBIT + Dep – Net CapEx – Increase NWC
  • UFCFs are independent from the capital structure

Go

Income Statement Free Cash Flows Revenues Net Income – Operating Costs + After‐tax Interest – Depreciation + Depreciation EBIT Operating Cash Flow – Interest – Net CapEx Earnings Before Taxes – Increase in NWC – Taxes Unlevered FCF (UFCF) Net Income – After‐tax Interest Levered FCF (LFCF)

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 3 – Terminal Value

  • The terminal value can be estimated in several

ways, and is usually estimated in one of two ways

  • A growing perpetuity
  • A multiple (M) of a fundamental variable

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 4 – Discount Rate

  • The discount rate depends on the FCFs used,

which in turn depends on the model chosen

  • WACC model
  • Cost of capital (RWACC)
  • APV model
  • UFCFs at the unlevered cost of equity (RU)

 CAPM with an unlevered beta

  • Tax shields at the required return on debt (RD)
  • FTE model
  • Levered cost of equity (RL)

 CAPM with a levered beta

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 5 – Present Value Calculation

  • WACC model

Go

  • Remarks
  • The PV of the UFCFs yields the value of the company
  • V = D+E
  • The value of the company’s equity is obtained after

subtracting the assumed long‐term debt from V

  • E = V–D
  • The impact of debt is accounted for in RWACC

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 5 – Present Value Calculation

  • APV model
  • Remarks
  • The value of the company is given by the PV of the

UFCFs plus the net impact of debt (V=D+E)

  • The value of the company’s equity is obtained after

subtracting the assumed long‐term debt from V (E = V–D)

  • The impact of debt is accounted for in the usually‐

miswritten last term ‘NPV(D)’

  • Unfortunately, the APV is usually written as …
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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Step 5 – Present Value Calculation

  • FTE model
  • Remarks
  • The PV of the LFCFs yields the value of the

company’s equity

  • No debt has to be subtracted from this value
  • The impact of debt is accounted for both in the

LFCFs and in RL

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Complementary Issues

  • WACC model (Valid for the other models as well)
  • Forecasting period
  • How long? What growth rate?
  • Stages of growth
  • How long each? What growth rate for each?
  • Terminal value

Go

  • Can easily be 40‐60% of the estimated value
  • Always perform sensitivity analysis on it (on g or M)
  • Keep in mind long‐term constraints (g ≤ gGDP)
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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Complementary Issues

  • In theory, all three models (and the DDM) should

yield exactly the same result

  • In practice, they hardly ever do
  • When to use each model?
  • WACC or FTE
  • Usually when the proportions of debt and equity are

expected to be (more or less) constant over time

  • APV
  • Usually when the level of future debt is (more or less)

known in advance

  • Other issues that have to be dealt with
  • Circularity, target capital structures, …

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Appendix

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Why Cash Flow?

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Why Cash Flow?

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Reasonable Disagreements

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Reasonable Disagreements

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

UFCFs and Capital Structure

Income Statement No Debt With Debt Revenues 16,667 16,667 – Operating Costs 15,000 15,000 – Depreciation 100 100 = EBIT 1,567 1,567 – Interest 300 = EBT 1,567 1,267 – Taxes (40%) 627 507 = Net Income 940 760 UFCFs Net Income 940 760 + After‐tax Interest 180 + Depreciation 100 100 = Operating CF 1,040 1,040 – Increase in NWC 100 100 – Net CapEx 100 100 = Unlevered FCF 840 840

Back Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The WACC Model

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Terminal Value

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Terminal Value

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