Professor Petersen

Valuation Tutorial
I)

Cash Flow Calculation The Numerator. A) Cash Flows: Not Accounting Earnings. 1) Forecasting earnings. a) Forecast sales. Most pro-forms will start with a sales forecast, and then other variables will be functions of sales. What will cause the sales to rise or fall in our forecasts? b) Forecast profit margin. By specifying a profit margin or costs as a percent of sales, we can have costs move with sales. However, the profit margin may rise or fall with our forecasts. Why would you expect them to rise or fall? c) Equilibrium profit margin. At the end of your pro-forma, you must believe the market is in some form of equilibrium. What determines the long run equilibrium profit margin? d) Earnings before interest and taxes. EBIT is where we start. This is revenues minus costs minus depreciation. I want to separate out depreciation. Even though it is a cost, since it is a non-cash cost. A non-cash cost is a cost which is called a cost in the income statement, but does not represent cash flowing out of the firm today. 2) Taxes. Corporations pay taxes and thus we must subtract off these cash flows. The taxes you subtract off should be cash taxes, not accounting taxes. 3) Operating profit from operations. This is defined as EBIT minus taxes. If the tax rate is constant this is EBIT * (1-). 4) Interest expense.2 We are excluding interest payments from our calculation of cash flow to assets. Interest is cash flow to debt which comes from the

This is an abbreviated version of what is covered in corporate finance (441 Finance II). It is designed to give you some of the language and some of the intuition prior to interviews. The long term key to successfully using these concepts is the ability to internalize them, integrate them into your thinking, and be able to explain them (teach them) in your own words. This is why it takes ten weeks in Finance II. One keys to valuation is to be consistent. Thus when discounting cash flows, you want to make sure the cash flow (in the numerator) and the discount rate (in the denominator) match. This means we discount the cash flow to assets at the asset discount rate, the cash flows to debt at the debt discount rate, and the cash flow to equity at the equity discount rates. CFA ' CFD % CFE A ' D % E ' CFA CFD CFE ' % 1 % rA 1 % rD 1 % rE
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The problem with subtracting off interest and not principal payments, is the resulting number is not the cash flow to assets (you have subtracted off interest), nor the cash flow to equity (you have not subtracted off principal payments).

Copyright 2005, Mitchell A. Petersen

B)

cash flow to assets. Consistency gets you a long way in finance. If you are valuing assets, you want the cash flow to assets. Changes in Net Working Capital. The difference between cash flow and earnings is capital expenditures. We will discuss two types of capital expenditure. The first is net working capital. 1) Definition. Net working capital is defined as current assets (excluding cash) minus current liabilities (excluding short term debt). By adjusting for changes in net working capital, we transform earnings into cash flow. Assets Liabilities

2) 3)

Increases in net working capital are a negative cash flow. Examples. This example demonstrates where accounting earnings and actual cash flows can differ significantly. a) No net working capital. Firm purchases a TV for $80 and sells it for $100 today. Both the purchase and the sale are cash transactions. Last Year Revenue Cost EBIT 8 NWC Net Cash Flow b) Accounts receivable. Firm purchases a TV for $80 and sells it for $100. The patients are given one year to pay. Last Year Revenue Cost EBIT 8 NWC Net Cash flow c) Accounts receivable and inventory. Firm purchased a TV last year 2 Valuation Tutorial Today 100 80 20 Next Year Today 100 80 20 Next Year

for $80 and sells it for $100 today. The customer is given one year to pay. The firms supplier was paid last year when the depressors were delivered. Last Year Revenue Cost EBIT 8 NWC Net Cash flow 4) 5) Recapture of net working capital. Net working capital accounts to exclude. We include almost all current assets and current liabilities when we calculate changes in net working capital. There are two exceptions. a) Short term debt is not included in current liabilities. We want to value the assets of a firm. Thus we want to discount the cash flows to assets at the asset discount rate. b) Cash is not included in current assets. We do not include cash because this is what we are trying to calculate. If we included cash as a current asset, our calculated cash flow would be zero. Capital Costs. This refers to long-term capital expenditures: investments in property, plant and equipment. Accounting and finance recognize investment expenditure at different times. What is the logic behind this difference? 1) Initial capital expenditure. 2) Depreciation. Depreciation is treated as a cost for accounting and tax purposes, but it is not a negative cash flow. 3) Sale of asset at projects completion. When we sell the capital equipment at the end of the project, this is a positive cash flow. If we have to pay to have the equipment or land scrapped, this is a negative cash flow. 4) Tax consequences of an asset sale or writeoff. When we sell an asset or write off and dispose of an asset, this will have tax consequences if the sale price differs from our basis. Which basis should we use for this calculation? 5) Net investment. Net investment is annual capital expenditure minus depreciation. This is the net amount we must invest (if this is positive) to maintain our business and generate the predicted sales. One thing to look at is how the level of depreciation relates to the level of capital expenditure. What does it mean if depreciation is larger than capital expenditure? Summary. We calculate cash flow as follows: Today 100 80 20 Next Year

C)

D)

Copyright 2005, Mitchell A. Petersen

Cashflow ' Revenue & Costs & Depreciation & Taxes[ R & C & D ] % Depreciation & Capital Expenditure & Increase in NWC % Salvage value & Taxes on salvage value % Recapture of NWC

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II)

Calculating the Projects Cost of Capital. To know the correct discount rate for a project we need to know how what required rate of return investors will demand for purchasing the securities of a firm. This will determine the firms cost of capital. A) Return on the Firms Assets. If we can calculate the expected return on the firms assets, this will be the firms cost of capital. When we say the firms assets, what are we including? 1) Assets are a portfolio. When you invest your personal or pension investments, you allocate your investment portfolio across different assets (e.g. stocks and bonds). The value of your portfolio is the sum of the value of all the stocks and bonds (or assets) in your portfolio. We can think of a firms assets in the same way. The assets of the firm are the sum of the values of the firms securities. Assets ' Debt % Equity 2) (2)

Expected return on firms assets. Since the firms assets are equal to its debt plus its equity, how do we calculate the return on the firms assets? We use the same method. D E % rE rA ' rD (3) D%E D%E Debt is tax favored. The tax code in the US, and many other countries, does not treat debt and equity equally. When a firm pays dividends to its shareholders, this comes out of after tax profits. When a firm pays interest to its debt holders, this comes out of pre-tax profits. Thus the cost of capital is: WACC ' (1 & ) r D D E % rE D%E D%E (4)

3)

B)

This is often called the firms weighted average cost of capital (WACC). Source of Capital: Debt and Equity. We want to calculate the cost of capital for a firm. Thus we need to know where to look up or estimate all the numbers in the cost of capital formula (equation 5).The first set of numbers we will get is the debt and equity ratios. This is the fraction of the firm which is financed with debt and with equity. Where do we get the debt and equity numbers? 1) Market ratios. Market values are the price at which you can buy or sell the securities in the open market. 2) Book values as estimates. Book values are the amounts reported on a firms 4 Valuation Tutorial

C)

balance sheet. 3) More complicated capital structures. Many firms have more complicated capital structures than the one here. They have multiple types of debt (short term bank debt and long term bonds) or multiple types of equity (preferred and common). In this case, we just have more terms in our cost of capital expression. We will need one term for each source of capital. Cost of Debt. Once we know how much debt and equity we have, we need to calculate the cost of the debt and the equity. 1) Definitions of Debt Returns. The cost of debt can be calculated from the rate we have to pay on the debt. There are three rates of return when it comes to debt. It is essential they be clear in your mind. If not, you might use the wrong one when valuing projects or firms. a) Coupon rate. This is the interest rate contractually set by the firm. The firm decides with the help of their investment bankers what rate of interest the debt will pay. Thus if debt with a maturity of one year has a face value of $100 and a coupon rate of 10%, then bond holders will receive and interest payment of $10 at the end of the year plus their principal ($100). b) Promised rate.3 This rate is not set by the firm, but by the market. It is based on the markets assessment of how risky the debt is. The higher the risk of default or the lower the credit rating, the higher the promised rate which the market will demand. Thus if the bond (face value of $100, coupon rate of 10%, and a one year maturity) sold for 97, then the promised rate would be 13.4%. Price ' FV (1 % rcoupon ) (5) 1 % rpromised 100 (1 % 0.10 ) ' ' 97 1 % rpromised 100 (1 % 0.10 ) & 1 ' 13.4% ' 97

rpromised

c)

In many cases, the promised return and coupon rate are the same when firms issue debt. In this case, the bond was issued at par. This means the bond was sold for face value. Expected rate of return. We are going to discount expected cash flows to assets at expected rate of return on assets. The expected return on assets is a weighted average of the expected return on debt and the expected return on equity. Thus the correct cost of debt is the expected, not the promised, return on debt. The more likely the bond

Traders usually refer to the yield on a bond. By this they mean the promised return. I will use return and yield interchangeable. When you use a bond yield, keep track of whether it is a promised or expected yield.

Copyright 2005, Mitchell A. Petersen

D)

is to default and the worse the return if the bond does default, the greater the difference between the expected and promised return. Cost of Equity. Asset pricing models are financial models which explain what the expected return on assets should be. The most common model/method which is used to estimate the risk of an asset and thus the cost of capital for an asset, equity in this case, is the capital asset pricing model (CAPM). It has two advantages. First, it is the most widely used model. More importantly, the intuition behind the model makes a lot of sense and you can explain it to someone who doesnt understand finance. 1) Decomposing Risk. The return on an asset can be divided into three components. The first is the riskfree return. The second and third terms are the risky parts of the returns. rEquity ' rriskfree % Equity ( rmarket & rriskfree ) % (6)

2)

Two Types of Risk: Definitions. The risk of an asset can be divided into two sources of risk: systematic and firm-specific. The risk of an assets is often measured as the variance of its return. Risk( rEquity ) ' 0 % Equity Risk ( rmarket ) % Risk( ) a)
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3)

Systematic risk. This is also called market risk, economy wide risk, and undiversifiable risk. This is the part of the variability in the return to a project which is correlated with, or related to, how well the economy is doing. If you think of the entire economy as a pie, this is how the pie grows in booms and shrinks in recessions. b) Idiosyncratic risk. This is also called firm specific risk, unique risk, or diversifiable risk. This is the part of the risk that is unrelated to how well the economy is doing. This risk is how the pie is divided up. Compensation for Risk. The reason we care about risk is because it affects our firms cost of capital. Our investors dont like risk. Thus if our projects are riskier than our investors will demand a higher rate of return and our cost of capital will go up. a) Payment for risk: The math. Although an investment can and in general will have both types, only the systematic risk is compensated. By compensated, I mean assets with more systematic risk have higher expected returns. Assets with more idiosyncratic risk do not have higher expected returns. E[ rEquity ] ' rriskfree % Equity E[ rmarket & rriskfree ] (8)

Valuation Tutorial

b)

Payment for risk: The intuition. 1) Investors are risk averse. Thus, if we want them to give us capital to invest in a risky project on their behalf, we have to bribe them for bearing the risk. The bribe is the higher expected return they receive from a risky project opposed to a riskfree project. 2) Firm specific risk need not be borne by investors. For example, how do you avoid the risk that one firm loses market share and another firm gains market share? 3) Systematic risk must be borne by investors. Once you own all firms, you still have a risky portfolio. How do you avoid bearing this risk? 4) Assumptions versus conclusions. You will often hear in classrooms and in finance discussions outside of classrooms that you dont get paid (compensated) for bearing firm specific (idiosyncratic) risk. This is not an assumption. It is a conclusion. The argument is that if investors are well diversified, they dont get compensated for bearing firm specific risk, because they dont bear the risk.

Copyright 2005, Mitchell A. Petersen

E)

Calculating the Cost of Equity. To calculate the cost of equity, we use the Capital Asset Pricing Model (CAPM) formula from above. Thus we need to calculate or look up three numbers: The riskfree rate, the firms equity beta, and the market price of risk. rEquity ' rriskfree % Equity E[ rmarket & rriskfree ] 1) (9)

Risk free rate. We will use the return on government securities, i.e. shortterm T-bills, as our proxy for the risk-free rate.
Term Structure of Govt Bond Yields
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0 0 5 10 15 20 25 30

2) 3)

Market price of risk. This is the expected amount by which the (stock) market will beat the riskfree rate (E[ rMarket - rRiskfree ]). Equity . We can obtain this from data vendors or estimate it ourselves.

Sara Lee's Beta

Valuation Tutorial

III)

Terminal Value Valuation. This is the way to value the cash flows that the project will generate after year T. A) Value of a growing perpetuity. First we need the formula for the value of a growing perpetuity. This is the value of a perpetuity that pays a cash flow of C next year and then grows at g percent forever. We saw this in a previous session. C1 C2 C3 PV ' % % ... (1%r) (1%r)2 (1%r)3 C C (1%g) C (1%g)2 ' % % ... (10) (1%r) (1%r)2 (1%r)3 4 C (1%g)t&1 C ' ' j t r & g t' 1 (1%r) B) Exit Value. We forecast the cash flows for a fixed number of years (T). The value of the cash flows in the years after year T can be valued by using the expression for a growing annuity. From our forecasts, we know the expected cash flow is in the final year (T). Given our assumed long term growth rate (g), we can estimate the expected cash flow in the next year. Then apply the formula for a growing perpetuity is straight forward. Terminal valueT ' E[ FCF T%1 ] r & g r & g 1 % g ' E[ FCF T ] r & g ' ( Exit Multiple ) E[ FCF T ] ' E[ FCF T (1 % g) ] (11)

C)

Choosing the growth rate. We already have the discount rate which we used to discount the first T years of cash flows. Thus the only additional assumption which is required is the long term (in perpetuity) growth rate.

Copyright 2005, Mitchell A. Petersen

IV)

Multiples Valuation. Unlike discounted cash flow, multiples have the advantage that you only need to make one assumption that the firm you are valuing and the firms you are using as comparables are the same in the relevant dimensions. One challenge of A) Grocery Store Comparison. B) Hierarchy of Multiples. There are an infinite number of multiples. One challenge is to figure out which mutiple to use. 1) Numerator: Equity or Asset Value. Since leverage alters most equity value multiples, even when there is no change in the value of the firm, I have a preference for asset value multiples. This is particularly appropriate if you are valuing the firm for example for an aquisition, spinn off or sale. 2) Denominator. There are many more choices here. Most (reasonable) multiples are based on a flow variable which can range from sales through income (with many definitions) to cash flow. Different multiples contain different assumptions. Thus your choice of multiple is driven in part on how many assumptions you want to make. C) Valuation versus Pricing. Multiples is not a valuation technique unless your MBA is from the University of Chicago.

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Valuation Tutorial