BUSINESS VALUATION MODELS Two methods: 1. Discounted Cash Flow 2. Relative Values

Estimating Intrinsic Value Present value of cash flows (PVCF) 1. Present value of free cash flow (FCFF) 2.Present value of free cash flow to equity (FCFE) 3. Adjusted Present Value

Discounted Cash Flows 1. Present value of free cash flow (FCFF) or (WACC) Approach: The Weighted Average Cost of Capital estimates a company’s value by discounting its unlevered free cash flows using a constant weighted average cost of capital.

Discounted Cash Flows 1) Unlevered free cash flows (UFCF) 2) Unlevered terminal free cash flow (UTFCF) 3) Expected future growth rate (g) 4) Weighted Average Cost of Capital, RWACC )

Discounted Cash Flows This method requires estimation of

Estimation of Unlevered FCF EBIT Less:Cash Taxes on EBIT Plus:Depreciation and Amortization Operating Cash Flow (OCF) Less:Increase in Net Working Capital (a) Less:Increase in Capital Expenditures (a) Less:Increase in other operating Assets (b) reduced by increase in other non-interest bearing liabilities Unlevered Free Cash Flow (UFCF)

Estimation of Unlevered FCF FCFF = EBIT (1-Tax Rate) + Depreciation Expense - Capital Spending -  in Working Capital -  in other assets UFCF = OCF - (  C  +  NWC)

Discounted Cash Flows Valuation Estimation Based on Constant Growth Where: FCFF1 = the free cash flow in period 1 WACC = the firm’s weighted average cost of capital gFCFF = the firm’s constant infinite growth rate of free cash flow

VALUATION OF EQUITY Present value of free cash flow to equity (FCFE) Pure Equity Financed Company The cost of capital is the unlevered cost of equity

VALUATION OF EQUITY Value of Equity when the Firm is levered,

Levered FCF EBIT Less:Interest payment Less:Cash Taxes on EBIT Plus:Depreciation and Amortization Operating Cash Flow (OCF) Less:Increase in Net Working Capital Less:Increase in Capital Expenditures Less:new debt issues minus debt repayments (NDP) Less:Increase in other operating Assets reduced by increase in other non-interest bearing liabilities Levered Free Cash Flow (LFCF)

Present Value of Free Cash Flow to Equity FCFE = Net Income + Depreciation Expense - Capital Expenditures -  in Working Capital - Principal Debt Repayments + New Debt Issues

Growth Rate Estimates Average Dividend Growth Rate

Growth Rate Estimates Average Dividend Growth Rate Sustainable Growth Rate = RR X ROE

Required Rate of Return Estimate Nominal risk-free interest rate Risk premium Market-based risk estimated from the firm’s characteristic line using regression

Required Rate of Return Estimate Nominal risk-free interest rate Risk premium Market-based risk estimated from the firm’s characteristic line using regression R = R F +  ( R M - R F )

Beta For a Levered Firm  L =  U [1 + (1- T C ) D/E]

Constant Growth Free Cash Flow to Equity FCFE = the expected free cash flow in period 1 k = the required rate of return on equity for the firm g FCFE = the expected constant growth rate of free cash flow to equity for the firm

An Alternate Measure of Growth g = (RR)(ROIC) where:  RR = the average retention rate  ROIC = EBIT (1-Tax Rate)/Total Capital

Calculation of WACC WACC = W E R E + W d R d where: W E = the proportion of equity in total capital R E = the after-tax cost of equity W D = the proportion of debt in total capital R d = the after-tax cost of debt

Relative Valuation Techniques Price Earnings Ratio  Affected by two variables:  1. Required rate of return on its equity (R)  2. Expected growth rate of dividends (g)

Relative Valuation Techniques Price Earnings Ratio  Affected by two variables:  1. Required rate of return on its equity (k)  2. Expected growth rate of dividends (g) Price/Cash Flow Ratio Price/Book Value Ratio Price-to-Sales Ratio

Analysis of Growth Companies Generating rates of return greater than the firm’s cost of capital is considered to be temporary Earnings higher the required rate of return are pure profits How long can they earn these excess profits? Is the FIRM properly valued?

Negative Growth Model Firm retains earnings, but reinvestment returns are below the firm’s cost of capital Since growth will be positive, but slower than it should be, the value will decline when the investors discount the reinvestment stream at the cost of capital