The Valuation of an Actual Chapter 13 The Valuation of an Actual Company: Home Depot DES Chapter 13

Steps to estimate value using the Corporate Valuation Spreadsheet The valuation spreadsheet has seven interrelated worksheets, each of which performs an essential function: (1) Proj & Val (2) Inputs (3) WACC (4) Hist Analys (5) Condensed (6) Comprehensive (7) Actual DES Chapter 13

Horizon Value Methods Recall what the “Proj & Val” sheet does: This sheet automatically forecasts the future Pro Forma financial statements, based on data in the Inputs Sheet. It automatically calculates future expected Free Cash Flows (FCF) from the Pro Formas. It then calculates Present Value (PV) of future expected FCF and finds estimated price per share. (continued) DES Chapter 13

Horizon Value Methods (continued) The value of a company is the present value of all future free cash flows A realistic approach to valuation involves: analysts only forecast a finite number of years (20 years is more than adequate) the last year in the forecast is called the horizon (i.e., it begins the steady state, period of constant growth) (continued) DES Chapter 13

Horizon Value Methods (continued) The discounting of the future free cash flows involves three steps: find the value of all free cash flows beyond the horizon, discounted back to the horizon. find the present value of the firm’s horizon value and all of its forecasted free cash flows for the years up to the horizon. add the two components of value together (continued) DES Chapter 13

Horizon Value Methods (continued) There are four ways to calculate the horizon value: continuing value method book value method convergence value method general value method (continued) DES Chapter 13

Horizon Value Methods (continued) 1) The Continuing Value Horizon Formula: Suppose the WACC=10%, and ROIC for the last year in the forecast is 15%. Q: can the company earn a return in excess of its cost of capital indefinitely? Are barriers protecting this company from the forces of competition? Will future competition in the period after our last forecasted year fail to drive down the company’s ROIC? (continued) DES Chapter 13

Horizon Value Methods (continued) If you think the answers to these questions are “Yes”, then use the Continuing Value Horizon Formula: Where HVT is the horizon value at year T. (continued) DES Chapter 13

Horizon Value Methods (continued) 2) The Book Value Horizon Formula: Suppose that immediately after the horizon year, competition will force the ROIC on existing capital and on new investment to the WACC. As of that time, the NPV of all the firm’s assets and future investment is zero, and the horizon value equals book value of capital as of the beginning of the horizon: (continued) DES Chapter 13

Horizon Value Methods (continued) 3) The Convergence Value Horizon Formula: Suppose ROIC on existing capital can be maintained, but competition will force ROIC on new capital (after the horizon) to equal the WACC. Then horizon value is just the value of the free cash flows from existing capital.* *Eventually the ROIC of the firm converges the WACC. (continued) DES Chapter 13

Horizon Value Methods (continued) 4) The General Value Horizon Formula Competition will result in a gradual reduction of the return on new capital, forcing the ROIC on new capital to fall from ROICT to some long-term sustainable ROICL, which may be greater than the WACC. DES Chapter 13

Valuing Operations: Home Depot Recursive Calculation of Value: The Val & Proj worksheet starts (in cell W97) with the horizon value as the value at year T (2023) of free cash flow beyond year T. This is V2023 = HV2023 The value at T-1 (2022) is the free cash flow during year T and subsequent years: V2022=(FCF2022+V2023)/(1+WACC) And so on, back to year 2003. (continued) DES Chapter 13

Valuing Operations: Home Depot, 2021 and beyond This is the horizon year Note hidden columns DES Chapter 13

The Half-Year Adjustment Cash flows occur throughout the year and not just on the last day of the year. The estimate of the value of operations based upon year-end cash collection understates the true value of operations. The half-year adjustment treats the total yearly cash flow as if it occurs at mid-year: VAfter Adjustment=VBefore Adjustment(1+WACC)0.5. (continued) DES Chapter 13

The Half-Year Adjustment for Home Depot This is the horizon year Note hidden columns DES Chapter 13

Target Valuation Date Cells in the “Calculating Value” section of the worksheet give the valuation calculations as of the end of the most recent fiscal year. It’s usually desirable to calculate value as of the current date, or some other “target date”, usually the date on which the valuation estimate is completed. (continued) DES Chapter 13

Target Valuation Date (continued) Cells in the “Price per share on target date” section adjust value of operations for the elapsed time from last FYR date to the target date by compounding at the WACC: Vtarget date = VFYR date (1 + WACC)#days/365 (continued) DES Chapter 13

Target Valuation Date (continued) Target date adjustments for Investments and nonequity claims use linear interpolation between FYR ends: Xtarget date = XFYR date + Adj, Where: Adj= [XFYR date+ 1 year - XFYR date](#days/365)]. (X stands for either investments or nonequity claims.) (continued) DES Chapter 13

Target Valuation Date Adjustments for Home Depot DES Chapter 13

Valuation of Home Depot Once satisfied that the projected financials are plausible, look closely at the projected ROIC: actual ROIC for 2003 was 19.2% declines gradually to 16.2% by 2023 assumed long-term ROIC is 10%, compared to WACC of 8.51% (continued) DES Chapter 13

Valuation of Home Depot (continued) Summary of valuation (worksheet row numbers in parentheses): (Row 97) the present value of all forecasted future free cash flows as of 2/2/2003 is about $75.0 billion (Row 98) the half-year adjustment give the value of operations on the target date of 5/21/03 at about $78.2 billion (continued) DES Chapter 13

Valuation of Home Depot (continued) Summary of valuation (continued): (Row 99) add nonoperating investments, which are less than $0.1 billion (Row 101) subtracting nonequity claims of $1.8 billion (continued) DES Chapter 13

Valuation of Home Depot (continued) Summary of valuation (continued): (Row 102) total value of equity of $76.4 billion (Row 104) dividing by shares outstanding gives intrinsic value for the most recent fiscal year-end, 2/02/2003, of $32.71 per share (continued) DES Chapter 13

Valuation of Home Depot (continued) Summary of valuation (continued): (Row 117) Finally, making the adjustments for target date valuation results in a target dated estimated share value of $33.45. (continued) DES Chapter 13

Valuation of Home Depot (continued) Perspective on value: To gain some perspective on the valuation result, put the intrinsic value estimate in the context of recent stock prices for Home Depot. As of this writing, there are almost five months of hindsight on the 5/21/2003 value estimate: (continued) DES Chapter 13

Home Depot stock prices: October 2002-October 2003 Intrinsic value estimate for 5/21/2003: $33.45 Actual HD stock prices Source: marketguide.com (http://www.multexinvestor.com/Home.aspx) DES Chapter 13

Other Financial Measures (Row 120) Economic profit - “profit” that the company generated during the year in excess of the “profit” that investors required at the beginning of the year: EP = NOPAT – Capital charges = NOPAT – WACC(Op. capital at the beg. of the year). (continued) DES Chapter 13

Other Financial Measures (continued) (Row 121) Market value added (MVA) - the estimated value of operations minus the total operating capital (at current book value): MVA = Value of operations – Operating capital (continued) DES Chapter 13

Other Financial Measures (continued) (Rows 122-125) Comparative valuation approaches: P/E (or just PE) ratio market to book ratio Value/Sales ratio Value/EBITDA ratio (EBITDA is earnings before interest, taxes, depreciation,and amortization.) (continued) DES Chapter 13

Other Financial Measures (continued) (Rows 126-127) Capital structure: market-based percent of the firm that is financed with debt times-interest-earned ratio (continued) DES Chapter 13

Other Financial Measures (continued) (Rows 149-157) Net cash flow from financing activities: short-term borrowing/ short-term investments long-term borrowing DES Chapter 13

Reverse Engineering What if intrinsic value estimates are substantially different from current market price? Reverse engineering is the process of discovering what changes in the analyst’s input choices would give an intrinsic value estimate that equals the market’s price. (continued) DES Chapter 13

Reverse Engineering (continued) Is the market price reasonable? If you only have to make small changes in the inputs that reflected your best judgment to get the model’s price equal to the market’s price, then the stock is probably fairly priced. (continued) DES Chapter 13

Reverse Engineering (continued) Is the market price reasonable? (continued) If not, then the market may be wrong. Perform sensitivity analysis to identify critical inputs, and determine how your valuation “holds up” under plausible variation in those inputs. (continued) DES Chapter 13

Scenario Analysis: Assessing the Impact of Managerial Decisions The FCF model is very useful in assessing the impact that operating decisions or external events have on the firm’s value. Change sales growth Change profitability (margin) Change working capital requirements Change fixed asset requirements (continued) DES Chapter 13

Scenario Analysis (continued) The financial projections from the free cash flow model may be used to facilitate long-term financial planning. Change in dividend policy Change in financial structure Stock repurchases DES Chapter 13