DES Chapter 12 1 Chapter 12 Projecting Cash Flows for An Actual Company: Home Depot

DES Chapter 12 2 Using the Corporate Valuation Spreadsheet Look at the file: Home Depot (for Ch 12-13, base inputs).xls. This file will be called Home Depot.xls for short.

DES Chapter 12 3 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 (next slide) Steps to estimate value using the Corporate Valuation Spreadsheet

DES Chapter 12 4 The Inputs Worksheet (continued)

DES Chapter 12 5 The Inputs Worksheet (continued) The Inputs worksheet has cells for the inputs needed to project free cash flow. Following is an explanation of how to find reasonable inputs. The focus is on: the mechanics of projection insights gained from explicitly linking competitive analysis to the financial statements. See DES Chapter 12 for details.

DES Chapter 12 6 Choosing Inputs A Useful Perspective on Projections projections reflect the analyst’s knowledge of the firm and the industry but no one has perfect foresight linking financial projections to economic factors and operating policies reveals the firm’s leverage points the point is to identify the relationship between specific corporate operating policy choices and financial consequences (continued)

DES Chapter 12 7 Choosing Inputs (continued) Projections must meet two criteria: Economic Plausibility. Projections must reflect how the firm might realistically be expected to operate in the future. Accounting Consistency. Projections must satisfy basic accounting rules. (continued)

DES Chapter 12 8 Choosing Inputs (continued) Key inputs needed: Ratios to calculate operating profit Ratios to calculate operating capital Ratios to calculate operating taxes Dividend and debt ratios Ratios to calculate the rest of the income statement and balance sheet (continued)

DES Chapter 12 9 Choosing Inputs (Continued) The spreadsheet will project 20 years into the future. Rather than input 20 years of for each ratio, you must enter only 4 variables for each ratio: Starting ratio (the one for the first year) Long-term ratio (the one at which the company will eventually level off). (continued)

DES Chapter Choosing Inputs (Continued) The time until the company reaches the long-term. A “fade” rate that determines how steeply the company’s starting ratio will “fade” to the long-term ratio. See the following example... (next slide)

DES Chapter An Example of Fade Rates: Growth Suppose you forecast a growth rate in sales (g 1 ) for next year of 14%. You think competition and market saturation will reduce it to 4% in the long term (g L ) You think it will take about 6 years. You think it will fade rather fast at first, and then fade slowly. (continued)

DES Chapter Fade Rates Example: Growth (continued) Example 1: Sales fade rapidly at first, then more slowly.

DES Chapter Fade Rates Example: Growth (continued) Example 2: Sales fade slowly at first, then more rapidly.

DES Chapter Putting fade rates in the Spreadsheet Typing in a growth rate for each year would be inconvenient, especially if you do sensitivity analysis and change your assumptions several times. Needed: a formula that will allow you to easily change the time profile. Fade Rates Example: Growth (continued) (continued)

DES Chapter You need to specify: Growth rate in year 1 (g 1 ) Number of additional years it takes for growth to level out (T) Growth rate when it levels out (g L ) How fast it fades to growth rate (c) where c is a constant. (next slide) Fade Rates Example: Growth (continued)

DES Chapter Fade Rates Example: Growth (continued) (continued)

DES Chapter This formula is in the spreadsheet, which also has “If” statements so that the formula is only for t<T. Fade Rates Example: Growth (continued)

DES Chapter g 1 = 14%, g L = 5%, T=5, and c=0.3 Fade Rates Example: Growth (continued) (continued)

DES Chapter g 1 = 14%, g L = 5%, T=5, and c=1 Fade Rates Example: Growth (continued) (continued)

DES Chapter g 1 = 14%, g L = 5%, T=5, and c= -0.4 Fade Rates Example: Growth (continued) (continued)

DES Chapter g 1 = 14%, g L = 5%, T=5, and c= -1 Fade Rates Example: Growth (continued) (continued)

DES Chapter g 1 = 14%, g L = 5%, T=5, and c= 0 Fade Rates Example: Growth (continued) (continued)

DES Chapter Summary of Fade Rates If the fade rate is zero, then the ratio falls linearly. If the fade rate is greater than zero, the curve falls fast initially and then slows down. If the fade rate is less than zero, the curve falls slowly initially, then falls rapidly towards the end of the period. Fade Rates Example: Growth (continued)

DES Chapter Choosing Inputs Inputs for projecting NOPAT: (continued)

DES Chapter Choosing Inputs (continued) Inputs for projecting Operating Capital: (continued)

DES Chapter Choosing Inputs (continued) Inputs for projecting Operating Taxes, Dividends and Debt:

DES Chapter Guidelines for Choosing Inputs Approach to estimating ratios: (1) examine the company’s own historical performance for each ratio (2) read analysts’ reports on the company and the industry (3) compare company with similar ratios for other companies in the same industry (4) use your common sense (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) Suggestion: choose a Starting Ratio similar to the ratio in the most recent year set the Long-term Ratio to the historical average, and then modify it to reflect trends, competition, the economy, etc. (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) choose the Time Until the Long-term and the Fade Rate base on evolving competitive conditions in the industry after choosing inputs for a ratio, click on the graph button to make a visual check of your assumptions (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) Finishing the inputs: Nonoperating items are often difficult to project, by their nature. Look out for exceptions to this rule, but otherwise use historical averages. (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) Finishing the inputs: For the interest rate on cash and short- term investments, look at the Federal Reserve website for short-term Treasury instruments. Set the fade parameters to allow this rate to revert to about 4% (the historical average). (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) For the interest rate on all current debt, start with the rate in the WACC sheet. Choices: Set the fade parameters to allow this rate to revert to about 6% (the historical average). Set the rate equal to the current cost estimated in the WACC worksheet (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) For the interest rate on long-term debt, use a starting rate that reflects rates on already outstanding debt. Set the long-term rate to the cost of debt calculated previously in the WACC worksheet (for long-term debt). (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) WACC vs. Long-term ROIC The WACC is shown on the Inputs worksheet, although it comes from the WACC sheet (i.e., don’t change it on the Inputs sheet). Due to competition, it is unlikely that a company will have an ROIC in the long-term (beyond 20 years) that is much greater than its WACC. (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) WACC vs. Long-term ROIC (continued) Choose an input for Long-term ROIC that is somewhere between its WACC and the projected ROIC for Year 20 (shown on the Proj & Val worksheet). See DES Chapter 13 for details. Finally, input a Target Valuation Date that is close to the current date. (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) Inputs for projecting nonoperating items: (continued)

DES Chapter Guidelines for Choosing Inputs (Continued) Other inputs for projecting complete financials:

DES Chapter Checklist for Plausibility of Inputs Is long run sales growth less than WACC? Is input for long run ROIC very large or very small (compared to WACC)? Have you made very large changes in input ratios compared with previous year? If so, why?

DES Chapter The “Proj & Val” Worksheet 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.

DES Chapter Checklist for Plausibility of Financial Forecasts Tips for tracking down the source of implausible projections: Have any items on the income statement or balance sheets changed by a much different percentage than the change in sales from the most recent year to the first projected year? If so, did you intend this to happen? Check the related input parameters. (continued)

DES Chapter Plausibility Checklist (Continued) How much short-term debt is there at the horizon? If it is a lot, then the company will probably have to decrease its dividend payout or increase its long-term debt (or even start issuing new equity). How much short-term investment is there at the horizon? If there is a lot, then the company should probably increase its dividend payout or start buying back stock. (continued)

DES Chapter Plausibility Checklist (Continued) How big, in absolute terms, is the company? (look at sales, total assets, PP&E). Is it so big that it would eventually be bigger than the economy? If so, your growth rates are too large. (continued)

DES Chapter Plausibility Checklist (Continued) Is the stock price positive? If not, then you probably have a long-term growth rate that is bigger than the WACC. Or it could be that your ROIC is never as big as the WACC, which means the company destroys value each year. (continued)

DES Chapter Plausibility Checklist (Continued) What if all previous questions have been answered satisfactorily, but you still have an unrealistic stock price? Double check to make sure your source of data for the most recent year has the correct number of outstanding shares of stock. (continued)

DES Chapter Plausibility Checklist (Continued) If all previous questions have been answered satisfactorily, then you have just determined your estimate of the stock’s fundamental, or intrinsic value. If the actual stock price is a lot lower than the fundamental value and you are Warren Buffett, then you buy the firm (otherwise, be content with a few shares). But always perform sensitivity analysis first!