Fin 4201/8001 Topic 4b: Valuing Companies How can this fun keep going….

…so in conclusion Value of firm = PV of future cash flows Value of firm = PV of future cash flows 1) Discount explicit forecast period 1) Discount explicit forecast period 2) Capitalize continuing value = 2) Capitalize continuing value = = value of firm = value of firm

Implications of the numbers Economic profit = Inv.capital * (ROIC –WACC) = NOPLAT – capital charge = NOPLAT – (invested capital*WACC) Economic profit = Inv.capital * (ROIC –WACC) = NOPLAT – capital charge = NOPLAT – (invested capital*WACC) EP does not have to translate into ↑ market value EP does not have to translate into ↑ market value FCF shows how firm generates or uses cash FCF shows how firm generates or uses cash Once you have done all of this have the elements to do ratio analysis Once you have done all of this have the elements to do ratio analysis

Estimating Cost of Capital – WACC You can build your own You can build your own Look at in a minute Look at in a minute Can just look it up Can just look it up Discounts FCF to PV for all investors Discounts FCF to PV for all investors Is after tax since FCF is after tax and is nominal Is after tax since FCF is after tax and is nominal Need to use market value (not BV) Need to use market value (not BV) Can be subject to change due to changes in inflation, risk, or capital structure Can be subject to change due to changes in inflation, risk, or capital structure

Estimating Cost of Capital – WACC WACC = kb(1-T)(B/V) + kp(P/V) + ks(S/V) where kb = pretax YTM on non-callable, nonconvertible debt T= marginal tax rate B= mkt value of debt V=market value of enterprise (B+P+S) kp=after tax cost of preferred stock P=mkt value of preferred ks=opportunity cost of equity capital S = mkt value of equity WACC = kb(1-T)(B/V) + kp(P/V) + ks(S/V) where kb = pretax YTM on non-callable, nonconvertible debt T= marginal tax rate B= mkt value of debt V=market value of enterprise (B+P+S) kp=after tax cost of preferred stock P=mkt value of preferred ks=opportunity cost of equity capital S = mkt value of equity

Forecasting performance Detailed forecast near term + summary forecast long term. Detailed forecast near term + summary forecast long term. First - Take strategic perspective and account for competitive advantage First - Take strategic perspective and account for competitive advantage You could say: Demand is increasing rapidly because of changing demographics, yet prices will remain stable because of the competitive structure of the industry. Given the company’s competitive position, it should be able to increase market share somewhat, although profitability will remain constant. You could say: Demand is increasing rapidly because of changing demographics, yet prices will remain stable because of the competitive structure of the industry. Given the company’s competitive position, it should be able to increase market share somewhat, although profitability will remain constant. Franchise, commodity, efficient use of capital, bargaining power Franchise, commodity, efficient use of capital, bargaining power Second – convert this viewpoint into numbers Second – convert this viewpoint into numbers

Forecasting performance Incorporate opinions into FCF. Incorporate opinions into FCF. Look at ratios = reality check Look at ratios = reality check Six steps Six steps 1) Revenue forecast – volume growth & price changes 2) Fore cast operational items 3) Project non-operating items (investments or interest exp) 4) Project equity accounts (old + NI – div&repurchases) 5) Balance cashflows and balance sheet 6) Calc ROIC, key ratios, and pull together

What’s the process? Look at spreadsheet Reorganize the financials to estimate ROIC Reorganize the financials to estimate ROIC Make sure you account for everything in statements (lines 1-29 Income and BS) Make sure you account for everything in statements (lines 1-29 Income and BS) Invested capital (denominator) lines Invested capital (denominator) lines NOPLAT (numerator) lines NOPLAT (numerator) lines ROIC couple of calculation methods ROIC couple of calculation methods Economic profit ( ) reflects spread (ROIC-WACC) Economic profit ( ) reflects spread (ROIC-WACC) FCF ( ) FCF ( ) Put it all together for firm value ( ) Put it all together for firm value ( )

Valuation Needs to be high quality since may be over half the valuation Needs to be high quality since may be over half the valuation Plug into – Plug into – Know assumptions Know assumptions Constant margins, returns on new investment, and capital turnover Constant margins, returns on new investment, and capital turnover What about changes over time (horizon)? What about changes over time (horizon)? Sensitivity analysis Sensitivity analysis Make sure reasonable Make sure reasonable

…so in conclusion Value of firm = PV of future cash flows Value of firm = PV of future cash flows 1) Discount explicit forecast period 1) Discount explicit forecast period 2) Capitalize continuing value = 2) Capitalize continuing value = = value of firm = value of firm