 Measure: ◦ Free Cash Flow  Discount Factor: ◦ Weighted Average Cost of Capital  Assessment: ◦ Works best for projects, business units, and companies that manage their capital structure to a target level.

 Measure: ◦ Economic profit  Discount Factor: ◦ Weighted Average Cost of Capital  Assessment ◦ Explicitly highlights when a company creates value.

 Measure: ◦ Free Cash Flow  Discount Factor ◦ Unlevered Cost of Equity  Assessment: ◦ Highlights changing capital structure more easily than WACC-based models.

 Measure: ◦ Capital Cash Flow  Discount Factor: ◦ Unlevered Cost of Equity  Assessment: ◦ Compresses the FCF and the interest tax shield in one number, making it difficult to compare performance among companies and over time.

 Measurement: ◦ Cash Flow to Equity  Discount Factor: ◦ Levered Cost of Equity  Assessment ◦ Difficult to implement correctly because capital structure is embedded in cash flow. ◦ Best used when valuing financial institutions

This method is specially valuable when extended to a multi-business company.

 Enterprise value equals the summed value of the individual operating units less the present value of the corporate centre costs, plus the value of non-operating assets.

 Value the company’s operations by discounting Free Cash Flow (FCF) at the weighted average cost of capital (WACC).  Value non-operating assets ◦ Excess marketable securities, non-consolidated subsidiaries, other equity investments etc.  Combining the value of operating assets and non-operating assets leads to enterprise value.

 Identify and value all non-equity financial claims against the company’s assets. ◦ Non-equity financial claims include fixed- and floating-rated debt, pension shortfalls, employee options and preferred stock.  Subtract the value of non-equity financial claims from enterprise value to determine the value of equity.  Divide equity value by the number of shares outstanding to determine share price.

 Value of an enterprise = ◦ PV of FCF during explicit forecast period + Continuing Value  Use the key value driver formula to measure the continuing value ◦ Continuing value = [NOPLAT(at t+1)× (1- g/RONIC)]/WACC-g

 NOPLAT: ◦ The NOPLAT should be based on a normalized level of revenues and sustainable margin and ROIC. ◦ The normalized level of revenue should reflect the mid point of its business cycle and cycle average profit margin

 RONIC: ◦ RONIC should be consistent with expected competitive conditions. ◦ Set RONIC equal to WACC ◦ For companies with sustainable competitive advantages, RONIC may be set equal to the ROIC during the later period of the explicit forecast period.

 Growth Rate: ◦ The best estimate is the long term rate of consumption growth for the industry’s product plus inflation.  WACC: ◦ The WACC should incorporate a sustainable capital structure and an underlying estimate of business risk consistent with expected industry conditions.

 Use multiples  Liquidation value  Replacement cost

 The future is unknowable but, careful analysis can yield insights into how a company may develop.  Analysts should not get engrossed in the details of individual line items.  He should place aggregate results in the proper context

 The analyst must determine how many years to forecast and how details the forecast should be.  The typical solution is to develop an explicit forecast for a number of years and then to value the remaining, called continuing value, by using a formula such as, the perpetuity formula.  The explicit forecast period must be long enough for the company to reach a steady state.

 The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.  The company earns a constant rate of return on new capital invested  The company earns a constant return on its base level of invested capital  As a result, free cash flow will grow at a constant rate and can be valued using a growth perpetuity.

 The forecast period should be long enough that the company's growth rate is less than or equal to that of the economy. ◦ Higher growth rates would eventually make companies unrealistically large, relative to the aggregate economy.  In general, a forecast period of 10 to 15 years is appropriate.  However, it may be longer for cyclical companies or those experiencing very rapid growth.

 Short explicit forecast period results in significant undervaluation of a company or requires heroic long term growth assumptions in the continuing value  Long forecast faces the difficulty of forecasting individual line items

 Split the explicit forecast into two periods ◦ A detailed five-to-seven year forecast ◦ A simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover  This approach not only simplifies the forecast, it also forces the analyst to focus on the business’s long-term economics, rather than the individual line items of the forecast.

 Raw historical data ◦ Raw data should be collected from the company’s financial statements, footnotes, and external reports in one place. The raw data should be reported in its original form.  Integrated financial statements ◦ Using from the raw-data work-sheet, the analyst should create a set of historical financials that find the right level of detail. ◦ The income statement should be linked with the balance sheet through retained earnings. ◦ This work-sheet will contain historical and forecasted financial statements.

 Historical analysis and forecast ratios ◦ For each line item in the financial statements, build historical ratios, as well as forecasts of future ratios. ◦ These ratios will generate the forecasted financial statements contained on the previous work-sheet.  Market data and WACC ◦ All financial market data should be collected on one work-sheet. ◦ This work sheet will contain estimates of beta, the cost of equity, the cost of debt, and WACC, as well as historical market values and valuation/trading multiples for the company.

 Reorganised financial statements ◦ Once a complete set of financial statements ( both historical and forecasted) are built, reorganise the financial statements to calculate NOPLAT, its reconciliation to net income, invested capital and its reconciliation to total fund invested.  ROIC and free cash flow ◦ Reorganised financial statements are used to build ROIC, economic profit, and free cash flow. ◦ Future free cash flow will be the basis of valuation.

 Valuation summary ◦ This work-sheet presents discounted cash flows, discounted economic profits, and final results. ◦ The valuation summary includes the value of operations, on-operating assets valuation, valuation of non-equity claims, and resulting equity value.

 Prepare and analyze historical financials  Build the revenue forecast  Forecast the income statement  Forecast the balance sheet; invested capital and non-operating assets  Forecast the balance sheet; investor funds  Calculate ROIC and FCF

 Collect raw data from the reported financials and notes  Use the raw data to build a set of financial statements; the income statement, balance sheet, and statement of retained earnings.  Statement of retained earnings is critical for error checking during the forecasting process.  Aggregate immaterial line items. Never aggregate operating and non-operating items.

 Top-down forecast : ◦ Estimate revenues by sizing of the total market, determining market share, and forecasting prices;  Bottom-up approach: ◦ Use company’s estimate of demand from existing customers, customer turnover, and the potential for new customers  When possible, use both methods to establish bounds for the forecast

 Rely on professional forecasts  Focus on market share by competitors  Make an assessment on which companies have the capabilities and resources to compete effectively and capture share.  Make an assessment of how the company is positioned for the future  Find answers to such questions as: ◦ Does the company have products and services to capture share? ◦ Do other competitors have products and services that will displace your company’s market position?

 Over the short term, top-down forecasts should build on the company’s announced intentions and capabilities for growth.  Top-down approach starts with aggregate market and predicts penetration rates, price changes, and market shares

 Determine short-term forecasts of revenue from current customer base by aggregating sales projections across customers  Eliminate a portion of estimated revenue based on an estimate of customer turnover.  Project how many new customers the company will attract and how much revenue those customer will contribute

 Forecasting revenues over long time periods is imprecise because customer preferences, technologies and corporate strategies change.  Constantly reevaluate whether the current forecast is consistent with industry dynamics, competitive positioning, and the historical evidence on corporate growth.  Use multiple scenarios to model uncertainty

 Decide what economically drives the line item  Estimate the forecasts ratio  Multiply the forecast ratio by an estimate of its driver  Pay special attention to depreciation and interest expenses and interest income.

 Operating items (other than depreciation) ◦ Forecast driver: Revenue ◦ Forecast ratios: COGS/Revenue; SG&A/Revenue  Depreciation ◦ Forecast driver: Prior years net PP&E ◦ Forecast ratios: Depreciation/net PP&E ◦ Tying depreciation with gross PP&E requires forecasting asset retirements ◦ If, internal information is available, a formal depreciation table can be constructed.

 Operating items (other than depreciation) ◦ Forecast driver: Revenue ◦ Forecast ratios: COGS/Revenue; SG&A/Revenue  Depreciation ◦ Forecast driver: Prior years net PP&E ◦ Forecast ratios: Depreciation/net PP&E ◦ Tying depreciation with gross PP&E requires forecasting asset retirements ◦ If, internal information is available, a formal depreciation table can be constructed.