1. The Valuation of an Actual
Chapter 13
The Valuation of an Actual
Company: Home Depot
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2. 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
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3. 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.
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4. 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)
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5. 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
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6. 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
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7. 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?
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8. 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.
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9. 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:
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10. 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.
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11. 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.
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12. 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.
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13. Valuing Operations: Home Depot, 2021 and beyond
This is the
horizon year
Note hidden
columns
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14. 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.
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15. The Half-Year Adjustment for Home Depot
This is the
horizon year
Note hidden
columns
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16. 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.
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17. 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
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18. 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.)
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19. Target Valuation Date Adjustments for Home Depot
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20. 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%
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21. 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
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22. 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
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23. 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
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24. 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.
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25. 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:
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26. Home Depot stock prices: October 2002-October 2003
Intrinsic value estimate
for 5/21/2003: $33.45
Actual HD stock prices
Source: marketguide.com (
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27. 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).
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28. 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
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29. Other Financial Measures (continued)
(Rows ) 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.)
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30. Other Financial Measures (continued)
(Rows ) Capital structure:
market-based percent of the firm that is financed with debt
times-interest-earned ratio
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31. Other Financial Measures (continued)
(Rows ) Net cash flow from financing activities:
short-term borrowing/ short-term investments
long-term borrowing
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32. 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.
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33. 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.
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34. 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.
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35. 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
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36. 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
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