1. Chapter 12 Equity Valuation

2. The Basic Steps (1) Gather Current and Historical data –Several years on financial statements –Firm level non-financial data –Industry data –Demographic data –Anything else that can help forecast the future

3. The Basic Steps (2) Analyze the current data –Quality of earnings –Trend analysis –Ratio analysis Common size statements

4. The Basic Steps (3) Create Pro-forma statements –Three to five years minimum –Ten years maximum –A terminal year Steady state

5. The Basic Steps (4) Choose a valuation method –Discounted cash flows –Residual income –Comparable firms

6. The Basic Steps (5) Apply your data to the valuation model –Determine appropriate discount rate

7. The Basic Steps (6) Determine if your answer appears reasonable

8. Pro-forma statements (1) Forecast future revenue –The single most important ingredient! –Most other items are a function of revenue

9. Pro-forma statements (2) Forecast other income statement items that are a function of sales. –COGS –SG&A Use common-size percentages if appropriate

10. Pro-forma statements (3) Forecast balance sheet items that support the level of forecasted revenue –Inventory Turnover ratio –A/R Turnover ratio –A/P Turnover ratio

11. Pro-forma statements (4) Forecast balance sheet items that support the level of forecasted revenue –PP&E Turnover Forecast depreciation as a function of PP&E

12. Pro-forma statements (5) Forecast the level of debt needed to finance operations and capital investments –Maintain a targeted capital structure Forecast interest expense as a function of debt

13. Pro-forma statements (6) Forecast any remaining income statement items. Forecast income taxes

14. Pro-forma statements (7) Forecast retained earnings based on net income and expected dividends

15. Pro-forma statements (8) Make sure the balance sheet balances It probably will not at this point Choose a plug account –Something with few or no dependencies

16. Pro-forma statements (8) Forecast the statement of cash flows from the forecasted balance sheets and income statements –Indirect method

17. Pro-forma statements (8) Determine a terminal year growth rate for the terminal year. –Make sure it is realistic since it is assumed to be a perpetuity.

18. Pro-forma statements Note that this is just one approach to forecasting financial statements. It is completely acceptable to use any other reasonable approach such as common- size percentages, etc. Just be sure the numbers appear to make sense.

19. Discounted Cash Flow Any asset (e.g., a bond, a machine, a firm) is worth the present value of the future cash flows that come from the ownership of the asset. Therefore the task is to extract the future cash flows from the pro-forma statements.

20. Discounted Cash Flow Partition the future into two sections –The forecast period –The period thereafter Continuing value or terminal value Assumes a steady state perpetuity TV = FCF / (discount rate – growth rate)

21. Free Cash Flow All capital providers Equity holders only

22. Free Cash Flow to Common Equity 1.Dividends – Net Stock Issuance 2.CFFO – Increase in cash + CFFI + Increase in debt 3.Net income – Increase in common equity

23. Free Cash Flow to Common Equity Discount FCF at the firm’s cost of equity CAPM Rate = risk-free rate + (beta x risk premium)

24. Residual Income Model Used earnings rather than cash flow Based on theory that value comes from earning more than the opportunity cost of the investment. RI = NI – r(CE)

25. Comparable Firms PE multiples –Trailing –Forward More of a short-cut practical approach than a theory-based approach.