1. Michael Dimond School of Business Administration

2. Valuation FIN 449 Michael Dimond

3. Michael Dimond School of Business Administration Calculating Free Cash Flow to Equity FCFE = Net income – Net investment + Net debt issued Need to adjust this slide

4. Michael Dimond School of Business Administration Net Investment Net investment = (Capital expenditures – Depreciation) + Increase in noncash working capital Need to adjust this slide

5. Michael Dimond School of Business Administration CapEx Line item on Statement of Cash Flows? Calculate the changes (from year to year) of ALL long-term assets shown on the balance sheet. Find the total amount (for a given year) shown in the “Investing” section of the Statement of Cash Flows. Issues? Need to adjust this slide

6. Michael Dimond School of Business Administration Depreciation “Basic definition” of net cash flow = net income + depreciation Non-cash expense In the “balance sheet” approach to define capital expenditures, depreciation is usually not incorporated explicitly. Why not? If the “Statement of Cash Flows” approach is used, one must explicitly subtract depreciation from capital expenditures (shown in the “Operating” section of the Statement of Cash Flows) Need to adjust this slide

7. Michael Dimond School of Business Administration Non-cash Working Capital Noncash working capital = (current assets – cash) – current liabilities… what else? Noncash working capital = (current assets – cash) – (current liabilities – interest bearing debt included in current liabilities) Why? Why not include cash? Need to adjust this slide

8. Michael Dimond School of Business Administration Net Debt Issued “Net” debt issued implies that one must take both debt issuances AND repayments into account Discussion: Constant Debt Ratio –Suppose a firm always finances new investment with a fixed debt ratio (say, 30% debt and 70% equity, for example). The general equation for FCFE could be expressed as follows: –FCFE = Net income – (1 – debt ratio)(Net investment) OR –FCFE = Net income – (equity ratio)(Net investment) Need to adjust this slide

9. Michael Dimond School of Business Administration Free Cash Flow to Equity FCFE = Net income – Net investment + Net debt issued Need to adjust this slide

10. Michael Dimond School of Business Administration Damodaran has resources online http://pages.stern.nyu.edu/~adamodar/ His spreadsheets are not always as helpful as you might want… An example of a valuation summary he did in 2008

11. Michael Dimond School of Business Administration What Damodaran’s valuation summary looks like: September 2008

12. Michael Dimond School of Business Administration What Damodaran’s valuation summary looks like: October 2008

13. Michael Dimond School of Business Administration Bear in mind, these were a summary. We will ultimately want something more detailed for a working document.

14. Michael Dimond School of Business Administration What does the DCF Model look like? What drives the figures? How sensitive are they to basic inputs?

15. Michael Dimond School of Business Administration Damodaran shows different ways to compute CFs To start, compute historic FCFF & FCFE for the past 5 years FCFF = NI + Int(1-t) + Depr - ΔFA - ΔNWC FCFE = NI + Depr - ΔFA - ΔNWC + ΔDebt - PfdDiv FCFF = FCFE + Int(1-t) - ΔDebt + PfdDiv FCFE = FCFF - Int(1-t) + ΔDebt - PfdDiv How accurate would it be to extrapolate the future cash flows from the past FCFE figures? In other words, can we simply assume FCFE will grow X% forever? Here are the historic FCFE for a company: Instead, we project the drivers of these figures for the future. Compute FCFF & FCFE based on the forecast figures

16. Michael Dimond School of Business Administration Building the sensitivity table What’s in the yellow cell in the middle of the table? (easier to click cells than type references) = ( NPV( $E223, $H$206, $I$206, $J$206, $K$206, $L$206+ ($L$206*(1+I$218)/($E223-I$218)) ) +$G$209) /$G$211 You should be able to paste the foumula into the remaining cells in the table and get the correct results. equals group everything together PV of cash flows Ke from the sensitivity table CF1 CF2 CF3 CF4 CF5 plus… terminal value, using %s in table close the NPV function add the cash divide by the number of shares

17. Michael Dimond School of Business Administration Valuing the first company Supplementary Material: 96 Common Errors in Company Valuations by Pablo Fernandez & Jose Maria Carabias http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151 Questions to ask yourself about trends and financial statement analysis Data Source: EDGAR http://www.sec.govhttp://www.sec.gov

18. Michael Dimond School of Business Administration

23. Valuation Value = Debt Value + Equity Value Equity Value / Shares Outstanding = “Correct” Price per Share Context & perspective come from comparables and other less robust methods Publicly traded company can be declared to be “overvalued” or “undervalued”

24. Michael Dimond School of Business Administration When to use Free Cash Flow to the Firm Use Firm Valuation (FCFF) (a) for firms which do not have an optimal capital structure (leverage is too high or too low), and expect to change the leverage over time. Debt payments and issues do not have to be factored into the cash flows and the discount rate (WACC) does not change dramatically over time. (b) for firms which have only partial information on leverage available (e.g. interest expenses are missing). (c) in cases where value of the firm is more relevant than the value to the shareholders (e.g. projects which create value). As a rule, firm valuation (FCFF) is a more flexible approach than equity valuation (FCFE).

25. Michael Dimond School of Business Administration FCFF – Circular Reasoning? To discount FCFF we use the WACC, which is calculated using the market values of equity and debt. We then use the present value of the FCFF as our value for the firm and derive an estimated value for equity. There appears to be some circular reasoning involved because the market values of equity and debt are both inputs in computing the cost of capital and outputs. To get around this issue, one could use an iterative approach: Re-estimate the WACC using the new estimated values, which would change the inputs and the cost of capital. There should be convergence at some point in this process, but is cumbersome.

26. Michael Dimond School of Business Administration When to use Free Cash Flow to Equity When leverage is stable, you can use the short cut for estimating free cash flows to equity (Firm Value – MV of Debt). Use Equity Valuation (FCFE) (a) for firms which have stable leverage, whether high or not, and (b) if equity (stock) is being valued When leverage is changing, modeling cash flows to equity becomes problematic (How much cash will be raised from new debt issues? How much old debt will be paid off each year?).

27. Michael Dimond School of Business Administration Measuring Cash Flows To go from reported to actual earnings we may have to: Update earnings & data to the date of interest Make corrections from Accounting Earnings Adjust for One-Time and Non-recurring Charges

28. Michael Dimond School of Business Administration From Reported to Actual Earnings

29. Michael Dimond School of Business Administration Updating Earnings When valuing companies, we often depend upon financial statements for inputs on earnings and assets. Annual reports are often outdated and can be updated by using- –Trailing 12-month data, constructed from quarterly earnings reports. –Informal and unofficial news reports, if quarterly reports are unavailable. Updating makes the most difference for smaller and more volatile firms, as well as for firms that have undergone significant restructuring.