Firm Valuation: A Summary

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Firm Valuation A Summary

• P.V. Viswanath
• Class Notes for Corporate Finance and Equity
  Valuation

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Discounted Cashflow Valuation

• where,
• n life of the asset
• CFt cashflow in period t
• r discount rate reflecting the riskiness
  of the estimated cashflows

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Two Measures of Discount Rates

• Cost of Equity This is the rate of return
  required by equity investors on an investment. It
  will incorporate a premium for equity risk -the
  greater the risk, the greater the premium. This
  is used to value equity.
• Cost of capital This is a composite cost of all
  of the capital invested in an asset or business.
  It will be a weighted average of the cost of
  equity and the after-tax cost of borrowing. This
  is used to value the entire firm.

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Equity Valuation

• Free Cash Flow to Equity Net Income Net
  Reinvestment (capex as well as change in working
  capital) Net Debt Paid (or Net Debt Issued)

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Firm Valuation
Free Cash Flow to the Firm Earnings before
Interest and Taxes (1-tax rate) Net
Reinvestment Net Reinvestment is defined as
actual expenditures on short-term and long-term
assets less depreciation. The tax benefits of
debt are not included in FCFF because they are
taken into account in the firms cost of capital.
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Valuation with Infinite Life
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Valuing the Home Depots Equity

• Assume that we expect the free cash flows to
  equity at Home Depot to grow for the next 10
  years at rates much higher than the growth rate
  for the economy. To estimate the free cash flows
  to equity for the next 10 years, we make the
  following assumptions
• The net income of 1,614 million will grow 15 a
  year each year for the next 10 years.
• The firm will reinvest 75 of the net income back
  into new investments each year, and its net debt
  issued each year will be 10 of the reinvestment.
• To estimate the terminal price, we assume that
  net income will grow 6 a year forever after year
  10. Since lower growth will require less
  reinvestment, we will assume that the
  reinvestment rate after year 10 will be 40 of
  net income net debt issued will remain 10 of
  reinvestment.

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Estimating cash flows to equity The Home Depot
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Terminal Value and Value of Equity today

• FCFE11 Net Income11 Reinvestment11 Net Debt
  Paid (Issued)11
• 6,530 (1.06) 6,530 (1.06) (0.40) (-277)
  4,430 million
• Terminal Price10 FCFE11/(ke g)
• 4,430 / (.0978 - .06) 117,186 million
• The value per share today can be computed as the
  sum of the present values of the free cash flows
  to equity during the next 10 years and the
  present value of the terminal value at the end of
  the 10th year.
• Value of the Stock today 6,833 million
  117,186/(1.0978)10
• 52,927 million

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Valuing Boeing as a firm

• Assume that you are valuing Boeing as a firm, and
  that Boeing has cash flows before debt payments
  but after reinvestment needs and taxes of 850
  million in the current year.
• Assume that these cash flows will grow at 15 a
  year for the next 5 years and at 5 thereafter.
• Boeing has a cost of capital of 9.17.

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Expected Cash Flows and Firm Value

• Terminal Value 1710 (1.05)/(.0917-.05)
  43,049 million

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What discount rate to use?

• Since financial resources are finite, there is a
  hurdle that projects have to cross before being
  deemed acceptable.
• This hurdle will be higher for riskier projects
  than for safer projects.
• A simple representation of the hurdle rate is as
  follows Hurdle rate Return for postponing
  consumption
  Return for bearing
  risk Hurdle rate Riskless Rate Risk
  Premium
• The two basic questions that every risk and
  return model in finance tries to answer are
• How do you measure risk?
• How do you translate this risk measure into a
  risk premium?

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The Capital Asset Pricing Model

• Uses variance as a measure of risk
• Specifies that a portion of variance can be
  diversified away, and that is only the
  non-diversifiable portion that is rewarded.
• Measures the non-diversifiable risk with beta,
  which is standardized around one.
• Relates beta to hurdle rate or the required rate
  of return
• Reqd. ROR Riskfree rate b (Risk Premium)
• Works as well as the next best alternative in
  most cases.

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From Cost of Equity to Cost of Capital

• The cost of capital is a composite cost to the
  firm of raising financing to fund its projects.
• In addition to equity, firms can raise capital
  from debt

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Estimating the Cost of Debt

• If the firm has bonds outstanding, and the bonds
  are traded, the yield to maturity on a long-term,
  straight (no special features) bond can be used
  as the interest rate.
• If the firm is rated, use the rating and a
  typical default spread on bonds with that rating
  to estimate the cost of debt.
• If the firm is not rated,
• and it has recently borrowed long term from a
  bank, use the interest rate on the borrowing or
• estimate a synthetic rating for the company, and
  use the synthetic rating to arrive at a default
  spread and a cost of debt
• The cost of debt has to be estimated in the same
  currency as the cost of equity and the cash flows
  in the valuation.

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Estimating Cost of Capital Boeing

• Equity
• Cost of Equity 5 1.01 (5.5) 10.58
• Market Value of Equity 32.60 Billion
• Equity/(DebtEquity ) 82
• Debt
• After-tax Cost of debt 5.50 (1-.35) 3.58
• Market Value of Debt 8.2 Billion
• Debt/(Debt Equity) 18
• Cost of Capital 10.58(.80)3.58(.20) 9.17

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Estimating the Expected Growth Rate
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Expected Growth in EPS

• gEPS (Retained Earningst-1/ NIt-1) ROE
• Retention Ratio ROE
• b ROE
• ROE  (Net Income)/ (BV Common Equity)
• This is the right growth rate for FCFE
• Proposition The expected growth rate in earnings
  for a company cannot exceed its return on equity
  in the long term.

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Expected Growth in EBIT And Fundamentals

• Reinvestment Rate and Return on Capital
• gEBIT (Net Capex Change in WC)/EBIT(1-t)
  ROC Reinvestment Rate ROC
• Return on Capital (EBIT(1-tax rate)) / (BV
  Debt BV Equity)
• This is the right growth rate for FCFF
• Proposition No firm can expect its operating
  income to grow over time without reinvesting some
  of the operating income in net capital
  expenditures and/or working capital.

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Getting Closure in Valuation

• A publicly traded firm potentially has an
  infinite life. The value is therefore the present
  value of cash flows forever.
• Since we cannot estimate cash flows forever, we
  estimate cash flows for a growth period and
  then estimate a terminal value, to capture the
  value at the end of the period

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Stable Growth and Terminal Value

• When a firms cash flows grow at a constant
  rate forever, the present value of those cash
  flows can be written as
• Value (Expected Cash Flow Next Period) / (r -
  g) where,
• r Discount rate (Cost of Equity or Cost of
  Capital)
• g Expected growth rate
• This constant growth rate is called a stable
  growth rate and cannot be higher than the growth
  rate of the economy in which the firm operates.
• While companies can maintain high growth rates
  for extended periods, they will all approach
  stable growth at some point in time.
• When they do approach stable growth, the
  valuation formula above can be used to estimate
  the terminal value of all cash flows beyond.

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Relative Valuation

• In relative valuation, the value of an asset is
  derived from the pricing of 'comparable' assets,
  standardized using a common variable such as
  earnings, cashflows, book value or revenues.
  Examples include --
• Price/Earnings (P/E) ratios
• and variants (EBIT multiples, EBITDA multiples,
  Cash Flow multiples)
• Price/Book (P/BV) ratios
• and variants (Tobin's Q)
• Price/Sales ratios

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Multiples and DCF Valuation

• Gordon Growth Model
• Dividing both sides by the earnings,
• Dividing both sides by the book value of equity,
• If the return on equity is written in terms of
  the retention ratio and the expected growth rate
• Dividing by the Sales per share,