Lecture 7

Valuation Models

DDM and DCF

2

Agenda

• Basic concepts

• Absolute (cash flow based) valuation models‒ DDM‒ FCFF and FCFE‒ One adjustment: excess cash

3

Firm or equity valuation?

Enterprise (or firm) valuation

DebtAssets in place

Growth assets

Assets Liabilities

EquityEquity valuation

4

Overview of valuation modelsValuation model

Absolute/relative/acrrual Valued entity

Discounted/compared cash flow or asset

Discounted dividend model (DDM)

Equity Dividend

DCF: FCFF Absolute Firm Cash flow to firm

DCF: FCFE Absolute Equity Cash flow to equity

DCF: Adjusted present value Absolute Firm Cash flow to firm

Residual income (RI) Accrual Equity RI to equity

Economic profit (EP) Accrual Firm RI to firm

Absolute

P/E Relative Equity Net incomeP/FCFE Relative Equity FCFE

P/S Relative Equity Sales

P/B Relative Equity Book value of assets

EV/EBITDA Relative Firm EBITDA

EV/EBIT Relative Firm EBIT

Venture capital method Both Firm Equity value at maturityReal options Absolute Equity Equity value at maturity

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Agenda

• Basic concepts

• Absolute (cash flow based) valuation models‒ DDM‒ FCFF and FCFE‒ One adjustment: excess cash

6

DDM computes value of equity as sum of discounted dividends

• Value of company for shareholders is the present value of all expected future dividends, discounted at the cost of equity.

• V0 =

whereV0 = Equity value at time 0 (present moment)Di = Dividend at time irE = cost of equity (required rate of return for this stock)

rE (Beta and D/E) should remain constant

...)1(

...)1()1( 2

21 ++

+++

++ n

E

n

EE rD

rD

rD

å¥

= +=

1 )1(ii

E

i

rD

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If dividends follow a constant growth rate, DDM can be written as Gordon’s model

• Geometric series and defined when (-1 < g < r)• Gives crazy valuation results if rE is close to g• If g > rE, the formula is not defined (gives negative values)

å¥

=

=>+

=1

0)1(ii

E

i

rDV

)(1

0gr

DVE -

=

8

DDM also allows for different growth stages

• It is also possible to write DDM using different growth stages.• Consider, for example, a company with growth rate g1 for years 1-5,

g2 for years 6-10, and g3 from year 11 into perpetuity. Then DDM can be written as:

11

10

6

55

1

00)1(

)1(

)1()1(

)1()1( 3

103

21

E

E

EE rgrDg

rDg

rDgV

ii

i

ii

i

+-

+

++

++

++

= åå==

PV of cash flows in years 1 - 5

PV of cash flows in years 6 - 10

Discounting cash flows from t=11 to t=0

PV of cash flows in years 11 –> at t = 11

Explicit forecasting period Terminal value (TV)

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Positives and negatives of DDM

Positives Negatives

• Conceptually convincing• Computationally easy• Connected to P/E multiples

• Dividend policy is irrelevant in perfect markets, not value driver

• Problematic with young, growing companies with no dividends

• Dividends are decision, not performance variables

• Actual current dividends may differ from sustainable dividends

• Need very long forecasting periods, not easy to forecast

• Basis for other more realistic approaches• Works well if stable payout ratio

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Dividend policy is irrelevant in DDM if rE = g

( )2110

1.011.1))1.01(100(

1.01 +-+

++

=DDV

• Assume that an all-equity company can produce a return at cost of equity 10% for all its capital. Let capital C(0) = 100, value of dividend at t=1 D1, and value of firm V0

• Dividend policy is irrelevant in DDM if rE = g

– A company with g > rE should have 0% dividend policy

– A company with g < rE should…?

1.01100

1.01110

+-+

+=

DDV

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Agenda

• Basic concepts

• Absolute (cash flow based) valuation models‒ DDM‒ FCFF and FCFE‒ One adjustment: excess cash

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Free Cash Flow to Firm (FCFF) Model• FCFF uses the same (DCF) formula than DDM

– The interpretation of the variables is different– FCFF uses Free cash flows (to debt and equity) and the discount

rate is Weighted Average Cost of Capital and the result is Corporate (=enterprise and firm) value

– Some sources use the term FCF instead of FCFF. These slidesuse FCFF to be specific about cash flows to firm rather than to equity

• FCFF model of corporate value

where FCF(i) = Free cash flow in period iWACC = weighted average cost of capital

• Equity Value = Corporate value – Market value of debt

å¥

= +1 )1(ii

i

WACCFCFF

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Positives and negatives of FCFF

Positives Negatives

• Strong link to finance theory and NPV

• Not dependent on accounting rules or choices

• Popular among investment bankers

• Cash flows are easy to understand and “real”

• FCFF can be negative for extended period of time

• Requires long forecasting periods

• Most of the value often in uncertain terminal value

• Easy to make unrealistic forecasts (check balance sheet and key accounting ratios for maintaining realism)

• Lots of moving parts (FCFF, beta of equity, D/E, g, equity premium etc.)

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Similar to DDM, FCFF can be written as sum of explicit forecasting period and terminal value PVs

V0 =

where

TVT =

å= +

++

T

iT

Ti

i

WACCTV

WACCFCFF

1 )1()1(

gWACCFCFFT

-+1

Explicit forecasting

period

Terminal value (TV)

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What is a Free Cash Flow ?• FCFF = How much cash “business operations” produce for suppliers of

capital (equity and debt) after tax and after all needed investments in working capital and fixed capital have been made

• Major annoyance: academic and practioner authorities disagree on theexact formulation of FCFF, although in spirit they agree

• FCFF constructed indirectly from financial statements, especially when it is supposed to be informative for forecasting purposes, is always an approximation:– Accounting laws dictate the format of cash flow statement (if

available) and it is based on history rather than designed to be goodbasis for forecasting

– ”Perfect” direct FCFF would only be possible when constructeddirectly from cash receipts

– Outside-in FCFF, especially a simple one, will deviate fromaccountant’s cash-flow statement

– A more detailed outside-in FCFF will of course be closer to accountant’s cash flow statement

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Definitions of FCFF starting from net income

Pinto et al.

Koller et al.

Palepu et al.

Definition

Net income + Interest expense x (1-

Tax rate) + Noncash charges -

Investments in fixed capital -

Investment in working capital

Net profit less adjusted taxes

(NOPLAT, excludes interest and

nonoperating income) + Noncash

operating expenses – Investments in

invested (fixed and working) capital

Net profit + after-tax net interest

expense – change in fixed capital –

change in working capital

Same overall logicin all approaches:

• Start with what is

left to equity- and

debtholders after

taxes

• Add back noncash

charges

• Take out

investments in

capital

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Our simple model for FCFF starting fromoperative cash flows

+ Sales – Cost of goods sold – Selling, general & administrative expenses

= Earnings Before Interest Tax Depreciation and Amortisation (EBITDA)– Depreciation (tax deductible) – [Amortization (if tax deductible, like in Finland, unlike in the US)]

= Operating Profit (EBIT) – Taxes on operating profit (cash taxes)

= Net operating profit less adjusted tax (= NOPLAT) + Depreciation (tax deductible) + [amortization (if tax deductible)]– Increase in working capital requirement – Capital expenditures (CAPEX)

= FREE CASH FLOW TO FIRM (FCFF)

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Ok, but what on earth is NOPLAT?

• It is a measure of operating profit available to all investors (equity

and debholders) after tax

• Interest paid on outstanding debt is not deducted from NOPLAT

• Operating income not generated by invested capital is not part of

NOPLAT (e.g., shares held in unaffiliated companies, which are

valued separately on top of FCFF valuation)

• NOPLAT takes out taxes on operating income (different from

accountant’s taxes in income statement)

– Hypothetical taxes on operating income as if the company were

100% equity financed

– WACC will take care of the tax shield of debt

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Definitions of operating working capital

Pinto et al.

Koller et al.

Palepu et al.

Definition

(Current assets – Cash and marketable securities)–(Current liabilities – Current debt and current portion of non-current debt)

Accounts receivable + inventory + working (excl. excess) cash balance + prepaid expenses –Accounts payable – Accrued expenses – Deferred revenue

(Current assets – Cash and marketable securities)–(Current liabilities – Current debt and current portion of non-current debt)

Same overall logicin all approaches:

• Operating workingcapital (OWC) is different fromaccountantsworking capital

• OWC = Operating assets – Operating liabilities

• (Excess) cash notpart of OWC

Our definition

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Typical non-cash charges• Depreciation of tangible assets or LT bond discounts• Amortization of intangible assets• Deferred revenue and prepaid expenses (saadut ja

maksetut ennakot)• Depletion of natural resources• Restructuring charges• Losses/gains on sale of non-operating assets• Write-downs of assets• Deferred taxes (depends):

– If financial reporting = depreciation schedule, then no change in deferred taxes

– If accelerated reporting, tax savings now, pay later (in the long-term will even out)

– For complicated tax structures (e.g., M&A), items maybe large enough to warrant detailed investigation, ifsmall, don’t bother

In our FCFF formula

Not in our FCFF formula, left out for simplicity

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Realized or adjusted FCFF as basis for forecasting?• Actual, realized FCFF can be measured by standardized Cash

flow statement (Palepu)

• For valuation forecasting purposes it makes sense to leave out non-recurring, one-time or extraordinary items for future years (adjusted FCFF). Also it makes sense to assume nominal or average tax rates even if starting year taxes had been exceptional.

• The purpose is to estimate the cash generating power of company operations– For this reason Interest expense after tax has to be added

back if they were deducted in Cash flow from operations

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Free Cash Flow to Equity (FCFE) Model• Value of Equity is estimated by discounting future Free cash flows to

Equity (FCFE) with cost of equity (DCF formula). If there are not share issues/repurchases, FCFE tells what amount could be paid out as dividends from annual cash flow.

Equity value0 =

Terminal value of equity VT =

FCFEi

(1+ re )i +

TVT(1+ re )

Ti=1

T

∑

FCFET+1

re − g

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Surprise! Academics and pracioners havealso different definitions for FCFEFCFE =

FCFF – Interest(1 – Tax Rate) + Net Borrowing

Net income + Non-cash charges – CAPEX – Net OWC investment + Net borrowing

CFO – CAPEX + Net Borrowing

from Standardized Cash Flow Statement (Palepu)

Pinto et al. Koller et al. Palepu et al.

Recommen-ded for simple models

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Agenda

• Basic concepts

• Absolute (cash flow based) valuation models‒ DDM‒ FCFF and FCFE‒ One adjustment: excess cash

25

Adjustments in FCFF and FCFE valuation

• Using a simple FCFF or FCFE skips some details in valuation. These details include:– Excess cash (and other nonoperational assets held for sale)– Minority interest– Extraordinary items included in net income– Modeling deferred tax asset and liability separately (cash

flow timing impact of accountant’s vs. taxmansdepreciation)

– Capitalizing operating leases and other off-balance sheetliabilities

– Treating expensed R&D as capital expenditure rather thancost

• In the interest of time, we cover just excess cash

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Excess cash is the amount of ”unnecessary” cash that could be paid out or used to retire debt

Assets in place

Growth assets

Assets Liabilities

Equity

Excess cash Gross debt

Net debt

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Excess cash is not king and should be thrown out from valuation

• Simplest way: verify that there is no excess cash. Small amount of cash is necessary anyway for smooth business

• Simple way: in case of excess cash, keep cash and associated interest income out from valuation and add back book value of cash after you are done

• Complex way: include interest income from cash. Adjust discount rate to incorporate the low-risk of cash: cash is a zero-beta asset

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Excess cash: simple way

• If there is substantial excess cash (or other non-operating assets) not needed in operations, they can be taken out from valuation and treated separately

• Treat company as sum of parts:– Operations +– Cash and other non-operating assets (e.g., assets held for

sale, shares held in unaffiliated companies)• VC = Value of the company = Value of Operations (VO) + Excess

Cash• If you decide to take out excess cash, then also use net debt

(gross debt – cash) for WACC market values and all financial ratios

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Review: what does all of this mean?

• FCFF, calculated from EBIT and excluding any non-recurring items (forecasting rather than accountants FCFF)

• Terminal Value from EV/EBITDA multiples or using TV formula• Check if excess cash:

– If trivial amount, do not bother and use gross debt in WACC calculations– If nontrivial amount, take out from balance sheet, value separately and use net

debt in WACC calculations