Frameworks for Valuation
Chapter 8 Summary
Paula Heathcoat
April 9, 2003
Valuing a company using the
discounted cash flow approach
4 models
Enterprise DCF model
Economic Profit Model
Adjusted Present Value (APV) Model
Equity DCF Model
All models provide the same results
(demonstrated later in this presentation)
Enterprise Discounted
Cash Flow Model
Formula: Single-Business Company
Equity Value = Operating Value - Debt Value
Free cash flow from operations
Discounted by
WACC
140
100
90
Debt Value
=
Cash flow to debtholders
43
20
26
50
33
+
Equity Value
Operating Value
70
130
Cash flow to equity owners
50
Year
1
64
2
87
90
4
5
67
3
Enterprise Discounted
Cash Flow Model
Formula: Multi-business Company
Equity value =
Sum of the values of the individual operating units
+ Marketable securities
- Corporate overhead
- Value of company debt and preferred stock
1,750
Marketable securities
250
200
1,500
Unit C
300
Debt
Unit D
150
300
P/S 100
Unit A
400
Common Equity Value
Unit B
700
Value of
operating units
Corporate
Overhead
Enterprise
Value
1,100
Value
distribution
Enterprise Discounted
Cash Flow Model
Reasons for recommending the enterprise
DCF model:
The model values the components of the business
(each operating unit) that add up to the enterprise
value
The approach helps to identify key leverage areas
It can be applied consistently to the company as a
whole or to individual business units
It is sophisticated enough to deal with the
complexity of most situations, yet easy to carry
out with personal computer tools
Enterprise Discounted
Cash Flow Model
Value of operations
Equals the discounted value of expected future
free cash flow
Free cash flow =
after tax operating earnings
+ non-cash charges
- investments in operating working capital,
property, plant, and equipment,
and other assets
Free cash flow =
sum of the cash flows paid to or received
from all the capital providers
Enterprise Discounted
Cash Flow Model
Value of operations
The discount rate applied to the free cash flow
should reflect the opportunity cost to all the
capital providers weighted by their relative
contribution to the company’s total capital, or
WACC
opportunity cost is the rate of return the investors
could expect to earn on other investments of
equivalent risk
Enterprise Discounted
Cash Flow Model
Value of operations
Indefinite life of a business
Separate the value of the business into two periods
during a precise forecast period
after a precise forecast period
Value = present value of cash flow during precise forecast
period + present value of cash flow after precise forecast
period
The value after the precise forecast period is the continuing
value
Continuing value = NOPLAT (1-g/ROICi)
WACC-g
Enterprise Discounted
Cash Flow Model
Value of debt
Equals the present value of the cash flow to debt
holders discounted at a rate that reflects the
riskiness of that flow
Value of equity
Equals the value of the operations plus nonoperating assets, less the value of its debt and any
non-operating liabilities
WACC Summary
Hershey Foods
Source
of
Debt
Equity
Proportion Opportunity Tax rate After-tax Contribution
of total
cost
cost
to weighted
capital
average
12.1%
5.5%
39.0%
3.4%
0.4%
87.9%
8.1%
8.1%
7.1%
WACC
7.5%
Free Cash Flow
Valuation Summary
Year
Free cash
flow
Discount
Factor
Present Value
Of FCF
(7.5%)
($ millio n)
331
349
0.930
0.865
308
302
485
14,710
0.485
0.485
235
7,138
9,855
1.037
10,217
450
10,667
1,282
9,385
62.78
($ millio n)
1999
2000
2008
Continuing value
Mid-year adjustment factor
Value of operations
Value of non-operating investments
Total enterprise value
Less: Value of debt
Equity value
Equity value per share
Enterprise Discounted
Cash Flow Model
Drivers of Free Cash Flow and Value
The rate at which the company is growing
Growth Rate = ROIC x Investment rate
Return on invested capital (relative to the cost of
capital, or WACC)
ROIC = NOPLAT / Invested capital
If ROIC > WACC , then value is greater
If ROIC = WACC, then value is neutral
If ROIC <WACC, then value is destroyed
Enterprise Discounted
Cash Flow Model
Drivers
To increase value, a company must do one or
more of the following
Earn a higher return on invested capital on
legacy assets
Ensure that ROIC(new) exceeds WACC
Increase the growth rate (keeping ROIC above
WACC)
Reduce WACC
Growth Rate & Free Cash Flow
5% Growth rate ($ millions)
Year 1
NOPLAT
100
Net Investment
25
Free cash flow
75
2
105
26
79
3
110
27
83
4
116
29
87
5
122
31
91
6
128
32
96
7
134
33
101
8
141
35
106
9
148
37
111
10
155
39
116
11
163
41
122
12
171
43
128
5
136
54
82
6
147
59
88
7
159
64
95
8
171
68
103
9
185
74
111
10
200
80
120
11
216
86
130
12
233
93
140
8% Growth rate ($ millions)
Year 1
NOPLAT
100
Net Investment
40
Free cash flow
60
2
108
43
65
3
117
47
70
4
126
50
76
How ROCI and Growth Drive Value
DCF Value
Operating profit
(annual growth)
3%
6%
9%
ROIC
7.50% 10.00% 12.50% 15.00% 12.00%
$887
$1,000
$1,058
$1,113
$1,170
$708
$1,000
$1,117
$1,295
$1,442
$410
$1,000
$1,354
$1,591
$1,886
Value Value
Destruction neutral
Value
creation
A ssumes starting NOP LA T = 100, WA CC = 10%, and a 25-year ho rizo n after which ROIC = WA CC
Economic Profit Model
Useful measure for understanding a
company’s performance in any single year
Economic Profit equals the spread between
the return on invested capital and the cost of
capital times the amount of invested capital
Economic profit =
Invested capital x (ROIC - WACC)
Translates the two value drivers (growth and
ROIC) into a single dollar figure
Economic Profit Model
Economic Profit is the after-tax operating profits
less a charge for the capital used by the
company
Economic Profit = NOPLAT - Capital charge
= NOPLAT - (invested capital x WACC)
The approach says that the value of a company
equals the amount of capital invested plus a
premium or discount equal to the present value
of its projected economic profit
Value = Invested capital + present value of projected
economic profit
Economic Profit Calculation
$ million
Return on invested capital
WACC
Spread
Invested capital (beginning of year)
Economic profit
NOPLAT
Capital charge
Economic profit
1997
24.30%
8.30%
16.00%
1,815
291
442
(151)
291
Forecast Forecast Forecast
1998
1999
2000
2001
23.0$
23.00%
22.70%
22.60%
7.50%
7.50%
7.50%
7.50%
15.50%
15.50%
15.20%
15.10%
1,885
1,830
1,919
2,005
293
283
292
304
434
420
436
454
(141)
(137)
(144)
(150)
293
283
292
304
Economic Profit
Valuation Summary
Year
Economic
Profit
($ millio n)
1999
2000
283
292
2008
403
Continuing value
11,858
Present value of economic profit
Invested capital (beginning of year)
Mid-year adjustment factor
Value of operations
Value of non-operating investments
Total enterprise value
Less: Value of debt
Equity value
Discount
Factor
Present Value of
Economic Profit
(7.5%)
($ millio n)
0.930
0.865
263
252
0.485
0.485
196
5,754
8,024
1,830
9,857
1.037
10,217
450
10,667
1,282
9,385
Free Cash Flow Valuation
Summary
Equity Value
9,385
Economic Profit Valuation
Summary
Equity Value
9,385
Adjusted Present Value (APV)
Model
The APV model discounts free cash flows to
estimate the value of operations, and
ultimately the enterprise value, where the
value of debt is then deducted to arrive at an
equity value.
This is very similar to the enterprise DCF
model, except:
APV model separates the value of operations into
two components
The value of operations as if the company were entirely
equity-financed
The value of the tax benefit arising from debt financing
Adjusted Present Value (APV)
Model
The APV model reflects the findings
from the Modigliani-Miller propositions
on capital structure Remember these guys from
602?value
In a world with no taxes, the Finance
enterprise
of a company (the sum of debt plus equity) is
independent of capital structure (or the amount
of debt relative to equity)
The value of a company should not be affected
by how you slice it up
Adjusted Present Value (APV)
Model
“Mr. Berra, would you like your pizza cut into six or eight
pieces?”
“Six please, I am not hungry enough to eat eight.”
The pizza is the same size no matter how many pieces
you cut into it!
Adjusted Present Value (APV)
Model
The implications of MM for valuation in a
world without taxes are
the WACC must be constant regardless of the
company’s capital structure
Capital structure can only affect value through
taxes and other market imperfections and
distortions
Adjusted Present Value (APV)
Model
The APV model
1) values a company at the cost of capital
as if the company had no debt in its
capital structure (the unlevered cost of
equity)
2) adds the impact of taxes from
leverage.
APV Free Cash Flow
Valuation Summary
Year
1999
2000
Free cash Unlevered Discount
flow (FCF) Cost of
Factor
($ millio n)
Equity
331
7.80%
0.928
349
7.80%
0.860
2008
485
Continuing value
13,526
7.80%
7.80%
Mid-year adjustment factor
APV value of FCF
0.472
0.472
Present
Value
($ millio n)
307
301
229
6,380
9,056
1.037
9,390
APV Free Cash Flow Valuation
Summary with Tax Impact
APV value of FCF
9,390
Value of debt tax shield
642
Non-operating assets
450
Total enterprise value
10,482
Less: value of debt
1,282
Equity Value
9,200
APV Free Cash Flow
Valuation Summary
Equity Value
9,200
Free Cash Flow Valuation
Summary
Equity Value
9,385
Why is there a difference in the equity values?
Adjusted Present Value (APV)
Model
Comparison…
In the enterprise DCF model, this tax benefit is taken
into consideration in the calculations of the WACC by
adjusting the cost of debt by its tax benefit
In the APV model, the tax benefit from the
company’s interest payments is estimated by
discounting the projected tax savings
The key to reconciling the two approaches is the
calculation of the WACC
Adjusted Present Value (APV)
Model
Relating WACC to the unlevered cost of
equity assuming that the tax benefit of debt
is discounted at the unlevered cost of equity
WACC = ku - kb (B/(B+S)) T
Where
ku = unlevered cost of equity
kb = Cost of debt
T = Marginal tax rate on interest
expenses
B = Market value of debt
S = Market value of equity
Enterprise DCF Adjusted for
Changing Capital Structure
Year
1999
2000
2008
Continuing value
Free cash
flow (FCF)
($ million)
331
349
Debt/Total WACC Discount Present
Value
value (percent) Factor
(7.5%) ($ million)
(percent
308
0.930
7.52
13.3
302
0.865
7.54
12.3
485
14,710
Mid-year adjustment factor
Value of operations
Value of non-operating investments
Total enterprise value
Less: Value of debt
WACC Equity Value
13.1
13.1
7.52
7.52
0.483
0.483
234
6,965
9,675
1.037
10,032
450
10,482
1,282
9,200
The enterprise DCF
model assumes that
the capital structure
and WACC would be
constant every period
However, the capital
structure does
change every year
A separate capital
structure and WACC
can be estimated for
every year
APV Free Cash Flow
Valuation Summary
Equity Value
9,200
Enterprise DCF Adjusted for
Changing Capital Structure
Equity Value
9,200
The Equity DCF Model
The equity DCF model discounts the cash
flows to the equity owners of the company at
the cost of equity
Equity DCF
Valuation Summary
Year
Equity
cash flow
($ million)
Discount
Factor
Present
Value
($ million)
1999
2000
245
137
0.925
0.856
227
118
2008
193
0.460
Continuing value
12,895
0.460
Discounted equity cash flows
Mid-year adjustment factor
Value of non-operating investments
Equity value
89
5,934
8,454
357
450
9,261
The Equity DCF Model
This model also needs to be adjusted for the
changing capital structure. It is necessary to
recalculate the cost of equity every period
using the following formula
ks = ku + (ku - kb)(B/S)
Where ks = levered cost of equity
Once the adjustment is made, the value
using the equity DCF approach is the same
as the APV approach and the enterprise DCF
model with WACC adjusted every period
Equity DCF
Valuation Summary
Year
Equity
Debt/Total
cash flow
value
($ million)
Levered Discount
ks
Factor
Present
Value
(percent
(percent)
13.3
12.3
8.16
8.13
0.925
0.855
227
117
2008
193
13.1
Continuing value
12,838
13.1
Discounted equity cash flows
Mid-year adjustment factor
Value of non-operating investments
Equity value
8.15
8.15
0.458
0.458
88
5,880
8,393
357
450
9,200
1999
2000
245
137
($ million)
The Equity DCF Model
Once the adjustment is made, the value
using the equity DCF approach is the same
as the APV approach and the enterprise DCF
model with WACC adjusted every period.
APV Free Cash Flow
Valuation Summary
Equity Value
9,200
Adjusted Enterprise DCF
Valuation Summary
Equity Value
9,200
Equity Value
9,200
Adjusted Equity DCF
Valuation Summary
The Equity DCF Model
The equity DCF approach is not as useful as
the enterprise model (except for financial
institutions) because
Discounting cash flow provides less information
about the sources of value creation
It us not as useful for identifying value-creation
opportunities
It requires careful adjustments to ensure that
changes in projected financing do not incorrectly
affect the company’s value
It requires allocating debt and interest expense to
each business unit, which creates extra work, yet
provides no additional information.
Additional Models and Approaches
Option Valuation Models
Models which adjust for management’s ability
to modify decisions as more information is
made available.
DCF Approaches
Using real instead of nominal cash flows
and discount rates
Discounting pretax cash flow instead of
after-tax cash flow
Formula-based DCF approaches
Summary of Models
Enterprise DCF Model
Advantage:
Economic Profit Model
Advantage over DCF
Model:
Enterprise
Values
the components
DCF
Pinpoints
key leverage areas
Consistent
Can handle complex situations
Easy to carry out
Economic
EP is a useful
Profit measure for
understanding a company’s
performance in any single
year, while cash flow is not
APV Model
Advantage over Enterprise
DCF Model:
Equity DCF Model
Advantage:
Simple and Straightfoward
Equity DCF
APV is easier
APVto use when
the capital structure is
changing significantly over
the projection period
Disadvantage:
Provides less information
Requires careful adjustments
Frameworks for Valuation
Questions?