Introduction Two important distinctions Javier Estrada Price v . - PDF document

Corporate Finance DCF Valuation Javier Estrada Spring, 2014 1. Introduction • Price v . Value • Absolute valuation v . Relative valuation 2. DCF Models • The general DCF model • Steps • Versions: WACC, APV, and FTE • Complementary issues Introduction  Two important distinctions Javier Estrada  Price v . Value IESE Business • Price is what you pay, value is what you get! School  Absolute valuation v . Relative valuation Barcelona Spain • Absolute valuation  DCF models: DDM, WACC, APV, FTE  Value is derived from fundamentals in a PV calculation ( Cash flows, not earnings, and their risk ) Go • Relative valuation  Multiples: P/E, P/B, P/CF, P/D, …  Value is derived from alignment to a benchmark  Remember a critical point  When valuing stocks, there is ample room for reasonable disagreement MBA Go CorpFin Spring, 2014 1

The General DCF Model Javier Estrada IESE Business School  Two key variables Barcelona Spain  Expected cash flows • T depends on the asset • Often a terminal value plays a role in E(CF T )  Discount rate • R = R f + RP  R f : Risk‐free rate (Compensates the expected loss of purchasing power)  RP : Risk premium (Compensates risk bearing) MBA CorpFin Spring, 2014 DCF Model – Steps  Basic steps Javier Estrada 1. Choose a model IESE Business 2. Estimate the appropriate free cash flows (FCF) for School that model over the forecasting period ( T ) Barcelona Spain 3. Estimate a terminal value (TV) 4. Estimate the appropriate discount rate (DR) for that model 5. Calculate the present value of all FCFs discounted at the DR MBA CorpFin Spring, 2014 2

Step 1 – Model  There are several versions of the DCF model Javier Estrada  WACC model IESE Business • Discounts unlevered FCFs at the cost of capital School  APV model Barcelona Spain • Discounts unlevered FCFs at the unlevered cost of equity • Adds the net present value of debt effects  FTE model • Discounts levered FCFs at the cost of equity  Recall  The DDM is just another version of the DCF model • Discounts dividends at the cost of equity MBA CorpFin Spring, 2014 Step 2 – Free Cash Flows Javier Income Statement Free Cash Flows Estrada Revenues Net Income IESE – Operating Costs + After‐tax Interest Business School – Depreciation + Depreciation Barcelona EBIT Operating Cash Flow Spain – Interest – Net CapEx Earnings Before Taxes – Increase in NWC – Taxes Unlevered FCF (UFCF) Net Income – After‐tax Interest Levered FCF (LFCF)  Remarks  FCFs can also be calculated beginning from EBIT • UFCF = (1– t c )⋅EBIT + Dep – Net CapEx – Increase NWC MBA  UFCFs are independent from the capital structure Go CorpFin Spring, 2014 3

Step 3 – Terminal Value  The terminal value can be estimated in several Javier Estrada ways, and is usually estimated in one of two ways IESE Business  A growing perpetuity School  A multiple ( M ) of a fundamental variable Barcelona Spain MBA CorpFin Spring, 2014 Step 4 – Discount Rate  The discount rate depends on the FCFs used, Javier Estrada which in turn depends on the model chosen IESE Business  WACC model School Barcelona • Cost of capital ( R WACC ) Spain  APV model • UFCFs at the unlevered cost of equity ( R U )  CAPM with an unlevered beta • Tax shields at the required return on debt ( R D )  FTE model • Levered cost of equity ( R L )  CAPM with a levered beta MBA CorpFin Spring, 2014 4

Step 5 – Present Value Calculation  WACC model Javier Go Estrada IESE Business School Barcelona Spain  Remarks  The PV of the UFCFs yields the value of the company • V = D+E  The value of the company’s equity is obtained after subtracting the assumed long‐term debt from V • E = V–D  The impact of debt is accounted for in R WACC MBA CorpFin Spring, 2014 Step 5 – Present Value Calculation  APV model Javier Estrada IESE Business School  Unfortunately , the APV is usually written as … Barcelona Spain  Remarks  The value of the company is given by the PV of the UFCFs plus the net impact of debt (V=D+E)  The value of the company’s equity is obtained after subtracting the assumed long‐term debt from V (E = V–D)  The impact of debt is accounted for in the usually ‐ MBA CorpFin miswritten last term ‘NPV(D)’ Spring, 2014 5

Step 5 – Present Value Calculation  FTE model Javier Estrada IESE Business School Barcelona Spain  Remarks  The PV of the LFCFs yields the value of the company’s equity • No debt has to be subtracted from this value  The impact of debt is accounted for both in the LFCFs and in R L MBA CorpFin Spring, 2014 Complementary Issues Javier Estrada IESE Business School  WACC model (Valid for the other models as well) Barcelona Spain  Forecasting period • How long? What growth rate?  Stages of growth • How long each? What growth rate for each?  Terminal value Go • Can easily be 40‐60% of the estimated value • Always perform sensitivity analysis on it (on g or M ) • Keep in mind long‐term constraints ( g ≤ g GDP ) MBA CorpFin Spring, 2014 6

Complementary Issues  In theory, all three models (and the DDM) should Javier Estrada yield exactly the same result IESE Business  In practice, they hardly ever do School  When to use each model? Barcelona Spain  WACC or FTE • Usually when the proportions of debt and equity are expected to be (more or less) constant over time  APV • Usually when the level of future debt is (more or less) known in advance  Other issues that have to be dealt with  Circularity, target capital structures, … MBA CorpFin Spring, 2014 Appendix Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 7

Why Cash Flow? Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Why Cash Flow? Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Back 8

Reasonable Disagreements Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Reasonable Disagreements Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Back 9

UFCFs and Capital Structure Javier Income Statement No Debt With Debt Estrada Revenues 16,667 16,667 IESE – Operating Costs 15,000 15,000 Business – Depreciation 100 100 School = EBIT 1,567 1,567 Barcelona Spain – Interest 0 300 = EBT 1,567 1,267 – Taxes (40%) 627 507 = Net Income 940 760 UFCFs Net Income 940 760 + After‐tax Interest 0 180 + Depreciation 100 100 = Operating CF 1,040 1,040 – Increase in NWC 100 100 – Net CapEx 100 100 MBA = Unlevered FCF 840 840 CorpFin Spring, 2014 Back The WACC Model Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Back 10

Terminal Value Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Terminal Value Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 Back 11