Value of operations= the discounted value of expected future free cash flow

Discount rate should reflect the opportunity costs to all capital providers weighted
by their relatives contribution(WACC)
(WACC= ke.We+Kd(1-t).Wd+Kps.Wps

Value = PV of CF + PV of CF after
during explicit period explicit forecast period

Continuing = NOPLAT(1-g/ROICI)
value WACC-g

2 value drivers of FCF

- rate at growth of revenue,profit,capital base
- ROIC relative to cost of capital

ROIC = NOPLAT
Invested capital
i.NOPLAT= NOP less Adjusted Taxes
ii. Invested Capital= Operating WC+Net
property,plant,equipment+ other assets

NOPLAT $100
-Net Investment $25
FCF $75

Analysis of historical performance

Reorganizing The Accounting Statements

Results in estimation of NOPLAT, operating inv. Capital
After NOPLAT and Invested Capital have been defined, ROIC can be calculated

EP = Invested Capital x (ROIC-WACC) or

EP = NOPLAT - Capital charge
EP = NOPLAT- (invested capital x WACC)

FCF = NOPLAT - net investment

= (NOPLAT+depn)-(net inv+depn)
= Gross Cash Flow - Gross investment

1
 ROIC= NOPLAT/Inv capital
NOPLAT= EBITA (1-cash tax rate)

ROIC = EBITA X ( 1 cash tax rate)
Invested
capital

If we relate EBITA and inv cap. to revenue

EBITA = EBITA X Revenue
Invested Revenues Invested
Capital Capital

Credit Health and Liquidity

Interest Coverage:
EBITA/(Interest Expense+ Required Preferred Dividends)

WACC = kb (1-Tc)(B/V)+ kp(P/V) + ks (S/V)

Kb = pretax market expected yield to maturity on noncallable, nonconvertible debt.
Tc = marginal tax rate
B = Market value of interest bearing debt
V = market value of enterprise (V = B + P + S)
Kp = after tax cost of capital for noncallable, nonconvertible preferred stock (which
equals the pretax cost of preferred stock when no deduction is made from corporate taxes
for preferred dividends.)
P = market value of preferred stock
Ks = market determined opportunity cost of equity capital
S = market value of equity

Steps For Estimating The WACC

Step 1: Develop Market Value Weights
Step 2: Estimate The Cost of Non Equity Financing
Step 3: Estimate The Cost Of Equity Financing

Step 1: Develop Market Value Weights

if capital structure changes, WACC must be adjusted
cap structure might be affected by changes in market value of outstanding
securities
used target cap structure to avoid circularity problems between WACC and mkt
value weights.

2
 Using target cap. structure: estimate current market value based cap structure,
review cap structure of comparable companies and review management approach
to financing

Estimating Current Capital Structure:

Best source of mkt value is market price
Simply multiply no of outstanding security by its price
Debt type financing: identify contract period, credit quality, calculate the
PV of payments. Eg: Option features, swaps, foreign currency obligation,
leases

Equity linked/hybrid financing: return (part or all) linked to to the value of

all or part of the business. Eg; warrants, ESOS, convertible securities - use
option pricing approach- if the no. is large, include in WACC
Minority interests - use DCF to value a separate subsidiary or PE/MBV of similar
companies for unlisted stocks
Preferred stock: cost = Dividend Yield/ Current Stock price

Common equity: if the V used in WACC is approx. equal to the PV using a
discount rate to the FCF, then you have an implied economic capital structure for
the business:

Step 2: Estimate The Cost of Non Equity Financing

Straight investment grade debt:
not convertible or callable: use DCF to estimate return and market value
use current mkt rate of equivalent risk for COC
Below investment grade debt:
use normal bond valuation and solve for I
adjust to reflect additional risk

Subsidized debt:
coupon normally below normal bonds
COC will be YTM or similar rated tax free issue
Leases: substitutes for other debts so their cost is similar to cos other long term
debt
Straight Preferred Stock: kp = div/p
if mkt price not available use yields on similar issues as estimate.

Foreign currency denominated debt:

effective cost equals the after tax cost of repayment in terms of local
currency
Use Interest rate parity:1+kb =(X0/Xf)(1+r0)
kb = domestic pretax cost of N year debt
X0 = The spot foreign exc. Rate
Xf = The N year forward foreign exchange rate ( units of
foreign per home currency)

3
 r0 = the foreign interest rate on an N year bond

Example (US company):

Domestic borrowing rate =7.25%
the rate on 1 year Swiss francs denominated loan= 4%
Spot exchange rate = 1.543 francs per dollar
One year forward rate = 1.4977
1+kb =(X0/Xf)(1+r0) =
1+kb = (1.543/1.4977)(1+0.04)= 1.0715
One year equivalent domestic borrowing rate = 7.15

Step 3:Estimate The Cost Of Equity Financing

CAPM = ks = rf + [E(rm)- rf](beta)
Determining the risk free rate - rf
risk free rate- return on securities with no default risk
best estimate is return of zero beta portfolio but not practical
Can choose from government securities: t bills, 10 year treasury
bond or 30 treasury bonds. The 10 year is recommended.

Determining the market risk premium -E(rm)-rf

Can be based on the past Or the future
Exhibit 10.4
Measure the risk premium as long a period as possible
Use arithmetic average of rates of return
Adjust the historical arithmetic average down by 1.5 to 2% to
purge of upward bias
Calculate the premium over LT govt bond returns to be consistent
with rf

Historical Period
A longer period is better than short one
Include all possible events, so the average include all kinds of
uncertainties
Geometric Vs Arithmetic Average Rate of Return
Arithmetic = sum/ no of period
Geometric : PV = FV/(1+k) where k is the geometric return
Refer Exhibit 10.6

Estimating The Systematic Risk (Beta)

published by investment firms - get a few sources
should also compare beta against industry average
if beta from several sources vary by more than 0.2 or the beta of
the company is more than .3 from the industry average - use
industry average

4
 Basic Steps Of Financial Forecast( Iterative rather than sequential):
Determine Length and Detail of Forecast
Develop Strategic Perspective
Translating The Strategic Perspective Into Financial Forecast
Develop Performance Scenarios
Checking For Consistency and Alignment
Explicit forecast for a number of years followed by a simplified approach to value the
remaining life of the company(continuing value)
Explicit forecast should be long enough for company to achieve a steady state by the end
of the period
Characteristics of the Steady State:
company earns a constant rate of return on all new capital investment
during the continuing value period
earns a constant return on its base level of invested capital
Grows at a constant rate and reinvests a constant proportion of its op.
Profits each year
Forecast long enough so that estimated growth is close to the economy
Recommended 10-15 years
3-5 years detailed forecast
Simplified forecast for the remaining focusing on important variables:
revenue growth, margins and capital turnover

Develop Strategic Perspective

Perspective: crafting a plausible story about the companys future performance to
provide context for financial forecast
The key is competitive advantage.
Competitive advantage = ROIC>WACC:
provide superior value to customers (comb. Of price and product attributes
that cannot be copied by others)
Achieve lower costs than competitors
Using capital more productively than competitors

To develop strategic perspective, use these four analytical frameworks:

Industry Structure Analysis
Porter 5 forces and S-C-P Model
Customer Segmentation Analysis
Competitive Business System Analysis
AKA Value Chain Analysis
Coyne/Subramaniam Model

Porter Industry Structure Model

5
 Substitutes

Supplier
Industry Customer
Bargaining power
profitability Bargaining power

Entry/exit
barriers

Structure-Conduct-performance Model
External shocks Structure Conduct Performance

- macroeconomics
- Technology
- Regulation feedback
Customer preferences/
demographic

Customer Segmentation Analysis

Purpose is to help estimate potential market share by identifying why customers
will choose one companys products over others
How a company could differentiate itself
Identify how profitable a group of customers based on needs and costs to serve
Works from 2 perspectives: Customer and producer

Customer: Product attributes have different importance to different group of

customers. Thus producers may include different attributes thus delivering
different benefits to different groups
Producer: Different customers have different costs to serve - determine how
profitable to serve a particular group.

Competitive Business System Analysis

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 Sales &
Product Design Manufacturing Marketing distribution
and development Procurement

Issues
Product attributes
Quality
Time to market
Proprietary technology
Access to sources Costs
Outsourcing
Costs
Cycle time
Quality
Pricing
Advertising/
Promotion
Packaging
Brands
Sales
Effectiveness
Costs
Channels
Transportation

Coyne/Subramaniam Model

Basis of competition
Industry structure/conduct (source of advantage)

Co-dependent systems Insight/foresight

Frontline execution
Privileged relationship

Traditional arms length Structural advantage

Translating The Strategic Perspective Into Financial Forecast

Build revenue forecast
Forecast operational items
Project non operating items
Project the equity accounts

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 Balancing the CF and BS using cash or debt accounts
Calculate ROIC tree and key ratios

Others issues in forecasting balance sheet items:

Stocks Vs Flows (Stock is preferred):
Stocks: directly from balance sheet figure. Example: Inventories as
a function of revenue
Flows: changes in the balance sheet items
Exh. 11.5
Inflation
Forecast and COC be estimated in real terms
Most valuation assume real risk free rate of 3-4%

Develop Performance Scenarios

Final stage: construct FCF and value drivers from IS and BS, then evaluate these
forecast in the same way historical performance was evaluated. ASK:
companys performance on value drivers consistent with the cos
economic and industry competitive dynamics?
Revenue growth consistent with industry growth?

IS ROIC consistent with industrys competitive structure? Entry barriers?

Bargaining power of customers? Return and growth relative to
competition?
How technology will affect return and risk?
Can the co manage all the investment it is taking?

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Guides For Forecasting
Companies rarely outperform their peers for long periods of time
Company performance varies widely from industry averages
Industry average ROICs and Growth rates are linked to economic fundamentals

Estimating Continuing Value

How to estimate CV?
Value= PV of CF in explicit period +PV of CF after the explicit period
Using CV eliminates the needs to forecast in detail the cos CF over an extended
period
Estimate of CV important because a large portion of value is derived from it (Ex
12.1)

Cont. Value = NOPLAT t +1 (1-g/ROIC I)

WACC g

NOPLAT t +1 = normalized level of NOPLAT in the first year after the explicit
forecast period.
G = expected growth rate in NOPLAT in perpetuity
ROIC1 = expected rate of return on net new investment
WACC = the weighted average cost of capital.

The formula known as value driver formula (contains g, ROIC, WACC)

Derived by projecting CF into perpetuity and discounting at WACC.
Assumptions:
earns constant margin, earns constant returns on existing invested capital
Rev and NOPLAT grow at a constant rate and invest same propotion of its
gross CF each year
Earns a constant return on all new investments

CV = (FCF T+1)/WACC-g

CV = continue value
FCF t +1 = normalized level of free cash flow in the first year after the explicit forecast
period.

FCF = NOPLAT x (1-IR)

g = ROIC I x IR
IR = g/ROICI

IR = investment rate

FCF = NOPLAT x (1-(g/ROIC I))

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Continuing value =
CV=NOPLAT T+1 (1-g/ROIC I)
WACC -g

= Invested + PV of EP + PV of EP
Value in explicit period after explicit period
capital
Econ Profit T+1 NOPLAT T+1 (g/ROIC I)(ROICI-WACC)
Cont Value = WACC -g + WACC(WACC -g)

Does the length of forecast affect the value of company? No, it simply
redistributes value between the explicit and continuing period (Ex 12.2)
Confusion about ROIC: supernormal followed by normal returns - not necessarily
linked to length of forecast - does not affect value.
When is value created? (Ex 12.5-7)

Estimating Parameters for Cont. Values Variables

NOPLAT:
NOPLAT should reflect normalized at midpoint of its business cycle.
Revenue reflect continuation in trends from the last forecast year.
Op Costs based on sustainable margin, tax on LT expected rates

FCF - estimate investment for Cont. period to sustain forecasted growth.

Normally lower than explicit period thus inv. Should be proportionately smaller.
Incremental ROIC: must be consistent with competitive position. Eventually
ROIC =WACC

Growth rate: cany grow faster than the conomy for long. At best estimate based
on LT rate of consumption growth + inflation
WACC: sustainable capital structure and business risk consistent with expected
industry conditions
Investment rate= ROIC/g - can be explained in light of industry economics

Common Pitfalls
Nave base year extrapolation
error in forecasting the base level of FCF
Nave overconservatism: assuming ROIC =WACC thus avoid the needs to
forecast growth needs
Purposeful overconversatism: due to uncertainty and size of CV

Calculating and Interpreting The Results

Value of operations 5000
Excess cash and MS 50
Inv in subsidiaries 300
Other non.op assets 100

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Enterprise Value 5450
Interest bearing debt (1000)
Cap value of op leases (400)
Minority Int (100)
Pref shares (200)
ESOS (200)
Equity Value 3550

Interpret The Results

Purpose of valuation- to guide mgt or inv decisions - must look at the perspective
of decision in hand
Value must be thought of in terms of scenarios and ranges of value that reflect the
associated uncertainties
Additional analyses important to gain confidence in results - impact on
shareholder value

Understand how variables could change - margin of error

Assess the likelihood of change in important assumptions underlying each
scenario:
impact and likelihood of change in the broad assumptions - broad
economic trends
Assumptions about the competitive structure of the industry
Assumptions about the companys internal capabilities to achieve results
predicted.

The Art of Valuation

Valuation depends on understanding of the business, its industry and gen econ
environment - prudent forecasting - foresight
Avoid shortcuts - develop a complete model:
include complete income statements and key performance ratios: ROIC,
Op Margin, Capital turnover, CF statement and Balance Sheet

Ground the model in historical fin statements; 5-10 years

Understand the accounting and tax complications of the cos fin statements
Remember valuation is as much a science as it is an art - imprecise
sensitive to small changes in assumptions of the future - PE of 20,
changing COC by 0.5% will change value by 12-14%- Changing g for 1%
value will change by 7%.
Sensitivity highest for high growth companies and when int. rates are low
Aim for valuation range of plus minus 15% as used by investment bankers.
Keep your aspiration for precision in check

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