BUSINESS VALUATION

MODELS
Two methods:
1. Discounted Cash Flow
2. Relative Values
Estimating Intrinsic Value

Present value of cash flows (PVCF)
1. Present value of free cash flow (FCFF)
2. Present value of free cash flow to equity (FCFE)
3. Adjusted Present Value
Discounted Cash Flows
1. Present value of free cash flow (FCFF)
or (WACC) Approach:
The Weighted Average Cost of Capital
estimates a companys value by
discounting its unlevered free cash flows
using a constant weighted average cost
of capital.
Discounted Cash Flows
1) Unlevered free cash flows (UFCF)
2) Unlevered terminal free cash flow (UTFCF)
3) Expected future growth rate (g)
4) Weighted Average Cost of Capital, RWACC )

)
T
WACC + (1
UTFCF
+
)
t
WACC + (1
UFCF
t
T
1 = t
= V


g - WACC
UFCF
1) + (T
= UTFCF Where
g) + (1
UFCF
T
=
UFCF
1) + (T
Which
Discounted Cash Flows
This method requires estimation of

R
E
)
V
S
( +
R
d
)
V
D
( t) - (1 =
WACC
Estimation of Unlevered FCF
EBIT
Less: Cash Taxes on EBIT
Plus: Depreciation and Amortization
Operating Cash Flow (OCF)
Less: Increase in Net Working Capital
Less: Increase in Capital Expenditures
Unlevered Free Cash Flow (UFCF)
Estimation of Unlevered FCF

UFCF = EBIT (1-Tax Rate)
+ Depreciation Expense - Capital Spending
- in Working Capital
UFCF = OCF - (CE + NWC)
Discounted Cash Flows Valuation
g WACC
FCF

1

U
Value Firm
Estimation Based on Constant Growth
Where: UFCF
1
= Unlevered free cash flow in period 1

WACC = the firms weighted average cost of capital
g = the firms constant infinite growth rate of free cash
flow
VALUATION OF EQUITY
Present value of free cash flow to equity (FCFE)
Pure Equity Financed Company
The cost of capital is the unlevered cost of
equity



)
T
R
u
+ (1
FCFE
1 + T
+
)
t
R
u
+ (1
FCFE
t
T
1 = t
= V

VALUATION OF EQUITY
Value of Equity when the Firm is levered,


)
T
R
LS
+ (1
T
LFCF
+
)
t
R
LS
+ (1
LFCF
t
T
1 = t
= V
1

Levered FCF
EBIT
Less: Interest payment
Less: Cash Taxes on EBIT
Plus: Depreciation and Amortization
Operating Cash Flow (OCF)
Less: Increase in Net Working Capital
Less: Increase in Capital Expenditures
Less: (new debt issues minus debt repayments)
Levered Free Cash Flow (LFCF)
Present Value of
Free Cash Flow to Equity
FCFE =
Net Income
+ Depreciation Expense
- Capital Expenditures
- in Working Capital
- Principal Debt Repayments
+ New Debt Issues

Growth Rate Estimates
Average Dividend Growth Rate
1
D
D
n
0
n

Growth Rate Estimates
Average Dividend Growth Rate




Sustainable Growth Rate = RR X ROE
1
D
D
n
0
n

Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the
firms characteristic line using regression
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the
firms characteristic line using regression
R = R
F
+ b( R
M
- R
F
)
Beta For a Levered Firm
b
L
= b
U
[1 + (1- T
C
) D/E]
Constant Growth
Free Cash Flow to Equity
FCFE = the expected free cash flow in period 1
R = the required rate of return on equity for the
firm
g = the expected constant growth rate of free
cash flow to equity for the firm
g R
FCFE
Value

1
An Alternate Measure of Growth
g = (RR)(ROIC)
where:
RR = the average retention rate
ROIC = EBIT (1-Tax Rate)/Total Capital
Calculation of WACC
WACC = W
E
R
E
+ W
d
R
d

where:
W
E
= the proportion of equity in total capital
R
E
= the after-tax cost of equity
W
D
= the proportion of debt in total capital
R
d
= the after-tax cost of debt
Relative Valuation Techniques
Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (R)
2. Expected growth rate of dividends (g)
g R
E D
E P

1
/
1
1
/
Relative Valuation Techniques
Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)
Price/Cash Flow Ratio
Price/Book Value Ratio
Price-to-Sales Ratio
Analysis of Growth Companies
Generating rates of return greater than the
firms cost of capital is considered to be
temporary
Earnings higher than the required rate of
return are pure profits
How long can they earn these excess
profits?
Is the FIRM properly valued?
Negative Growth Model
Firm retains earnings, but reinvestment
returns are below the firms cost of capital
Since growth will be positive, but slower
than it should be, the value will decline
when the investors discount the
reinvestment stream at the cost of capital