Valuation: Cash Flow-Based Approaches

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Valuation: Cash Flow-Based Approaches

Dr. Nancy MangoldCalifornia State University, East Bay

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Valuation

Security Analyst and Investment Bankers

Make buy, sell, or hold recommendations

Right Price for IPOPrice for a corporate acquisition

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Valuation

Economic TheoryValue of any resource equals the

present value of the returns expected from the resource, discounted at a rate that reflects the risk inherent in those expected returns

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Valuation

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Rationale for Cash-Flow Based Valuation

Cash is the ultimate source of valueCash serves as a measurable

common denominator for comparing the future benefits of alternative investment opportunities

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Cash Flow vs Earnings

Investors cannot spend earnings for future consumption

Accrual earnings are subject to numerous questionable accounting methods Pooling vs purchase in acquisition valuation Expensing of R & D costs

Earnings are subject to purposeful management by a firm

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Cash Flows vs Earnings

Earnings are not as reliable or meaningful as a common denominator for comparing investment alternatives as cash

$1 earnings (Firm 1) not equal to $1 earnings (Firm 2).

$1 Cash (Firm 1) = $1 Cash (Firm 2)

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Cash Flow-Based Valuation

Three elements neededExpected periodic cash flowsResidual (Terminal) value - Expected

cash flow at the end of the forecast horizon

Discount rate used to compute the present value of the future cash flows

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I. Periodic Cash FlowsCash Flow to the Investor vs Cash Flow

to the FirmCash Flow to the Investor: CF dividends

expected to be paid to the investorCash Flow to the Firm (CF dividends + CF

retained by firm) If the rate of return of retained CF equals the

discount rate, either CF will yield the same valuation

Use Cash Flow to the Firm

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Periodic Cash Flows: Relevant Firm Level Cash Flows

Which cash flow amounts from the projected statement of cash flows the analyst should use to discount to present value when valuing a firm

Unleveraged free cash flows leveraged free cash flows

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Periodic Cash Flows: Relevant Firm Level Cash Flows

Unleveraged free CF is CF before considering debt vs equity financing

Unleveraged free cash flows =CFO + interest cost (net of tax)

+(-) Cash flow for investing activitiesThis pool of cash flows is available to

service debt, pay dividends and provide funds to finance future earnings

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Leveraged free cash flows

Leveraged free cash flows = CFO - Cash flow for investing activities

+(-) net change in ST & LT borrowing +(-) Changes and dividends on on preferred stock

Cash flows available to the common shareholders after making all debt service payments to the lenders and paying dividends to preferred shareholders

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Measurement of Unleveraged and Leveraged Free Cash Flows

Unleveraged Free CF Cash Flow from

Operations before subtracting Cash outflows for interest costs (net of tax savings)

=Unleveraged CFO +(-) CF for Investing Act. = Unleveraged Free

Cash Flow to All Providers of Capital

Leveraged Free CF CFO before interest - Cash outflows for interest

costs (net of tax savings) =leveraged CFO +(-) CF for Investing Act. +(-)CF for changes in

ST&LT borrowing +(-)CF for changes in and

Dividends on preferred stock

= leveraged Free CF to Common Shareholders

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Unleveraged Free Cash Flows

If the objective is to value the assets of a firm, then the unleveraged free cash flow is the appropriate cash flow

Discount rate should be weighted average cost of capital

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Leveraged Free Cash Flows

If the objective is to value the common shareholders’ equity of a firm, then the leveraged free cash flow is the appropriate cash flow

Discount rate should be the cost of equity capital

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Unleveraged vs Leveraged Free Cash Flows

The Valuation Difference = the value of total interest-bearing liabilities and preferred stock

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Value interest-bearing liabilities by discounting debt service costs (including repayments of principal) at the after tax cost of debt capital

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Valuing preferred stock by discounting preferred stock dividends at the cost of preferred equity

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Valuation for total assets (unleveraged Free CF) =

Valuation for common equity (leveraged Free CF)

+ Value of interest-bearing liabilities + Value of preferred stock

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Acquiring the operating assets of of another firmAcquiring firm will replace with its

own financing structurePrice to pay for the division’s assets?

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Acquiring the operating assets of of another firmCF these assets will generateUse unleveraged free cash flows

(Operating cash flows - cash outflow for investing)

Discount these projected cash flows at the weighted average cost of capital of the new division

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Engage in a leveraged buy out (LBO) of a firm

Managers offer to purchase the outstanding common shares of the target firm at a particular price if current shareholders will tender them

The managers invest their own funds for a portion of the purchase price (usualy 20% - 25%) and borrow the remainder from various lenders

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The managers use the equity and debt capital raised to purchase the tendered shares

After gaining voting control of the firm, the managers direct the firm to engage in sufficient new borrowing to repay the bridge loan obtained to execute LBO

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The lenders have a direct claim on the assets of the firm

Managers shift any personal guarantees they made on the bridge loans to the firm

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Price of LBO

Use Valuation of common equityLeveraged free cash flows

discounted at the cost of common equity capital

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Price of LBO

Or Use Valuation of total assets and subtract the market value of the debt raised to execute the LBO.

PV of unleveraged free cash flows using the weighted average cost of debt and equity capital

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Price of LBO

The projected debt service costs after the LBO will differ significantly

Valuation of the equity must reflect the new capital structure and the related debt service cost

The cost of equity capital will increase as a result of the higher level of debt in the capital structure

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Nominal Vs Real Cash Flows

Nominal cash flows include inflationary or deflationary components

Real cash flows filter out the effect of changes in general purchasing power

Valuation should be the same whether one uses nominal cash flow amounts or real cash flow amounts, as long as discount rate used is consistent with CF

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If projected cash flows ignore changes in the general purchasing power of the monetary unit

Then the discount rate should incorporate an inflation component

Nominal CF 1.15 million (land price)Discount rate s/b 1/1.02 /1.1 Interest rate 2% and inflation rate 10%Value 102.5

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If projected cash flows filter out the effects of general price changes

Then the discount rate should exclude the inflation component

Real CF 1.15 million (land price)/1.1 (inflation rate)

Discount rate s/b 1/1.02 Land Value 102.5

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A firm owns a tract of land that it expects to sell one year from today for 115 million

The selling price reflects a 15% increase in the selling price of the land

General price level is expected to increase 10%

The real interest rate is 2%

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The Value of Land

Discount rate including expected inflation115m x 1/(1.02)(1.1)= 102.5 million

Discount rate excluding expected inflation(115 million/1.10) x 1/1.02 = 102.5 million

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PreTax vs After-Tax Cash Flows

Discount pretax cash flows at a pretax cost of capital

Discount after-tax cash flows at an after-tax cost of capital

Valuation will be the same

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Selecting a Forecast Horizon

For how many future years should the analyst project periodic cash flows?

Theoretically: the expected life of the resource to be valued (machine, building )

To value the equity claim on the portfolio of net assets of a firm, the resource has indefinite life

Analyst must project the years of CF and residual value at the end of forecast horiz.

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Prediction of CF requires assumptions for each item in the IS and BS and then deriving the related CF

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Using a relatively short forecast horizon (3-5 years) enhances the likely accuracy of the projected periodic cash flows

near term cash flows is often an extrapolation of the recent past

near term cash flows have the heaviest weight in the PV computation

But a large portion of the total PV will be related to the residual value

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The valuation is difficult when near-term cash flows are projected to be negative in rapidly growing firm that finances its growth by issuing common stock

All of the firm’s value relates to the less detailed estimation of the residual value

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Selecting a longer period in the forecast of periodic cash flows (10-15 years)

Reduces the influence of the estimated residual value on the total PV

Predictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable

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It is best to select as a forecast horizon the point at which a firm’s cash flow pattern has settled into an equilibrium

This equilibrium position could be either no growth in future cash flows or growth at a stable rate

Security analysts typically select a forecast horizon in the range of 4-7 years

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II. Residual Value

Residual Value at end of Forecast Horizon= Periodic Cash Flow n-1 x 1+g

r-gWheren= forecast horizong= annual growth rate in periodic cash

flows after the forecast horizonr= discount rate

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Residual Value

Leveraged free cash flow of a firm in year 5 is 30 millions

0 growth expectedCost of equity capital = 15%Residual value

= 30 x (1+0.0)/(.15-0.0) = 200 millionPV of RV (in Year 5)= 200 x 1/(1.15)5

= 99.4 million

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Residual Value

Add growth rate = 6%Residual value =

30 x (1+0.06)/(.15-0.06) = 353.3 millionPV = 353.3 x 1/(1.15)5 = 175.7

million

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Residual Value

Add growth rate = -6%Residual value =

30 x (1-0.06)/(.15 - (-0.06) = 134.3 millionPV = 134.3 x 1/(1.15)5 = 66.8 millionAnalysts frequently estimate a

residual value using multiples of 6-8 times leveraged free cash flows in the last year

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Difficulty in Using Residual Value

When the discount rate and growth rate are approximately equal

The denominator approaches zero and The multiple becomes exceedingly large.When the growth rate exceeds discount

rateThe denominator becomes negative, the

resulting multiple becomes meaningless

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Alternative Approach to Estimate Residual Value

Use free cash flow multiples for comparable firms that currently trade in the market

this model provides a market validation for the theoretical model

The analyst identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors.

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III. Cost of Capital

The analyst uses the discount rate to compute the present value of the projected cash flows

The discount rate equals the rate of return that lenders and investors require the firm to generate to induce them to commit capital given the level of risk involved

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Cost of Capital

Cost of debt capital equals the after-tax cost of each type of capital provided to a firm

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Cost of Debt Capital

Common practice excludes operating liability accounts from weighted average cost of capital

The present value of unleveraged free cash flows is the value of total assets net of operating liabilities which equals debt plus shareholders’ equity

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The cost of debt capital equals (1- marginal tax rate) x yield to maturity

of debtThe yield to maturity is the rate that

discounts the contractual cash flows on the debt to the debt’s current market value

The yield=coupon rate if the debt sells at par(face) value

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Capitalized lease obligation have a cost equal to the current interest rate on collateralized borrowing with equivalent risk

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The analyst should include the present value of significant operating lease commitment in the calculation of the weighted average cost of capital

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If the analyst treats operating leases as part of debt financing, then the cash outflow for rent should be reclassified as interest and repayment of debt in leveraged and unleveraged free cash flow

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Cost of Preferred Equity Capital

Dividend rate on the preferred stock

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Cost of Common Equity Capital

Capital Asset Pricing Model (CAPM)In equilibrium, the cost of common

equity capital equals the market rate of return earned by common equity capital

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Cost of Common Equity Capital

R(i) = R(f) + b (R(m) - R(i))Cost of common equity =

Interest rate on risk free securities + Market beta (Average return on the market portfolio - Interest rate on risk free securities)

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Cost of Equity Capital

b=1R(I)=R(m)The cost ofcommonequity capitalis the averagereturn on themarketportfolio

b>1 greater

systematicrisk,

higher costof equitycapital

b<1 less

systematicrisk

lower costof equitycapital

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Risk Free Interest Rate

Yield on LT US government securitiesNot a good choice, the longer the term to

maturity, more sensitive to changes in inflation and interest rates, greater systematic risk

Common practice to use the yield on either short or intermediate-term US government securities as risk free rate

Historically averaged around 6%

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Market Return

Depends on period studiedHistorically the market rate of return

has varied between 9 and 13%The excess return over the risk free

rate has varied between 3 and 7 percentage points

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Market Returns

Financial reference sources publish market equity beta for publicly traded firms

Standard & Poor’s Stock ReportsValue Line, Moody’sConsiderable variation in the published

amounts for market beta among different sources due to period used to calculate the betas

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Adjusting Market Equity Beta

to Reflect a New Capital Structure The market equity beta computed

using past market price data reflects the capital structure in place at a particular time

Analyst can adjust this equity beta to approximate what it is likely to be after a change in the capital structure

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Unleverage the current betathen releverage it to reflect the new

capital structureCurrent leveraged equity beta =

Unleveraged Equity beta [1+(1-income tax rate) ( Current market value of debt)/ current market value of equity)]

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Equity Beta = 0.9Income tax rate = .35Debt/equity ratio = .60Change D/E ratio to 140%Unleveraged equity beta x0.9 = X [1+ (1 - 0.35) (0.60/1.0)]X = 0.65

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Releveraged market betaY = 0.65 [ 1 + (1- 0.35)(1.4/1.0)]Y= 1.24

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Evaluating the Cost of Equity Capital Using CAPM: Criticisms

Market betas do not appear to be stable over time and are sensitive to the time period used in their computation

The excess market rate of return is not stable over time and is likewise sensitive to the time period

Fama and French suggests that during the 1980s size was a better proxy for risk than market beta

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Weights Used for Weighted Average Cost of Capital

Should use the market values of each type of capital

Market value of debt securities is disclosed in notes to financial statements

Market price quotations for equity securities provide the amounts for determining the market value of equity

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A Firm’s Capital Structure on Balance Sheet

Long Term Debt 10% annualcouponPreferred Stock, 4% dividendCommon StockRetained Earnings

$20,000,000

5,000,000 10,000,000 15,000,000 $50,000,000

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Cost of Capital

LT Debt 8% x (1-.35) = 5.2%Preferred Equity4%Common Equity6% + .9 (13% - 6%) = 12.3%

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Weighted AverageCost of Capital

Security

LT DebtPref. EqCom.EqTotal

Amount

22,000,0005,000,00033,000,00060,000,000

Proport

37%8%55%100%

Cost

5.2%4%12.3%

WeighAverage1.92%0.32%6.77%9.01%

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Valuation of a Single Project

Investment = 10 millionUnleveraged CF 2 million/year foreverFinancing 6 million debtFinancing 4 million Common EquityDebt interest rate 10%Tax rate 40%Cost of Capital 25.625%

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Value of Common Equity

Unleveraged Free Cash Flow

2,000,000

Interest paid on Debt.10*6,000,000

(600,000)

Income Tax Savings on Interest .4*600,000

240,000

Leveraged Free CF 1,640,000

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Value of Common Equity

The value of the project to the common equity

1640000/.25625=6,400,000Excess over investment6,400,000-4,000,000=2,400,000The factor of PV of an annuity that

last forever is 1/r

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Value of Debt + Equity

Value of DebtAfter tax cost for debt is 6% 6% = (10% * (1-40%))The common equity cost .25625%

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Type of Capital

Amt Weight

Cost WeightedAverage

Debt 6M .48387

.06 .02903

Common Equity

6.4M .51613

.25625

.13226

Total 12.4 M

1.00 .16129

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PV (Debt + Equity) is2,000,000/.16129 = 12,400,000Subtracting 6 million of debt Common Equity is 6.4 million

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Valuation of Coke

Yr 8 Yr 9 Yr 10 Yr 11 Yr 12

CF from Operations

3,610 3,788 3,974 4,166 4,366

CF from Investing

-1,198

-1,390

-1,534

-1,691

-1,866

CF from Debt Financing

1,017 1,355 1,619 1,835 1,988

Leveraged Free CF

3,429 3,753 4,059 4,310 4,488

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Year 12 Residual Value

The analyst make assumption about net cash flows after year 12

The average compound growth rate of leveraged free CF between year 8-12 is 7%, assume it will remain at 7%

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Year 12 Residual Value

Yr 7 market beta is .97Risk free rate = 6%Excess Mkt Return over Risk Free

Rate = 7%Cost of Equity Capital =6% + .97(7%) = 12.8%4,488 x 1+.07 = $82,796

0.128 - .070

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Present Value

Year CF 12.8 Factor

PV

8 3,429 .88652 3,040

9 3,753 .79719 2,992

10 4,059 .69674 2,828

11 4,310 .61768 2,662

12 4,488 .54759 2,458

Aft 12

82,796 (4488x(1.07/0.128-.07))

.54759 45,338

Total 59,318

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Price per Share

price per share 59,318 million/2,481 million shares =

23.91Coke’s market price in yr 7 = 52.63

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Price Difference

Inaccurate projections of future cash flow

Errors in measuring the cost of equity capital

Market inefficiencies in the pricing of Coke

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Advantages- Present Value of Cash Flow Valuation

Focus on cash flowsProjected amounts of CF result from

projecting likely amounts of revenues, expenses, assets, liabilities and shareholders’ equity which require the analyst to think through many future operating, investing and financing decisions of a firm

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Disadvantages of the PV of Future Cash Flow Valuation

The residual or terminal value tends to dominate the total value in many cases

This residual value is sensitive to assumptions made about growth rates after the forecast horizon

The projection of cash flows can be time consuming and costly when analyst follow many companies and identify under and overvalued firms regularly.

Documents

Valuation: Cash Flow-Based Approaches