Michael Dimond
School of Business Administration
Valuation
FIN 449
Michael Dimond
Calculating Free Cash Flow to Equity
• FCFE = Net income – Net investment + Net debt issued
Need to adjust this slide
Michael Dimond
School of Business Administration
Net Investment
• Net investment = (Capital expenditures – Depreciation) +
Increase in noncash working capital
Need to adjust this slide
Michael Dimond
School of Business Administration
CapEx
• Line item on Statement of Cash Flows?
• Calculate the changes (from year to year) of ALL long-term
assets shown on the balance sheet.
• Find the total amount
a given
year) shown in the “Investing”
Need(for
to adjust
this slide
section of the Statement of Cash Flows.
Issues?
Michael Dimond
School of Business Administration
Depreciation
• “Basic definition” of net cash flow = net income + depreciation
• Non-cash expense
• In the “balance sheet” approach to define capital expenditures,
depreciation is usually
incorporated
Need not
to adjust
this slide explicitly. Why not?
• If the “Statement of Cash Flows” approach is used, one must
explicitly subtract depreciation from capital expenditures (shown
in the “Operating” section of the Statement of Cash Flows)
Michael Dimond
School of Business Administration
Non-cash Working Capital
• Noncash working capital = (current assets – cash) – current
liabilities… what else?
• Noncash working capital = (current assets – cash) – (current
liabilities – interest bearing debt included in current liabilities)
Why?
Need to adjust this slide
• Why not include cash?
Michael Dimond
School of Business Administration
Net Debt Issued
• “Net” debt issued implies that one must take both debt
issuances AND repayments into account
• Discussion: Constant Debt Ratio
– Suppose a firm always finances new investment with a fixed debt ratio
(say, 30% debt and 70% equity, for example). The general equation
to adjustas
this
slide
for FCFE could beNeed
expressed
follows:
– FCFE = Net income – (1 – debt ratio)(Net investment)
OR
– FCFE = Net income – (equity ratio)(Net investment)
Michael Dimond
School of Business Administration
Free Cash Flow to Equity
• FCFE = Net income – Net investment + Net debt issued
Need to adjust this slide
Michael Dimond
School of Business Administration
Damodaran has resources online
• http://pages.stern.nyu.edu/~adamodar/
• His spreadsheets are not always as helpful as you might
want…
• An example of a valuation summary he did in 2008
Michael Dimond
School of Business Administration
What Damodaran’s valuation summary looks like: September 2008
Michael Dimond
School of Business Administration
What Damodaran’s valuation summary looks like: October 2008
Michael Dimond
School of Business Administration
• Bear in mind, these were a summary. We will ultimately want
something more detailed for a working document.
Michael Dimond
School of Business Administration
What does the DCF Model look like?
FC Year ->
FCFE ->
PV of FCFE
SUM of PV
Cash
2
1
9,291
7,941
6782.5928 6777.6741
78,287
23,207
101,494
Total Value
30,851
Shares Outstanding
3.29
Value per Share $
3.51
Adj. Close Price at 12/31/12 $
Terminal Value
5
4
3
102,804
12,376
11,262
10,236
6377.782 5993.5825 5625.4721 46729.87595
Terminal Growth Rate
4.5%
Rf
β
MRP
2.95%
3.14
4.50%
• What drives the figures?
• How sensitive are they to basic inputs?
Michael Dimond
School of Business Administration
Damodaran shows different ways to compute CFs
• To start, compute historic FCFF & FCFE for the past 5 years
FCFF = NI + Int(1-t) + Depr - ΔFA - ΔNWC
FCFE = NI + Depr - ΔFA - ΔNWC + ΔDebt - PfdDiv
FCFF = FCFE + Int(1-t) - ΔDebt + PfdDiv
FCFE = FCFF - Int(1-t) + ΔDebt - PfdDiv
• How accurate would it be to extrapolate the future cash flows
from the past FCFE figures?
• In other words, can we simply assume FCFE will grow X% forever?
• Here are the historic FCFE for a company:
2008
110,737
2009
53,050
2010
(1,118)
2011
5,024
2012
25,071
• Instead, we project the drivers of these figures for the future.
• Compute FCFF & FCFE based on the forecast figures
Michael Dimond
School of Business Administration
Building the sensitivity table
What’s in the yellow cell in the middle of the table?
(easier to click cells than type references)
equals
=
group everything together
(
PV of cash flows
NPV(
$E223, Ke from the sensitivity table
$H$206, CF1
$I$206, CF2
$J$206, CF3
$K$206, CF4
$L$206+ CF5 plus…
($L$206*(1+I$218)/($E223-I$218))
close the NPV function
)
+$G$209) add the cash
/$G$211 divide by the number of shares
terminal value, using %s in table
You should be able to paste the foumula into the
remaining cells in the table and get the correct results.
Michael Dimond
School of Business Administration
Valuing the first company
Supplementary Material:
• 96 Common Errors in Company Valuations
by Pablo Fernandez & Jose Maria Carabias
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151
• Questions to ask yourself about trends and financial
statement analysis
• Data Source: EDGAR http://www.sec.gov
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Valuation
• Value = Debt Value + Equity Value
• Equity Value / Shares Outstanding
= “Correct” Price per Share
• Context & perspective come from comparables and other
less robust methods
• Publicly traded company can be declared to be “overvalued”
or “undervalued”
Michael Dimond
School of Business Administration
When to use Free Cash Flow to the Firm
• Use Firm Valuation (FCFF)
(a) for firms which do not have an optimal capital structure
(leverage is too high or too low), and expect to change the
leverage over time. Debt payments and issues do not have to
be factored into the cash flows and the discount rate (WACC)
does not change dramatically over time.
(b) for firms which have only partial information on leverage
available (e.g. interest expenses are missing).
(c) in cases where value of the firm is more relevant than the
value to the shareholders (e.g. projects which create value).
• As a rule, firm valuation (FCFF) is a more flexible
approach than equity valuation (FCFE).
Michael Dimond
School of Business Administration
FCFF – Circular Reasoning?
• To discount FCFF we use the WACC, which is
calculated using the market values of equity and debt.
We then use the present value of the FCFF as our
value for the firm and derive an estimated value for
equity.
• There appears to be some circular reasoning involved
because the market values of equity and debt are
both inputs in computing the cost of capital and
outputs.
• To get around this issue, one could use an iterative
approach: Re-estimate the WACC using the new
estimated values, which would change the inputs and
the cost of capital.
• There should be convergence at some point in this
process, but is cumbersome.
Michael Dimond
School of Business Administration
When to use Free Cash Flow to Equity
• When leverage is stable, you can use the short cut for
estimating free cash flows to equity (Firm Value – MV
of Debt).
• Use Equity Valuation (FCFE)
(a) for firms which have stable leverage, whether high or not, and
(b) if equity (stock) is being valued
• When leverage is changing, modeling cash flows to
equity becomes problematic (How much cash will be
raised from new debt issues? How much old debt will
be paid off each year?).
Michael Dimond
School of Business Administration
Measuring Cash Flows
Cash flows can be measured to
All claimholders in the firm
EBIT (1- tax rate)
- ( Capital Expenditures - Depreciation)
- Change in non-cash working capital
= Free Cash Flow to Firm (FCFF)
Just Equity Investors
Net Income
- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital
- (Principal Repaid - New Debt Issues)
- Preferred Dividend
Dividends
+ Stock Buybacks
To go from reported to actual earnings we may have to:
 Update earnings & data to the date of interest
 Make corrections from Accounting Earnings
 Adjust for One-Time and Non-recurring Charges
Michael Dimond
School of Business Administration
From Reported to Actual Earnings
Firm’s
history
Comparable
Firms
Operating leases
- Convert into debt
- Adjust operating income
Normalize
Earnings
R&D Expenses
- Convert into asset
- Adjust operating income
Cleanse operating items of
- Financial Expenses
- Capital Expenses
- Non-recurring expenses
Measuring Earnings
Update
- Trailing Earnings
- Unofficial numbers
Michael Dimond
School of Business Administration
Updating Earnings
• When valuing companies, we often depend upon financial
statements for inputs on earnings and assets. Annual reports
are often outdated and can be updated by using– Trailing 12-month data, constructed from quarterly earnings reports.
– Informal and unofficial news reports, if quarterly reports are
unavailable.
• Updating makes the most difference for smaller and more
volatile firms, as well as for firms that have undergone
significant restructuring.
Michael Dimond
School of Business Administration