Financial Modelling
Lecture 8
Vedat Mizrahi
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
1
Overview of Valuation Process
• Top down:
– Value firm as a whole
– Value firm debt
– Value convertible securities
• Convertible bonds
• Warrants
• Equity = Residual value
• "Bottom up"--direct valuation of particular security
– Most common example:
• Equity valuation = PV (dividends + anticipated terminal value)
• Bond valuation = PV (future anticipated interest + principal
repayments)
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
2
Why Sequential Valuation Process?
Analysis
Result
Economy and industry
Projection of sales
Firm
Projection of costs
Firm risk
Estimation of RADR
Firm valuation
Debt risk
Debt Valuation
Valuation of convertible
securities
Valuation of stock
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
3
Why Pro Forma Model of the Firm?
• Important disciplinary exercise
– It forces the analyst to be specific about how you think the
firm works
– In the process you learn a lot about what you know and
more importantly what you don’t know!
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
4
Valuation Process
Stage 1: Study the corporate environment
• Can the firm expand its sales, either along with or
independent of its industry?
• Does the firm require new fixed capital to expand
sales?
• Does expansion of sales require NWC Balance?
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
5
Valuation Process
Stage 2: Build financial model for the firm--Pro Forma
financial statements
• Integrated in accounting sense
• Balance Sheet with Income Statement
• Integrated structural view of the firm
• Incorporate projected financial ratios for firm
• historical?
• projected future?
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
6
Valuation Process
Stage 3: Convert projected financial performance to
values
• Project using pro formas
• Project firm CFOs and FCFs
• Project terminal value - the "last cash flow"
• Use appropriate RADR (rA, rW , rE)
Stage 4: Consider alternative techniques
• P/E ratios
• Market to Book ratios
• …..
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
7
Valuation Process
Stage 5: Sanity checks
• Does your valuation make any sense?
• Does it serve the user?
– Difference between M&A & portfolio
• Did we do too much "hard wiring"
– what do firm insiders think?
– are there non-quantifiable, strategic considerations?
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
8
Principles of Valuation
• Value cash flow streams as opposed to:
– valuation by ratios
– valuation by accounting measures
• Be consistent in your treatment of inflation:
– identify CFs as real or nominal
• Identify recipients of cash flow streams:
–
–
–
–
dividends to equity holders
interest & principal to bondholders
convertible bonds?
warrants?
• Make sure discount rates are appropriate: correspondingly real or
nominal incorporate tax rates of recipient
• Use several methods of valuation: “bottom up” and “top down”,
multiples, different ways of identifying discount rates
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
“FIND
THE BALL PARK”
9
Overview of Pro Forma Model & Basic Setup
Modular Approach
•
Core Statements
– Income Statement
– Balance Sheet
– Cash Flow Statements
•
Supporting Schedules:
– Do all the detail work
– Link between core statements
– Complete the supporting schedules and export to the core statements
•
Balance Sheet and Cash Flow Statements:
– “Dumb” schedules
– All projections are references from schedules
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
10
Modular Approach
Working
Capital
Income
Income
Statement
Statement
PP&E,
Depreciation
Cash
Cash Flow
Flow
Statement
Statement
Shareholders’
Equity
Intangibles,
Amortization
Balance
Balance
Sheet
Sheet
Other LT
Items
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
Debt &
Interest
11
Balance Sheet Projections
Line Item
Source
Cash
From the cash flow statement.
Non-Cash Current Assets
From the working capital schedule.
PP&E / Fixed Assets, net
From the depreciation schedule.
Goodwill, net
From the amortization schedule.
Other Long Term Assets
From other long term items schedule.
Non-Cash Current Liabilities
From the working capital schedule.
Deferred Taxes
Many approaches: (1) Keep constant; (2) project as percent of sales or
(3) From a tax schedule if detailed tax information is available.
Other Long Term Liabilities
From other long term items schedule.
Short-Term Debt (Revolver)
From the debt schedule.
Long-Term Debt
From the debt schedule.
Shareholders’ Equity Items
From the equity schedule.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
12
Cash Flow Statement Projections
Line Item
Source
Cash Flow from Operating Activities:
Net Income
From the income statement.
Depreciation
From the depreciation schedule.
Amortization
From the amortization schedule.
Change in Working Capital
From the working capital schedule.
Change in Other Long-Term Assets and Liabilities
From the other long-term items schedule.
Cash Flow from Investing Activities:
Capital Expenditures
From the depreciation schedule.
Acquisition of Operating Division
From a acquisition schedule, if appropriate.
Cash Flow from Financing Activities:
Issuance / (Repayments) of Revolver
From the debt schedule (“cash sweep”).
Issuance / (Repayments) of Long-Term Debt
From the debt schedule.
Issuance / (Repayments) of Equity
From the equity schedule.
Dividends
From the equity schedule.
Options Proceeds
From the equity schedule.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
13
Final Model: Flow of Information
Net Income
Depreciation
Sales
Interest Expense
Amortization
COGS
Change in
Working Capital
Working
Capital
Working
Capital
CapX, Dep.
PP&E,
Depreciation
PP&E
Income
Income
Statement
Statement
w
Flo
h
/
s
a
ents
eC
m
e
y
r
F
s
epa
t R owing
b
e
D Borr
Net Income
Cash
Cash Flow
Flow
Statement
Statement
Beg. Cash
Debt &
Interest
Share Rep., Option
Proceeds, Div, FX Effects
Ending Cash
Amortization
Intangibles,
Amortization
Vedat Mizrahi, Ph.D
Goodwill
Debt
Balances
Balance
Balance
Sheet
Sheet
Kadir Has UNiversity - Financial Modelling
Equity
Balance
Shareholders’
Equity
Change in
Other LT Items
Other LT Items
Other LT
Items
14
Steps in Building the Model
• Step 1: Set up the Income Statement
– Start with the Annual Report Format – Keep it simple!
– Show more detailed line items if necessary.
• Step 2: Set up the Balance Sheet
– Start with the Annual Report Format.
– Simplify – Combine line items if they are immaterial to
analysis.
• Step 3: Set up the Cash Flow Statements
– Use standard format (FASB) to match the financial
reports .
– Report “Valuation Cash Flows” separately.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
15
Basic Income Statement
Sales
Cost of Goods Sold (COGS)
Selling, General, Administrative Expenses (SG&A)
Interest
Profits Before Taxes
Taxes
Profit After Taxes
Dividends
Retained Earnings
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
16
Balance Sheet
Assets
Liabilities & Owners’ Equity
Current Assets: short-term assets
Cash
Accounts Receivable
Inventories
Current Liabilities: short-term
obligations
Accounts Payable
Accrued Taxes
Current Portion of LT Debt
Short-Term Borrowing
Fixed Assets
Leased Property & Equipment
PP&E
Land
Long-Term Liabilities
Leased Property & Equipment
Long-Term Debt
Goodwill
Vedat Mizrahi, Ph.D
Preferred Stock
Equity
Stock Value
Kadir Has UNiversity - Financial Modelling
Retained Earnings
17
Summary of “Theory of Valuation”
•
•
•
•
•
•
Use APV when capital structure is not constant
over time (at terminal point firm is at optimal capital
structure).
Use UFCF and discount at rA to get VU.
PVTS can be computed by discounting tax shields
at rD.
If rD is lower than market value, we need to
estimate the value of subsidy.
VL = VU + PVTS + Subsidies and other benefits
from financing.
Do not adjust discount rates on an ad hoc basis.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
18
3
Summary of “Theory of Valuation”
•
When we investigate the interaction between the
financing & investment, we may have the following
cases:
– NPVU > 0, NPVL > 0
– NPVU < 0, NPVL < 0
– NPVU < 0, NPVL > 0
Vedat Mizrahi, Ph.D
Invest
Do not invest
Invest if financing is project
specific.
Do not invest if financing is
not project specific.
Kadir Has UNiversity - Financial Modelling
19
4
Summary of “Theory of Valuation”
• IRR on equity flows can be used with some caviats
and caution.
– Since D/E is changing there is no well defined cutoff rate
(rE) to compare the computed IRR on equity with.
– If APV had positive NPV, then we can be sure that IRR on
equity flows should be high enough to accept the project.
This rate is now is the return on equity invested in the
project.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
20
5
DCF Valuation Models: Overview
Inputs
Cash Flow
Dividends
Cash-flows to Equity
Expected Dividends to FCFE = EBT(1-T) + Dep
Shareholders
- ∆NWC - CAPX – ∆D
Discount
Rate
Cost of Equity
CAPM: Riskfree Rate + (Risk Premium)Beta
MFM: Riskfree Rate +Σ(Risk Premium)jBetaj
Cash-flows to
Firm
UFCF=
EBIT(1-T) + Dep
-∆NWC -CAPX
Cost of Capital
WACC=ke (E/V)
+kd(1-T)(D/V)
Growth
Pattern
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
21
6
Constant Growth Model
•
The value of firm, under the constant-growth model,
is a function of the expected UFCF in the next
period, the stable-growth rate, and the required rate
of return.
–
•
V0 =UFCF1/(rW – g)
Implicit assumptions
1. Growing at a rate less than or equal to the growth rate in the
economy in which they operate
2. Cap Ex = Depreciation
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
22
7
Valuing Equity – Two-Stage Model
•
The value of any stock is the present value of the FCFE per year for the
extraordinary growth period plus the present value of the terminal price at the
end of period.
•
Assumptions:
– Growing at a rate moderately higher than the nominal-growth rate in the economy
in which they operate;
– Specific sources of growth (patents, legal protections) that are expected to expire
after a fixed period;
– Free cash flows to equity are significantly different from dividends;
– Stable financial leverage.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
23
8
Mid-Point (“Holt”) Model
• The model is based upon the assumption that the earnings growth rate
starts at a high initial rate (ga) and declines linearly over the extraordinary
growth period (which is assumed to last 2H periods) to a stable growth
rate (gn). It also assumes that the dividend payout is constant over time,
and is not affected by the shifting growth rates.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
24
9
Three-Stage Model
• This model assumes an initial period of stable high growth, a second
period of declining growth, and a third period of stable growth that
lasts forever.
Vedat Mizrahi, Ph.D
Kadir Has UNiversity - Financial Modelling
25
10