Fin 4201/8001
Topic 4a: Valuing Companies
The adventure continues….
The Project
 Next
few classes, little reading
= time to get organized
 Sources – usual suspects
 Analyze with tenets, spread
sheet w/ forecasts, ratios….
 Play from your strengths
Another look
 Abstract
 Introduce
firm and environment
 Operations
 Industry
Another look
 Ratio
analysis
 Buffett’s tenets
 Equity Valuation
 Recommendation
 References, Tables, Charts,…
Valuation

Objective: Investment decision


Price < Estimated value = BUY
Three step approach (Top-down)
Analysis of economies and markets
 Analysis of Industry
 Analysis of individual firm

Valuation (The softer side)
Most of the 12 tenets
 Macro economic implications
 Corporate governance and the market
for corporate control
 Buffett = cost < value
 How do you know? Valuation
 Our focus ≈ ROIC, NOPLAT, and DCF

Return On Invested Capital =
Profit/capital

ROIC is after tax profit divided by
(working capital + PPE)
 Scorecard vs. some benchmark
 Goal ≠ maximize
 But can’t just look at $ either – Capital
costs money (growth for growths sake)
 ROIC > Opportunity cost of capital
 Ultimate = stock performance or value
creation
NOPLAT = Net Operating Profit
Less Adjusted Taxes
≈ Owner earnings
 Look at example in a couple of slides

DCF – Discounted Cash Flow





Returns depend on market expectations
The great equalizer
Goal = Maximize PV of cash or economic
profit
Ultimate measure is stock performance
Problems
 Predict future (Buffett KISS and stable)
 Earnings can be manipulated
Historical Analysis
Need to understand past to be able to
predict the future
 Reorganize statements to reflect
economic vs. accounting performance
 Measure and analyze ROIC = ability
to create value
 Assess financial health and capital
structure for short and long term

Historical Analysis
ROIC = NOPLAT / Invested capital
 Reorg Balance Sheet to create
invested capital
 Reorg Income statement to get
NOPLAT
 How much cash can be taken out?
 FCF = NOPLAT + noncash Op exp –
invested capital

ROIC = NOPLAT / Invested
Capital

Invested capital = Balance sheet =
Debt + Equity?
Debt equivalents = unfunded retirement
liabilities, restructuring reserves,…
 Equity equivalents = deferred taxes…

Non op assets not
included in capital
Operating liabilities netted
against operating assets
Balance sheet
Assets
Inventory
Net PP&E
Equity Investments
Total Assets
Prior
Year
Liabilities & Equity
Accounts Pay
Debt
Common Stock
Retained Earnings
Total Liab & Eq
200
300
15
515
125
225
50
115
515
Invested Capital
Current
year
225
350
25
600
150
200
50
200
600
Prior
Year
Inventory
Accounts Pay
Working Cap
Current
year
200
225
-125
-150
75
75
Net PP&E
Invested Capital
300
375
350
425
Equity Investments
Total Fund Invested
15
360
25
450
Total Fund Invested
Debt
Common Stock
Retained Earnings
Total Fund Invested
225
50
115
390
200
50
200
450
ROIC = NOPLAT / Invested
Capital

Now to Income statement = NOPLAT
Interest expense not subtracted
 Exclude non operating income
 Adjust taxes to reflect exclusions


What you have is basically an all
equity, operations only firm
Interest = payout to
investor, not
expense
If not in capital =
not in NOPLAT
Income Statement
Revenue
Op costs
Depreciation
Op Profit
Interest
Non-op income
EBT (Pretax inc)
Taxes
Net Income
Taxes calc’d on
operating profits
Invested Capital
Current
year
1000
-700
-20
280
-20
4
264
-66
198
Revenue
Op costs
Depreciation
Op Profit
Current
year
1000
-700
-20
280
Op Taxes
NOPLAT
-70
210
After Tax non op Inc.
Income to all
3
213
Reconcile w/ NI
Net Income
After-tax interest
Income to all
198
15
213
ROIC = NOPLAT / Invested
Capital

Now what about Free Cash Flow?
Basically the same as tenet #8 in
Topic 3 ≈ FCF = NOPLAT + Non cash
opexpense – investment in capital
 Intangibles and goodwill – usually
exclude
 Other Long Term assets
 Hidden Assets – leases, R&D
 Cash if large ≠ operating

Interest = payout to
investor, not
expense
CF from non-op
treated separate
Cash Flow
Net Income
Depreciation
chnge Inventory
chang in A/P
CF from Ops
Cap Exp
chg in equity
CF from Invest
chg in debt
chg in stock
dividends
CF from Financing
Taxes calc’d on
operating profits
Free Cash Flow
Current
year
198
20
-25
25
218
-70
-10
-80
-25
0
-113
138
NOPLAT
Depreciation
Gross CF
Current
year
210
20
230
chnge Inventory
chang in A/P
Cap Exp
Gross Invest
-25
25
-70
-70
Free Cash Flow
160
After Tax non op Inc.
chg in equity
CF to investors
3
-10
153
After tax interest
chg in debt
chg in stock
dividends
CF to investors
15
25
0
113
153
Forecasting
Models = try to reduce to simple
numbers
 Make realistic assumptions on sales
and costs
 Look for the “drivers”
 Two-stage growth model

The Forecast
1) Analyze historicals
 Aggregate items or add more lines
 CNBC, Yahoo, Edgar, Compustat
(WRDS),…
2) Start with IS
 Revenue forecast consistent with
historical and economy-wide growth
The Forecast
3) Forecast rest of income statement consistent
with “drivers”
COGS – function of sales adjusted for competition
and/or productivity
 Depreciation = % of revenue or % of PPE or
historical equipment purchase
 Interest exp or income tied to asset or liability that
generates it
 Taxes – look to historical or just plug 39%

4) Forecast Balance sheet, invested capital, and
non-op assets

E.g. working capital tied to COGS or PPE tied to
revenue or depreciation
The Forecast
5) Forecast investor funds
 Retained earnings = old RE + NI dividends
 Other equity accounts
6) Calculate ROIC and FCF to generate
value
 Can use WACC or do like Buffett (long
treasury rate)
7) Other issues