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Measure:
◦ Free Cash Flow
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Discount Factor:
◦ Weighted Average Cost of Capital

Assessment:
◦ Works best for projects, business units, and
companies that manage their capital structure to a
target level.
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Measure:
◦ Economic profit
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Discount Factor:
◦ Weighted Average Cost of Capital
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Assessment
◦ Explicitly highlights when a company creates value.

Measure:
◦ Free Cash Flow
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Discount Factor
◦ Unlevered Cost of Equity

Assessment:
◦ Highlights changing capital structure more easily
than WACC-based models.

Measure:
◦ Capital Cash Flow

Discount Factor:
◦ Unlevered Cost of Equity

Assessment:
◦ Compresses the FCF and the interest tax shield in
one number, making it difficult to compare
performance among companies and over time.

Measurement:
◦ Cash Flow to Equity

Discount Factor:
◦ Levered Cost of Equity
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Assessment
◦ Difficult to implement correctly because capital
structure is embedded in cash flow.
◦ Best used when valuing financial institutions
This method is specially
valuable when extended to a
multi-business company.

Enterprise value equals the summed value of
the individual operating units less the present
value of the corporate centre costs, plus the
value of non-operating assets.
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
Value the company’s operations by
discounting Free Cash Flow (FCF) at the
weighted average cost of capital (WACC).
Value non-operating assets
◦ Excess marketable securities, non-consolidated
subsidiaries, other equity investments etc.

Combining the value of operating assets and
non-operating assets leads to enterprise
value.

Identify and value all non-equity financial
claims against the company’s assets.
◦ Non-equity financial claims include fixed- and
floating-rated debt, pension shortfalls, employee
options and preferred stock.


Subtract the value of non-equity financial
claims from enterprise value to determine the
value of equity.
Divide equity value by the number of shares
outstanding to determine share price.

Value of an enterprise =
◦ PV of FCF during explicit forecast period +
Continuing Value

Use the key value driver formula to measure
the continuing value
◦ Continuing value = [NOPLAT(at t+1)× (1g/RONIC)]/WACC-g

NOPLAT:
◦ The NOPLAT should be based on a normalized level
of revenues and sustainable margin and ROIC.
◦ The normalized level of revenue should reflect the
mid point of its business cycle and cycle average
profit margin

RONIC:
◦ RONIC should be consistent with expected
competitive conditions.
◦ Set RONIC equal to WACC
◦ For companies with sustainable competitive
advantages, RONIC may be set equal to the ROIC
during the later period of the explicit forecast
period.

Growth Rate:
◦ The best estimate is the long term rate of
consumption growth for the industry’s product plus
inflation.

WACC:
◦ The WACC should incorporate a sustainable capital
structure and an underlying estimate of business
risk consistent with expected industry conditions.
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

Use multiples
Liquidation value
Replacement cost



The future is unknowable but, careful analysis
can yield insights into how a company may
develop.
Analysts should not get engrossed in the
details of individual line items.
He should place aggregate results in the
proper context
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
The analyst must determine how many years
to forecast and how details the forecast
should be.
The typical solution is to develop an explicit
forecast for a number of years and then to
value the remaining, called continuing value,
by using a formula such as, the perpetuity
formula.
The explicit forecast period must be long
enough for the company to reach a steady
state.
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The company grows at a constant rate and
reinvests a constant proportion of its
operating profits into the business each year.
The company earns a constant rate of return
on new capital invested
The company earns a constant return on its
base level of invested capital
As a result, free cash flow will grow at a
constant rate and can be valued using a
growth perpetuity.

The forecast period should be long enough
that the company's growth rate is less than
or equal to that of the economy.
◦ Higher growth rates would eventually make
companies unrealistically large, relative to the
aggregate economy.


In general, a forecast period of 10 to 15
years is appropriate.
However, it may be longer for cyclical
companies or those experiencing very rapid
growth.


Short explicit forecast period results in
significant undervaluation of a company or
requires heroic long term growth
assumptions in the continuing value
Long forecast faces the difficulty of
forecasting individual line items

Split the explicit forecast into two periods
◦ A detailed five-to-seven year forecast
◦ A simplified forecast for the remaining years,
focusing on a few important variables, such as
revenue growth, margins, and capital turnover

This approach not only simplifies the
forecast, it also forces the analyst to focus on
the business’s long-term economics, rather
than the individual line items of the forecast.

Raw historical data
◦ Raw data should be collected from the company’s
financial statements, footnotes, and external
reports in one place. The raw data should be
reported in its original form.

Integrated financial statements
◦ Using from the raw-data work-sheet, the analyst
should create a set of historical financials that find
the right level of detail.
◦ The income statement should be linked with the
balance sheet through retained earnings.
◦ This work-sheet will contain historical and
forecasted financial statements.

Historical analysis and forecast ratios
◦ For each line item in the financial statements, build
historical ratios, as well as forecasts of future
ratios.
◦ These ratios will generate the forecasted financial
statements contained on the previous work-sheet.

Market data and WACC
◦ All financial market data should be collected on one
work-sheet.
◦ This work sheet will contain estimates of beta, the
cost of equity, the cost of debt, and WACC, as well
as historical market values and valuation/trading
multiples for the company.

Reorganised financial statements
◦ Once a complete set of financial statements ( both
historical and forecasted) are built, reorganise the
financial statements to calculate NOPLAT, its
reconciliation to net income, invested capital and its
reconciliation to total fund invested.

ROIC and free cash flow
◦ Reorganised financial statements are used to build
ROIC, economic profit, and free cash flow.
◦ Future free cash flow will be the basis of valuation.

Valuation summary
◦ This work-sheet presents discounted cash flows,
discounted economic profits, and final results.
◦ The valuation summary includes the value of
operations, on-operating assets valuation,
valuation of non-equity claims, and resulting equity
value.
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


Prepare and analyze historical financials
Build the revenue forecast
Forecast the income statement
Forecast the balance sheet; invested capital and
non-operating assets
Forecast the balance sheet; investor funds
Calculate ROIC and FCF




Collect raw data from the reported financials
and notes
Use the raw data to build a set of financial
statements; the income statement, balance
sheet, and statement of retained earnings.
Statement of retained earnings is critical for
error checking during the forecasting
process.
Aggregate immaterial line items. Never
aggregate operating and non-operating
items.

Top-down forecast :
◦ Estimate revenues by sizing of the total market,
determining market share, and forecasting prices;

Bottom-up approach:

When possible, use both methods to establish
bounds for the forecast
◦ Use company’s estimate of demand from existing
customers, customer turnover, and the potential for
new customers

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

Rely on professional forecasts
Focus on market share by competitors
Make an assessment on which companies
have the capabilities and resources to
compete effectively and capture share.
Make an assessment of how the company is
positioned for the future
Find answers to such questions as:
◦ Does the company have products and services to
capture share?
◦ Do other competitors have products and services
that will displace your company’s market position?


Over the short term, top-down forecasts
should build on the company’s announced
intentions and capabilities for growth.
Top-down approach starts with aggregate
market and predicts penetration rates, price
changes, and market shares



Determine short-term forecasts of revenue
from current customer base by aggregating
sales projections across customers
Eliminate a portion of estimated revenue
based on an estimate of customer turnover.
Project how many new customers the
company will attract and how much revenue
those customer will contribute



Forecasting revenues over long time periods
is imprecise because customer preferences,
technologies and corporate strategies
change.
Constantly reevaluate whether the current
forecast is consistent with industry dynamics,
competitive positioning, and the historical
evidence on corporate growth.
Use multiple scenarios to model uncertainty


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
Decide what economically drives the line item
Estimate the forecasts ratio
Multiply the forecast ratio by an estimate of
its driver
Pay special attention to depreciation and
interest expenses and interest income.

Operating items (other than depreciation)
◦ Forecast driver: Revenue
◦ Forecast ratios: COGS/Revenue; SG&A/Revenue

Depreciation
◦ Forecast driver: Prior years net PP&E
◦ Forecast ratios: Depreciation/net PP&E
◦ Tying depreciation with gross PP&E requires
forecasting asset retirements
◦ If, internal information is available, a formal
depreciation table can be constructed.

Operating items (other than depreciation)
◦ Forecast driver: Revenue
◦ Forecast ratios: COGS/Revenue; SG&A/Revenue

Depreciation
◦ Forecast driver: Prior years net PP&E
◦ Forecast ratios: Depreciation/net PP&E
◦ Tying depreciation with gross PP&E requires
forecasting asset retirements
◦ If, internal information is available, a formal
depreciation table can be constructed.