Frameworks for Valuation
Using DCF to Value Companies
• There are five well-known
frameworks for valuing a
company using DCF, the most
common being enterprise
DCF.
• In theory, each framework will
generate the same value. In
practice, the ease of
implementation and the
interpretation of results varies
across frameworks.
• In this presentation, we
examine how to value a
company using each of the
five frameworks.
Frameworks for DCF-Based Valuation
Model
Measure
Discount factor
Assessment
Enterprise Free cash
discounted flow
cash flow
Weighted average
cost of capital
Works best for projects,
business units, and companies
that manage their capital
structure to a target level
Economic
profit
Economic
profit
Weighted average
cost of capital
Explicitly highlights when a
company creates value
Adjusted
present
value
Free cash
flow
Unlevered cost of
equity
Highlights changing capital
structure more easily than
WACC-based models.
Capital
cash
flow
Capital cash
flow
Unlevered cost of
equity
Compresses free cash flow and
the interest tax shield in one
number, making it difficult to
compare performance among
companies and over time
Equity
cash
flow
Cash flow to
equity
Levered cost of
equity
Difficult to implement correctly
because capital structure is
embedded within cash flow. Best
used when valuing financial
institutions
1
The Valuation Process using Enterprise DCF
Valuation is an
iterative process…
5. Calculate and Interpret Results
Once the model is complete, examine
valuation results to ensure your
findings are technically correct, your
assumptions are realistic, and your
interpretations plausible.
4. Compute the Cost of Capital
To value the enterprise, free cash
flow is discounted by the weighted
average cost of capital. The cost of
capital is the blended rate of return
for all sources of capital, specifically
debt & equity.
1. Analyze Historical Performance
By thoroughly analyzing the past, we can
document whether the company has
created value, whether it has grown, and
how it compares with its competitors.
2. Forecast Financials & Cash Flows
Project financials over the short and
medium term. Short-term forecasts
should be consistent with announced
operating plans. Medium-term
forecasts should focus on operating
drivers, such as margins, and capital
turnover.
3. Estimate a Continuing Value
To forecast cash flows in the
long-term future, use a perpetuity
that focuses on the company’s
key value drivers, specifically
ROIC and growth.
Begin the process by
analyzing historical
performance…
2
Analyze Historical Performance: Analyzing ROIC
1. Analyze Historical Performance
• Before projecting future cash flow,
examine the company’s historical
performance. A good analysis
focuses on the key drivers of value:
return on invested capital (ROIC) and
growth.
• ROIC measures a company’s ability
to create value.
• Both Home Depot and Lowe’s
improved ROIC between 2001 and
2003. Historically speaking, Home
Depot has performed better than
Lowe’s. Going forward, will Home
Depot be able to maintain this
advantage?
ROIC Analysis: Home Depot vs. Lowes
Home Depot
Lowe's
18.2
16.0
14.3
13.9
12.8
10.3
2001
2002
2003
How do we compute ROIC?
3
Analyze Historical Performance: Computing ROIC
NOPLAT
After-tax operating profit equals
revenues minus operating costs, less
any taxes that would have been paid if
the firm held only core assets and
were finance only with equity.
Invested Capital
Invested capital equals the operating
assets required for core business
activities (such as inventory and
PP&E) less any financing provided by
customers, employees, and suppliers
(such as accounts payable).
Home Depot
2001
Net sales
Cost of merchandise sold
Selling, general and admin
Depreciation
Operating lease interest
Adjusted EBITA
5,228
Operating taxes
2003
64,816
58,247
(44,236)
(40,139)
(11,375) (12,658)
(895) (1,075)
276
260
2003
30,838
(21,231)
(5,671)
(758)
114
6,098
7,123
3,292
(2,020)
(2,117)
(2,040)
(1,069)
3,208
3,981
5,083
Invested capital
Operating working capital
Net property and equipment
Capitalized operating leases
Net other assets
2,552
15,375
5,459
(216)
2,746
17,168
5,890
(247)
2,674
20,063
6,554
(524)
1,363
11,945
2,762
211
Invested capital (w/o goodwill)
23,170
25,557
28,767
16,281
419
46
575
54
833
55
0
730
Invested capital (w/ goodwill)
23,635
26,185
29,655
17,012
ROIC w/ goodwill (average)
14.3%
16.0%
18.2%
13.9%
NOPLAT
Intangibles and goodwill
Cumulative amortization
ROIC is computed by
comparing after-tax
operating profits to
invested capital
53,553
(37,406)
(10,451)
(756)
288
2002
Lowe’s
2,223
4
Forecast Financials: ROIC versus WACC
2. Forecast Financials
• To compute a company’s value using enterprise DCF, future free cash flow is
discounted by the weighted average cost of capital. Rather than forecast FCF
directly, however, forecast the financials that drive free cash flow.
• One of the primary drivers of free cash flow is return on invested capital. For
simplicity, we assume each company’s financial performance will remain constant.
In actuality, these figures will change over time, and this must be modeled.
Forecasting ROIC: Home Depot versus Lowe’s
20%
Home Depot ROIC
15%
Lowes ROIC
10%
Home Depot WACC
5%
0%
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
5
Forecast Financials: Free Cash Flow
Forecast Free Cash Flow (FCF)
• Free cash flow, which is driven by revenue growth and return on invested capital,
provides the basis for enterprise DCF valuation.
• The computation of FCF should be consistent with that of ROIC. Free cash flow begins
with NOPLAT, adds depreciation, and subtracts investments in invested capital.
Forecast
Historical
2001
2002
2003
2004
2005
2006
NOPLAT
Depreciation
3,208
756
3,981
895
5,083
1,075
5,185
1,193
5,741
1,321
6,342
1,459
Gross cash flow
3,964
4,876
6,157
6,378
7,062
7,801
Investment in operating working capital
Net capital expenditures
Investment in capitalized operating leases
Investments in intangibles and goodwill
Decrease (increase) in net other assets
Increase (decrease) in other comp income
834
(3,063)
(775)
(113)
105
(153)
(194)
(2,688)
(430)
(164)
31
138
72
(3,970)
(664)
(259)
277
172
(294)
(3,399)
(721)
(92)
58
0
(318)
(3,708)
(780)
(99)
62
0
(344)
(4,036)
(842)
(107)
67
0
Gross investment
(3,165)
(3,307)
(4,372)
(4,448)
(4,843)
(5,261)
799
1,569
1,785
1,930
2,219
2,539
Free cash flow ($ millions)
Gross
Cash
Flow
Investments in
Invested
Capital
NOPLAT plus
depreciation, less
investments in
invested capital
6
Continuing Value
3. Continuing Value
• To estimate a company’s value,
we separate a company’s
expected cash flow into two
periods and define the company’s
value as follows:
Home Depot: Estimated Free Cash Flow
$ millions
12,000
10,000
Present Value of Cash Flow
Value =
+
8,000
$ millions
during Explicit Forecast Period
6,000
4,000
Present Value of Cash Flow
2,000
after Explicit Forecast Period
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
• The second term is the continuing
value: the value of the company’s
expected cash flow beyond the
explicit forecast period.
Explicit Forecast
Period
2014 2015 2016 2017 2018 2019
Continuing
Value
7
Continuing Value: The Key Value Driver Formula
• Although many continuing-value models exist, we prefer the key value driver
model. The key value driver formula is superior to alternative methodologies
because it is based on cash flow and links cash flow to growth and ROIC.
g
NOPLATt + 1 1 - RONIC
Continuing valuet =
WACC - g
$12,415 1 Continuing valuet =
RONIC is the return on
new investment, return
on existing investment
is captured in NOPLAT
4.0%
9.3%
9.3% - 4.0%
= $133,360
The continuing value is
measured as of 2013. This
value must still be
discounted to present day.
8
Weighted Average Cost of Capital
4. Weighted Average Cost of Capital
• When performing and Enterprise DCF, make sure to choose the cash flows and
discount factor consistently. Since free cash flows are the cash flows available to all
investors, the discount factor for free cash flow must represent the risk faced by all
investors.
• The weighted average cost of capital (WACC) blends the required rates of return for
debt kd and equity ke based on their target market values.
Target (market-based) weights on
debt and equity
D
E
WACC  k d (1  Tm )  k e
V
V
Home Depot Cost of Capital
Proportion of
total capital
After-tax
opportunity
cost
Contribution
to weighted
average
8.3
91.7
2.9
9.9
0.2
9.1
100.0%
After-tax cost of
debt
9.3%
After-tax cost
of equity
9
Putting It all Together: Enterprise DCF Valuation
Home Depot Valuation
Year
Free cash
flow (FCF)
$ Million
Discount
factor
@ 9.3%
1,930
2,219
2,539
2,893
3,283
3,711
4,180
4,691
5,246
5,849
133,360
0.915
0.837
0.766
0.700
0.641
0.586
0.536
0.491
0.449
0.411
0.411
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Continuing value
Present
value of FCF
$ Million
1,766
1,857
1,944
2,026
2,104
2,175
2,241
2,301
2,355
2,402
54,757
Present value of cash flow
Mid-year adjustment factor
75,928
1,046
Value of operations
79,384
Value of excess cash
Value of other nonoperating assets
To determine the enterprise value,
add the value of non-operating
assets, such as excess cash.
1,609
84
Value of debt
Value of capitalized operating leases
81,077
(1,365)
(6,554)
Equity value
73,158
Enterprise value
To determine the value of
operations, discount free cash
flow at the weighted average
cost of capital.
To determine the equity value,
subtract the value of non-equity
financial claims, such as debt and
capitalized operating leases.
10
Economic Profit Valuation Models
• The economic profit model
highlights how and when the
company creates value yet
leads to a valuation that is
identical to that of enterprise
DCF.
• An advantage of the
economic profit model over
the DCF model is that
economic profit is a useful
measure for understanding a
company’s performance in
any single year, whereas free
cash flow is not.
Frameworks for DCF-Based Valuation
Model
Measure
Discount factor
Assessment
Enterprise Free cash
discounted flow
cash flow
Weighted average
cost of capital
Works best for projects,
business units, and companies
that manage their capital
structure to a target level
Economic
profit
Economic
profit
Weighted average
cost of capital
Explicitly highlights when a
company creates value
Adjusted
present
value
Free cash
flow
Unlevered cost of
equity
Highlights changing capital
structure more easily than
WACC-based models.
Capital
cash
flow
Capital cash
flow
Unlevered cost of
equity
Compresses free cash flow and
the interest tax shield in one
number, making it difficult to
compare performance among
companies and over time
Equity
cash
flow
Cash flow to
equity
Levered cost of
equity
Difficult to implement correctly
because capital structure is
embedded within cash flow. Best
used when valuing financial
institutions
11
Defining Economic Profit
•
Economic profit translates size, return on capital, and cost of capital into a single
measure. Economic profit equals the spread between the return on invested capital
and the cost of capital times the amount of invested capital.
Economic profit = Invested Capital x (ROIC – WACC)
•
The above formula for economic profit can be rearranged and defined as after-tax
operating profits less a charge for the capital used by the company:
Economic profit = NOPLAT - (Invested Capital x WACC)
•
This approach shows that economic profit is similar in concept to accounting net
income, but it explicitly charges a company for all its capital, not just the interest on
its debt.
12
Economic Profit at Home Depot
2001
2002
2003
2004 E
ROIC
15.0%
16.8%
19.4%
17.5%
- WACC
10.1%
9.0%
9.3%
9.3%
4.9%
7.9%
10.1%
8.2%
21,379
23,635
26,185
29,655
1,048
1,857
2,645
2,424
Method 1
• Consider both measures of
economic profit for Home
Depot. Since Home Depot
has been earning returns
greater than its cost of
capital, its historical
economic profit is positive.
• Not every company has a
positive economic profit. In
fact many companies earn an
accounting profit (net income
greater than zero), but can’t
earn their cost of capital.
= Economic spread
X Invested capital
= Economic profit
( in $ millions)
2001
2002
2003
2004 E
Invested capital
21,379
23,635
26,185
29,655
WACC
10.1%
9.0%
9.3%
9.3%
Capital charge
2,159
2,124
2,438
2,761
NOPLAT
3,208
3,981
5,083
5,185
(2,159) (2,124)
(2,438)
(2,761)
1,857
2,645
2,424
Method 2
Capital charge
Economic profit
1,048
13
Discounted Economic Profit Leads to Same Results as DCF
• To demonstrate how economic profit can be used to value a company—and to
demonstrate its equivalence to enterprise DCF, consider a stream of growing cash
flows valued using the growing-perpetuity formula,
Value 0 
FCF1
WACC  g
• Using a few algebraic transformations and the assumption that the company’s ROIC on
new projects equals the company’s current ROIC, we can transform the cash flow
perpetuity into an economic-profit based key value driver model,
Value 0  Invested Capital 0 
Invested Capital 0 x ROIC - WACC
WACC  g
• Substituting the definition of economic profit,
Value 0  Invested Capital 0 
Economic Profit 1
WACC  g
14
Home Depot: Economic Profit Valuation
Home Depot Valuation
Year
Invested
Capital
$ Million
2004
29,655
2005
2006
2007
2008
2009
2010
2011
2012
2013
32,910
36,432
40,235
44,329
48,729
53,445
58,488
63,870
69,600
ROIC
Percent
17.5
17.4
17.4
17.4
17.3
17.3
17.3
17.2
17.2
17.2
Continuing value
Economic
WACC profit
Percent $ Million
9.3
9.3
9.3
9.3
9.3
9.3
9.3
9.3
9.3
9.3
2,424
2,677
2,950
3,242
3,556
3,890
4,247
4,627
5,031
5,458
57,671
Discount
factor
@ 9.3%
0.915
0.837
0.766
Present value
of economic
profit
$ Million
2,217
0.449
0.411
2,241
2,259
2,271
2,278
2,281
2,278
2,270
2,258
2,241
0.411
23,679
0.700
0.641
0.586
0.536
0.491
Present value of economic profit
46,273
Invested capital*2004
29,655
75,928
Invested capital plus present value of economic profit
Mid-year adjustment factor
Value of operations
1.046
79,384
The value of
operations equals:
the sum of
discounted economic
profit
+
current invested
capital
Economic Profit
leads to the same
value for operations
as Enterprise DCF!
*Measured at the beginning of the year
15