A Complete Corporate Valuation
for a Simple Company
1
Three types of value
• Book value: the company’s historical value as
shown on its financial statements.
• Market value: the current price at which an
asset can be bought or sold.
• Intrinsic value: estimate of the value an
individual buyer places on an asset.
2
Objective:
• Objective is to provide a sound basis for
estimating the intrinsic value of a stock.
• This intrinsic value is also called its
fundamental value.
• The process is known as fundamental
valuation—Warren Buffet is very successful at
identifying a company’s fundamental value!
3
The three basic concepts of valuation
• Investors can only spend cash so "Cash is good and
more cash is better."
• Cash today is worth more than cash tomorrow.
• Risky cash flows are worth less than safe cash flows.
• These three imply the value of a company depends
on the size, timing, and riskiness of its cash flows.
4
Steps in the corporate valuation
• Determine weighted average cost of capital
• Estimate expected future free cash flows---cash flows
available to all investors—called free cash flows
(FCFs).
• Discount free cash flows at the average rate of return
required by all investors
• Find value of company
5
Estimating the Weighted Average Cost of
Capital (WACC)
• Company has two types of investors
– Debtholders
– Stockholders
• Each type of investor expects to receive a
return for their investment
• The return an investor receives is a “cost of
capital” from company’s viewpoint.
6
Cost of Debt
• MPR’s cost of debt: rD = 9%.
• But MPR can deduct interest, so cost to MPR is
after-tax rate on debt.
• If tax rate is 40%, then after-tax cost of debt is:
– After-tax rD = 9%(1-0.4) = 5.4%.
7
Cost of Equity
• Cost of equity, rs, is higher than cost of debt
because stock is riskier.
– MPR: rs = 12%
8
Weighted Average Cost of Capital
• WACC is average of costs to all investors, weighted by
the target percent of firm that is financed by each
type.
• For MPR, target percent financed by equity:
– wS = 70%
• For MPR, target percent financed by debt:
– wD = 30%
(More….)
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WACC (Continued)
WACC
= wD rD (1-T) + wS rS
= 0.3(9%)(1 - 0.4) + 0.7(12%)
= 10.02%
10
Free Cash Flow (FCF)
• FCF is the amount of cash available from
operations for distribution to all investors
(including stockholders and debtholders) after
making the necessary investments to support
operations.
• A company’s value depends upon the amount
of FCF it can generate.
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Calculating FCF
• FCF = net operating profit after taxes minus
investment in operating capital
12
Financial Statements
• Balance sheet
– Assets (all of MPR’s assets are used in operations)
• Operating assets
– Operating current assets
– Property, plant, and equipment (PPE)
13
Operating Current Assets
• Operating current assets are the CA needed to
support operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because
these are not a part of operations.
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Operating Current Liabilities
• Operating current liabilities are the CL
resulting as a normal part of operations.
– Op CL include: accounts payable and accruals.
– Op CA exclude: notes payable, because this is a
source of financing, not a part of operations.
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Balance Sheet: Assets
Op. CA
Total CA
Net PPE
Tot. Assets
2012
162,000.0
162,000.0
199,000.0
361,000.0
2013
168,000.0
168,000.0
210,042.0
378,042.0
2014
176,400.0
176,400.0
220,500.0
396,900.0
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Balance Sheet: Claims
2012
Op. CL
57,911.5
Total CL
57,911.5
L-T Debt
136,253.0
Total Liab. 194,164.5
Equity
166,835.5
TL & Eq. 361,000.0
2013
62,999.7
62,999.7
143,061.0
206,060.7
171,981.3
378,042.0
2014
66,150.0
66,150.0
150,223.0
216,373.0
180,527.0
396,900.0
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Income Statement
Sales
Costs
Op. prof.
Interest
EBT
Taxes (40%)
NI
Dividends
Add. RE
2012
400,000.0
344,000.0
56,000.0
11,678.7
44,321.3
17,728.4
26,592.7
21,200.0
5,392.7
2013
420,000.0
361,994.2
58,005.8
12,262.8
45,743.0
18,297.2
27,445.8
22,300.0
5,145.8
2014
441,000.0
374,881.6
66,118.4
12,875.5
53,242.9
21,297.2
31,945.7
23,400.0
8,545.7
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NOPAT (Net Operating Profit After
Taxes)
• NOPAT is the amount of after-tax profit
generated by operations.
• NOPAT is the amount of net income, or
earnings, that a company with no debt or
interest-income would have.
NOPAT
= (Operating profit) (1-T)
= EBIT (1-T)
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Calculating NOPAT
NOPAT
NOPAT14
= (Operating profit) (1-T)
= EBIT (1-T)
= 66.1184 (1-0.4) = 39.67104
million.
20
Calculating Operating Capital
• Operating capital (also called total
operating capital, or just capital) is the
amount of assets required to support the
company’s operations, less the liabilities
that arise from those operations.
– The short-term component is net operating
working capital (NOWC).
– The long-term component is factories, land,
equipment.
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Net Operating Working Capital
NOWC =
Operating current assets
– Operating current liabilities
This is the net amount tied up in the “things”
needed to run the company on a day-to-day
basis.
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Net Operating Working Capital
NOWC
NOWC14
= Operating CA – Operating CL
= $176.4 – $66.15
= $110.25 million
23
Operating Capital
• Operating capital =
– Net operating working capital (NOWC)
plus
– Long-term capital, such as factories, land,
equipment.
24
Operating Capital = NOWC + LT Op. Capital
Capital14
= $110.25 + $220.50
= $330.75 million
This means in 2014 MPR had $330.75 million
tied up in capital needed to support its
operations. Investors supplied this money. It
isn’t available for distribution.
25
Investment in operating capital
• Operating capital in 2013 was $315.0423
million
• Operating capital in 2014 was $330.75 million
• MPR had to make a net investment of $330.75
– $315.0423 = $15.7077 million in operating
capital in 2014.
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Calculating FCF
FCF = NOPAT – Investment in operating capital
FCF14
= $39.67104 – (330.75 – 315.0423)
= $39.67104 – $15.7077
= $23.96334 million
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There are five ways for a company to
use FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies,
etc.)
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Reinvestment
Bucket
Free Cash Flow
Bucket
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How Did MPR use its FCF?
• Paid dividends: $23.4 million
• Paid after-tax interest of: $12,875.5 (1-0.4) = $7.7253
million
• For a total of $31.1253 million! This is $7.162 million
more than the $23.9 million FCF available! Where
did it come from?
• MPR increased its borrowing by $150.223 –
$143.061) = $7.162 million to make up the
difference.
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Corporate Valuation
• Forecast financial statements and use them to
project FCF.
• Discount the FCFs at the WACC
This gives the value of operations
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Value of Operations:

FCFt
VOp  
t
t 1 1  WACC 
Of course, this requires projecting free cash flows out
forever.
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Constant growth
• If free cash flows are expected to grow at a
constant rate of 5%, then this is easy:
FCF
2014
23.963
2015
25.161
2016
26.419
2017
27.740
2018
29.127
2019
30.584
There is an easy formula for the present value of free cash
flows that grow forever at a constant rate…
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Constant Growth Formula
• The summation can be replaced by a single
formula:
FCF1
VOp 
WACC  g 
FCF0 (1  g )

WACC  g 
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The value of operations
FCF0 (1  g )
VOp 
WACC  g 
$23.96334 (1  0.05)
VOp 
0.1002  0.05
 $501.225 million
35
Value of Equity
• Sources of Corporate Value
– Value of operations = $501.225 million
– Value of non-operating assets = $0 (in this case)
• Claims on Corporate Value
– Value of Debt = $150.223 million
• Value of Equity = ?
• Value of Equity = $501.225 - $150.223 =
$351.002 million, or just $351 million.
36
Value of Equity
Price per share
= Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share
37
A picture of the breakdown of MPR’s value
Debt
Equity
38
Return on Invested Capital (ROIC)
ROIC can be used to evaluate MPR’s
performance:
ROIC = NOPAT / Total operating capital in place
at the beginning of the year
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ROIC calculation
ROIC14 = NOPAT14 / Capital13
ROIC14 = 39.67104 / 315.0423 = 12.6%.
This is a good ROIC because it is greater than the return
that investors require, the WACC, which is 10.02%.
So MPR added value during 2014.
40
Economic Value Added (EVATM)
(also called Economic Profit)
• EVA is another key measure of operating
performance.
• EVA is trademarked by Stern Stewart, Inc.
• It measures the amount of profit the company
earned, over and above the amount of profit
that investors required.
• EP = NOPATt – WACC(Capitalt-1)
41
Calculating EVA
EVA = NOPAT- (WACC)(Begng. Capital)
EVA14 = NOPAT14 – (0.1002)(Capital13)
EVA14 = $39.67104 – (0.1002)(315.0423)
= $39.67104 – $31.56742
= $8.1038 million
(More…)
42
Economic profit…
This shows that in 2014 MPR earned about $8
million more than its investors required.
Another way to calculate EP is
EPt
= (ROIC – WACC)Capitalt-1
= (0.125923 – 0.1002)$315.0423
= $8.1038 million
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Intuition behind EP
If the ROIC – WACC spread is positive, then the firm is
generating more than enough “profit,” and is
increasing value. But, if the ROIC – WACC spread is
negative, then the firm is destroying value, in the
sense that investors would be better off taking their
money and investing it elsewhere.
44
Applications of the corporate valuation
model
• Mergers and acquisitions
– Evaluate how much a target is worth under various
operating scenarios
• Value-based management
– Make decisions with the goal of increasing the company’s
value
• Fundamental investing
– Identify firms that are worth more than the current stock
price
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