Income Approach to Valuation + WACC

unlevered fcf is a

SYNTHETIC construct we have constructed so that if u take pv of it, u get enterprise value

market risk premium is actually

a function of risk aversion in the market more risk averse, larger market risk premium demanded

big question - what do we do with short term debt should we include short term debt in weight of debt or not?

answer = it depends if the short term debt is permanent component of capital structure (look q1, q2, q3) - > gonna include it in total debt

as long as i earn --- on the $2 of capital i earn 30 cents

as long as i earn 15%

so we start with EBIT - why

bc we need something w interest IN it haven't taken out interest out yet

if you ADD debt, what happens to beta?

beta goes up

if firm is solvent or good credit risk (BBB or above)

book val of debt + market val of debt are relatively close

how to get weight of debt?

book value of debt supposed to be market value of debt but MOST firms don't have publicly traded debt + even when it trades it is HIGHLY illiquid

so how do u do this approach

calc ev with dcf method, take out market val of preferred, take out market val of debt, add back excess cash

what if this firm does NOT hav 10 year bonds but has BBB rating bonds

can find another firm in industry w 10 year bonds, find their ytm

so as long as growth rate is nicely far from discount rate

can use

when g is really close to cost of capital

can't will completely destroy val

capm says that all the risk in the world is

captured by beta and that there's a linear relationship btwn risk and return. this make sense AROUND 1 BUT if beta is SUPER high, the relationship is NOT linear ex: cruise ship industry

operating cash flow

cf available for debt repayment problem is if you discount this at WACC you have a PROBLEM bc you have a tax shield in denominator AND tax shield in numerator so have to synthetically PRETEND cash flow is for a firm that has no debt

enterprise value formula

common equity value + preferred + market val debt - excess cash

which means that traditional dcf - values

consistently UNDERVALUES companies and the HIGHER the WACC the MORE it undervalues companies

wacc formula what is d? what is e?

d is market val of debt e = market val of equity

how to data validate a cell

data data tools --> data validation --> allow --> decimal --> btwn --> 0 and 100 can add INPUT message too

who has a claim on enterprise value?

debtholdrs, preferred stockholders, equity holders

why does it have to b unlevered

denominator = - / (1+wacc) ^n - / (1+ (wd(kd)(1-t)+weke denominator ALREADY reflects cost of debt and tax shield SO if you were to use denominator is LOWER bc of tax shield meaning valuation goes up so we need a NUMERATOR that does NOT have the benefit of the tax shield

what are the income approaches

direct indirect

if firm is in financial distress

do NOT use this model so now we have weight of equity

if you are a BUYER you

do NOT want to use mid year convention

LAST RESOIRT

do what we did in back out bank debt, interest expense / debt last resort, least accurate problem is this is rlly backward-looking, care abt future

if terminal value is large

don't be surprised if terminal value is very large relative to cfs! closer the growth rate gets to the discount rate, the BIGGER this gets

unlevered fcf with ebit =

ebit - taxes on ebit + depreciation + amortization - capex - changes in working cap add back dep and amortization bc non cash charges

unlevered fcf =

ebitda - taxes on ebit - capex - changes in working capital

AGENDA income approach

enterprise value WACC CAPM

what is terminal value?

enterprise value at end of year 3 if you were to sell firm at end of year 3 you would get that amount

forward beta comes from

equity research reports will tell you what they think sensitivity will be. that's what you use for capm.

when to data validate cell

esp whenever you're doing something for a client and they have to divide by something; data validate so they don't put something stupid

problems

even if u r able to find this out you CAN't force managers to do this bc agency problem

why is risk premium 5.45%

experts believe for nxt 15-20 years, s+p will on AVERAGE out-perform the risk free rate

if you are valuing equity -

for the risk free rate , look at the most liquid long term bond u can ; LONGEST. not 29. there's a liquidity premium priced into things 30 year treasury bond

valuing equity using dividend discount model non-constant growth

forecast out until growth is constant get terminal value take PV of finite cash flows

NOW what happens if you earn LESS than your required return on capital say 10%

give bank back what about me? i gave firm a $1 and i wanted 20 cents back. means you OVERPAID for price of that stock. means stock price will go down in the market

in 2008 switzerland

had negative interest rates bc in financial crisis MASS exodus of money. went to china to stable places. SM demand to park money in switzerland that they were willing to PAY switzerland to park their money in their bonds

so if you want to VALUE enterprise value

have to use a cash flow available to ALL capital providers

popular approach is called the INDIRECT, unleveled free cash flow approach

have unlevered free cash flows, discount back at WACC, get ENTERPRISE value, we take out debt + preferred, then are left with equity get equity INDIRECTLY

with ebitda

i can forecast ebitda directly, cant forecast divs directly bc dont know if they'll b paid

why use mid year convention?

i want to negotiate MORE value; get what the company is actually worth

what constitutes debt?

if it has interest on it + is long term , it is debt (loans, bonds, debentures) financial leases, operating lease

changes in working capital

if negative, means working capital went up less changes in working capital (1.0) doesn't mean working capital went DOWN. means working capital went up and you're just subtracting it

best possible answer for calculating cost of debt

if publicly traded debt, find debt that matches MATURITY of your investment and calculate the effective ANNUAL yield to maturity (bonds are semiannual, so need to calc effective ANNUAL yield to mat) 10% semi is 10.25% effective annual yield to maturity

how to calculate the market value of equity?

if publicly traded, can get it on yahoo finance open interest * current price of stock (# of shares outstanding * price per share)

do we use dividends as cfs and cost of equity for risk?

if so we price equity DIRECTLY

MOST textbooks do what w short term debt

ignore it. but that is WRONG bc should be permanent

direct, value equity approach is what we get

in intro to finance

so you should be indifferent btwn

including infinite stream of cfs or terminal val into the revised cf calculation

ytm

internal rate of return of the bond

what we are trying to do is we forecasted set of future cash flows that have a certain risk and what we want to do is be COMPENSATED for the risk that we will bear in the FUTURE SO, the current/actual capital structure

is IRRELEVANT you need to use that TARGET capital structure to project correctly

the dividend growth model - popularity

is NOT popular why? to get the right answer for price of stock need 2 necessary conditions. 1. solve for dynamic dividend policy first 2. can't get management to necessarily obey ut

setting discount rate

is harder than you think

just like how ebitda

is not best of cash for many firms , it is used UNIVERSALLY

dividend discount model

is the DIRECT model value equity DIRECTLY

unlevered free cash flow

is the cash available for DISTRIBUTION to owners and creditors AFTER paying back worthwhile investment activities (labor, raw material, overhead, capex, working capital)

only difference w mid-year convention

is you are changing 1 to 0.5 0.5, 1.5, 2.5

the minute you use EBIT instead of ebt

it is UNLEVERED

market approach -->

it's not YOUR ideas that drive the market ; it is the MARKET ( supply + demand conditions in the market ) that set prices not what we as individuals think it outta be

terminal value means what

it's what the infinite stream of cash flows is equal to at the end of year 3

if you do tax on EBT it's called

levered free cash floor or just plain are cash flow

green means

link to another spreadsheet within workbook

if you are valuing 10 year bond

look at 10 year treasury bond

if you CAN't do this either

look in footnotes, see if has any info on most recent issue

asset-based approach

looks at book-value balance sheet + then look at EVERY bucket on bal sht and mark it all to market) --> write it ALL up; try to get market val for every asset - will include things like brand -goal is to get market val balance sheet -take out liabilities / claims against it + then you are left with equity -problem here is getting the val of ALL the stuff --> how do you get val of human capital, patents etc.

if firm is NOT solvent tho (BBB or worse)

market val of debt and book val of debt will DIVERGE

so enterprise value is the

market value of ALL of the capital equity, preferred stock, net debt so market value of ALL the capital in the firm

SO lesson abt time

maturity of WACC must be same as maturity of investment t

so what do we do when cfs happen SMOOTHLY during the year ex:

mcd. doesn't rlly have seasons, pretty consistent. so PUNISHES companies like mcd also punishing companies like peeps that makes most of $ in q1. discounting cfs by 9 months more than should be

so if you wanted to buy his guitar company

need to buy his equity out retire 100k debt

excess cash

negative debt if you have excess cash, why should you have debt? should rlly just retire the debt

you CANNOT have a

negative required return if it's negative means i PAY someone to use my money

on GAAP balance sheet

no such thing as unlevered fcf on bal sht

but what if i earn MORE than my required return on capital say 20% , 40 cents.

now i was promised 20 cents but i actually got 30. everyone wants it for dollar bc they want that return so my stock is going to go up from $1

for ex - direct method valuing equity

numerator = dividends, DENOMINATOR = return on capital that CREATED the dividends which is return on equity

so now indirect method = numerator and denominator this is to get enterprise val then will take out debt + preferred to get val of equity

numerator = unlevered fcf denominator = return on all the capital that CREATED that cash flow equity, debt, and preferred so what is the rate with similar risk -- wacc

when you are doing dcf it is important

numerator and denominator JIBE w/ e/o

this is VERY SIMILAR to

operating cash flow

found that value firms w beta

outperformed opposite

for kd - what are we trying to understand?

over life of the project if i have to borrow MORE money, what will it cost me? what will be the incremental cost of taking on more debt

usually capital structure is

pretty sticky so if you use current you probs wouldn't mess up that much but still

so what is enterprise val

price you will pay if you buy a company market val of ALL financial claims against the asset

how do we calculate enterprise value?

project future cfs to capital providrs convert each cash flow to a pv sum pv cfs

valuing equity using dividend discount model constant growth

pv = cf (t+ 1)/ (k-g) anything growing at constant rate, you can model

valuing equity using dividend discount model no growth

pv = cf / k

difference is

rather than tax on EBT (w operating) we do tax on EBIT here instead

synonym for discount rate

required rate of return hurdle rate wacc

capm required rate of return =

risk free rate + PREMIUM as you start to add risk well what's the risk? well if you hold a diversified portfolio, the only risk you have is SYSTEMATIC risk

ebitda is function of

sales cogs overhead

why is he not a fan of npv function

says it works well if cfs are indeed at end of year but if they are at days instead, npv function would not work

beta -

sensitivity of stock's return to market beta you find in yahoo finance is HISTORICAL. we don't care about this

beta

sensitivity to market return

study grouped tog based on beta

small companies w beta outperform bigger companies w beta

so we need a cash flow that HAS interest in it (pre-interest) so available to all capital providers

so starts with EBIT or EBITDA

intuition for wacc i want to start a business, i need $2 of capital. i put $1 in myself and in need 20% rate of return on my investment. bank says he will loan u a $1 but they req 10% interest. want 10 cents. so i need to earn 10 cents for amal and 20 cents for himself. so my required earnings is 30 cents. if i earn 30 cents, everyone is happy

so what is the required return on capital .30/2 = 15%

undervaluation is REALLY a problem esp for

startup companies w a high WACC

how do you get weight of debt and equity? do we use actual or target weights

target weights

tax on ebt v tax on ebit

tax on ebt is LOWER than tax on ebit bc interest is a tax shield so if you used EBT in numerator and wacc in denominator you'd be BIASING the valuation UP CAN'T double count the tax shield why you use an UNLEVERED cash flow

for ex - say you try to use income approach to price tesla

tesla's price is so high that the terminal growth rate you would need to price tesla would be like 15% (some insane terminal growth rate) doesn't matter what your own assumptions say ; if market says you will pay $400 for a share THAT is what you are going to pay

traditional dcf assumes

that ALL cfs happen at the end of the year

income approach makes STRONG assumption

that ALL cfs happen on 12/31 which means you LITERALLY get it all on 12/31 - not smoothly through the year with this def you are UNDERVALUING the firm. bc you assume everything comes in at 12/31 but some probably comes jan, feb etc.

just REALIZE if you use price/sales to estimate equity

that if you are taking a MARKET multiple + using that for ur private firm, understand that those stocks are LIQUID + yours is NOT say you are looking at similar firms w p/s of 5. w/ 1m of sales. you would say this firm is worth (1m)*5 = 5mill BUT that is what it would be worth if it WERE Publicly traded

for npv what cash flows must you put in

the ORIGINAL cash flows NOT the pv calcs

dividend discount model = value of equity is just

the PRESENT val of the future dividends so FORECAST dividends and discount hem back at the RISK (cost of equity capital) which then gives you what the stock is worth not popular but we used this in intro to cf

what is enterprise value NOT

the market val of the assets of the firm

SO enterprise value IS

the market value of ALL of the financial claims against the firm

the market risk premium is ACTUALLY

the market's EXPECTATION of how much the market will outperform the similar-maturity treasury bond REALLY call 300 equity research analysts; will say how much they believe the market will outperform similar-maturity bond

if you used LEVERED free cash flow in numerator

then u have benefit of tax shield in numerator and denominator

do we use unlevered fcfs + wacc for risk?

then we value ENTERPRISE value tech is same , no diff

so bear in mind if you use public p/s that

there's a liquidity PENALTY you must hit it with has to trade at discount , HAS to be less valuable bc it is NOT liquid

purple means

there's an external hyperlink

but for privately traded companies --> capm

they have 1/2 money tied up in company, obvi have idiosyncratic risk, so this is not good for them

capm - for publicly traded companies

this is not bad

risk free rate is SUPPOSED

to reflect richest of capital over LIFE of investment NOT the 30 day treasury rate. the treasury rate is TOO late

how to calculate the market value of equity? for private equity

tougher bc private equity does NOT have transaction price ; is not liquid so you have to IMPUTE what the transaction price is has used price/sales, p/e multiples to get close

NOT using krf as

treasury rate

what does red do?

tries attention

for dcf you need 2 things

unlevered cash flows discount rate

what is the appropriate cf for wacc

unlevered free cash flow

how to calculate the cost of equity

use capm good way BUT it is WRONG. brilliant back then. even tho it is wrong, it is old

how to get cost of equity

use capm why? bc everyone uses it

if you are a SELLER, you would rather

use mid-year convention assumes that rather getting all cfs on 12/31, u get all of them on 6/31. this is fair

so if you believe capital structure will change from actual

use the target

so even when firm is traded

usually market val of equity, book val of debt

direct income approach

values equity DIRECTLY uses dividends bc dividends are the cf to equity holders . you discount them back at the cost of equity , u get the price of equity DIRECTLY not popular approach

so ebit is

very last thing u have before interest expense

what is the appropriate discount rate for unlevered free cash flow

wacc

if you are a SELLER

wake UP mid year valuation will really HELP you

remember when we took accounting operating leases

were NOT debt did not appear on the books. now they do

only diff btwn dcf and income approach

what are the cfs? (dividends) and what do we use as risk

ex: peeps lil candy things for easter

will only have st debt in q1 when selling for easter in that case, will not include st debt

private firms worth

worth LESS bc they are NOT liquid there's a liquidity premium so appropriate p/s would maybe be 4.2 or 4.25

dynamic dividend policy

would need it student to build algorithm using forecast OPTIMIZING how much in dividends and how much to send back to retained earnings good luck ; ppl don't know how to do this. mis ppl only

so IF growth rate is close to the wacc discount rate

you CANNOT use this method/technology instead of using growth rate you will use terminal val/ebitda multiple

bottom line if you DON'T use an unlevered fcf

you UPWARDLY bias the valuation estimate by double-counting the tax shield

forward not usually available AS LONG AS YOU BELIEVE there are no dramatic market changes coming soon

you can use a historical beta NOT accurate; approximation; but u can use

wacc formula

(1-t)(kd)wd + kewe (1-t)(kd)(d/v) + ke(e/v)

income approach (discounted cf method) is a matter of

-matter of WHAT cash flow are you discounting -- is it dividends? then it is direct valuation of equity is cf you are valuing unlevered fcf - then what you get is enterprise val , take out preferred and get debt indirectly very popular

if i were peeps i would go to war for

0.25 , 1.25, 2.25, 3.25

with the income, def approach 2 things are always required

1. forecasted cash flow (what are the appropriate cfs) 2. discount rate (understanding of what the risk would be over the LIFE of the cash flows) --> not backward lookign

parts to capm

1. what is appropriate risk free rate 2. what is appropriate beta 3. what is the appropriate market risk premium

corporate tax rate

21% that's what u will pay

How many ways to value companies?

4 ways least popular to most 1. using real options - value equity as call option on assets of firm where strike price = market val of debt (not often bc not always accurate) 2. asset-based approach 3. income approach (discounted cf method) (very popular) 4. market approach -->

RN it is about

5.45% function of RISK AVERSION in the market the more risk averse the market is, the BIGGER premium demanded over risk free rate lower risk averse, lower premium

say u r buying guitar company

500k in equity, 100k in debt, 25k in cash so ev = 500+100-25 = 575k bc you used cash to retire some debt

say you don't have access to those researchers - what do you do?

80 year geometric average of km-kf will still get pretty close to 5.45%

TV formula

CF(t+1) / wacc -g

npv function rlly

CONSTRAINS you

if you hold stock forever, the only cf you will get is

DIVIDENDS. that is it. stocks = infinite life

what do we want for beta?

FORWARD beta. what do we expect

the bigger the wacc, how does the diff btwn traditional and midyear convention change

HIGHER wacc, higher/greater difference

income approach gives you

INTRINSIC value ; each person has their OWN assumption on what this thing is worth based on your given assumptions

beta is a

LEVERED beta, equity beta WHY? bc return on stock is a FUNCTION of its debt. debt makes good times better, bad times worse

but is everyone holding a diversified portfolio

NO. angel investors aren't etc. but capm ASSUMES that's what you hold

when you buy a company, how much $ do you have to show up with to buy the company?

NOT all the assets bc some assets are FREE to finance (accounts payable)

the dcf is

NOT suited for firm in distress bc tough to value debt

what is market premium NOT

NOT the diff btwn current s&p500 and current treasury bill rate NOT AT ALL RIGHT

risk free rate what is it NOT

NOT the treasury bill in cap budgeting, you need to MATCH maturity of asset with capital we use to fund the asset equity is infinitely lived; no such thing as infinite treasury bond. but there is 30 year treasury bond.