series 79 chapter 5

inc in AP reps a source of cash. companies aspire to maximize or push out dpo to inc ST liquidity

accrued liab and other current liab= salaries, rent, int, taxes that have been incurred by company byt not yet paid. proj as % of sales in line with historical levels. inc reps source of cash

a given company's growth profile can vary significantly from that of its peers within the sector with certain business models and mgmt teams more focused on or capable of expansion. profitability may also vary for companies within a given sector dep on a multitude of factors, including mgmt, brand, customer base, operational focus, product mix, sales/mk strategy, scale, and tech. similarly, in terms of fcf generation, there are often meaningful differences among peers in terms of capex (e.g. expansion projects) or owned versus leased machinery) and working capital efficiency for ex

after studying the target and det key performance drivers, the banker is prepared to project its fcf. as previously discussed, fcf is the cash generated by a company after paying all cash operating expenses and associated taxes, as well as the funding of capex and working capital, but prior to the payment of any interest expense. fcf is independent of capital structure, as it represents cash available to all capital providers. EBIT * (1-tax rate) + d&a - capex - inc in nwc = fcf

wacc can also be thought of as opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk profile. companies with diverse business segments may have different costs of capital for their various businesses. in these instances it may be advisable to conduct a dcf using a sum of the parts approach in which a separate dcf analysis is performed for each business segment and then summed to arrive at an TEV for the entire company

after tax cost of debt x % debt in cap struc + cost of equity x % equity in cap struc = wacc

with a diff discount rate, pv of perp changes. if discount rate is only 5%, perp cash flow of 1mm worth 20mm. higher the discount rate, smaller the pv

ev = cash flow to invested capital x (1+growth rate) / wacc - growth rate or annual cash flow/wacc - growth rate

ex firm has sales of $10mm, gp of $7, operating income of $5 and net income of 2mm. tax rate is 40% market cap is 45$ and 5mm shares outstanding. existing assets in which it has capital invested of $25mm and cost of capital of 10%

eva = 5x60% - 25$ x 10% = 0.5mm

public company's historical beta may be sourced from financial info resources such as bloomberg, factset, or thomson reuters. recent historical equity returns (i.e. over previous two to five years) however, may not be reliable indicators of future returns. therefore, many bankers prefer to use a predicted beta (provided by MSCI Barra) whenever possible as it is forward looking

exercise of calc wacc for private company involves deriving beta from group of publicly traded peer companies that may or may not have similar cap structures to one another or target. to neutralize effects of diff cap struc (remove influence of leverage), banker must unlever beta for each company in peer group to achieve asset beta (unlevered beta)

pros of dcf cash flow based= reflects value of projected fcf which represents a more fundamental approach to valuation than using mutliples based methods, market indep, more insulated from market aberrations, such as bubbles and distressed periods. self sufficient, does not rely entirely upon truly comp cos or transactions, which may or may not exist, to frame valuation. dcf particularly important when there are limited or no pure play public comps to the company being valued

flexibility= allows banker to run multiple financial performance scenarios including improving or declining growth rates, margins, capex req, and working capital efficiency

as equity research normally does not provide estimates beyond two or three year period excluding initiating coverage reports, banker must derive growth rates in the outer years from alternative sources. without the benefit of mgmt guidance, this typically involves more art than science. often, industry reports and consulting studies provide estimates on longer term sector trends and growth rates. in the absence of reliable guidance, the banker typically steps down the growth rates incrementally in outer years to arrive at reasonable long term growth rate by the terminal year (e.g. 2 to 4%)

for a highly cyclical business, such as steel or lumber company, however, sales levels need to track the movements of the underlying commodity cycle. consequently, sales trends are typically more volatile and may incorp dramatic peak to trough swings dep on the company's point in the cycle at the start of the projection period. regardless of where in the cycle the projection period begins, it is crucial that the terminal year financial performance represents a normalized level as opposed to a cyclical high or low. otherwise, the company's TV, which usually comprises of a substantial portion of the overall value in a dcf, will be skewed toward an unrepresentative level. therefore, in a dcf for a cyclical company, top line projections might peak or trough in the early years of the projection period and then decline or increase precipitously before returning to a normalized level by the terminal year

progress check

1. B 2. B 3. A 4. B 5. C THE COMPANY HAD SALES OF 500MM DURING YEAR, BUT AR INC BY 50. COMPANY ACTUALLY RECEIVED 450 IN CASH FROM SALES. REMAINING 50M ARE SALES ON CREDIT. 50M OF OP EX DO REDUCE CASH FLOW BUT DO NOT AFFECT CASH RECEIVED BY COMPANY FROM ITS CUSTOMERS

unit exam

1. B 2. D 3. C 4. D 5. C 6. B 7. B 8. B EBITDA MINUS CAPEX TAKES INTO ACCOUNT CASH EXPENDITURES FOR CAPITAL ADDITIONS, REPLACEMENTS, AND IMPROVEMENTS WHILE ALSO ADDING BACK D&A WHICH IS A NONCASH CHARGE 9. B 10. A 11. B

ex. company y pays $2mm in divs on 20mm shares in 2015. in 2016 expects to repurchase 1mm shares while also inc its div per share by 10%. what are total divs in 2016?

1. div per share in 2015 = 2mm/20 = 0.10 2. div per share in 2016= 0.10 x (1.10) = 0.11 3. 2016 share count = 20mm - 1mm = 19mm shares 4. 2016 total dividends = 19mm x 0.11 = 2.09mm

the assumptions driving a dcf are both its primary strength and weaknesses vs market based valuation techniques. on positive side, use of defensible assumptions regarding financial projections, wacc, and tv helps shield target's valuation from market distortions that occur periodically. in addition, dcf provides the flexibility to analyze the target's valuation under diff scenarios by changing underlying inputs and examining the resulting impact. on negative side, a dcf is only as strong as its assumptions. hence, assumptions that fail to adequately capture the realistic set of opportunities and risks facing the target will also fail to produce a meaningful valuation

1. study the target and determine key performance drivers. the first step in performing a dcf as with any valuation exercise is to study and learn as much as possible about the target and its sector. shortcuts in this critical area of due diligence may lead to misguided assumptions and valuation distortions later on. this exercise involves det the key drivers of financial performance (in particular sales growth, profitability, and fcf generation), which enables the banker to craft or support a defensible set of projections for the target. step 1 is invariably easier when valuing a public company as opposed to private due to the avail of info from sources such as SEC filings (e.g. 10ks, 10qs, and 8ks), equity research reports, earnings call transcripts, and investor presentations

prepaid exp and other CA= pmts made by co before product has been delivered or service performed. insurance premiums paid upfront and cover LT period. projected as a % of sales in line with historical levels. inc reps use of cash

AP= amts owed by co for p/s already purchased. DPO = ap/cogs x 365. measures days it takes for co to make pmt on outstanding purch of p/s. higher a dpo, more time avail to use cash on hand for various business purp before paying outstanding bills

tv typically accounts for substantial portion of co's value in a dcf, sometimes as much as three quarters or more. imp that co's terminal year financial data reps a steady state level of financial performance, as opposed to a cyclical high or low. similarly the underlying assumptions for calculating the TV must be examined and sensitized

EMM calcs remaining value of co's fcf produced after the projection period on basis of a multiple of its terminal year ebitda or ebit. based on current LTM trading multiples for comp cos. as current multiples may be affected by sector or economic cycles, it is imp to use both a normalized trading multiple and ebitda. peak or trough multiple or an un normalized ebitda level can produce a skewed result. esp imp for companies in cyclical industries

given numerous assumptions involved in det wacc and its sizeable impact on valuation, its key inputs are typically sensitized to produce a wacc range. range is then used in conjunction with other sensitized inputs such as exit multiple to produce a valuation range for the target

TV to capture value of co beyond projection period. calc on basis of co's fcf or proxy such as ebitda in final year of proj period

a quick and dirty short cut for projecting YOY changes in nwc involves projecting nwc as a % of sales at a designated historical level and then calculating the YOY changes accordingly. used when a company's detailed bs and cogs info unavail and wc ratios cannot be determined. more granular and rec approach is to project the indiv components of both CA and CL for each year in proj period. nwc and yoy changes are then calculated accordingly

a company's CA adn CL components are typically projected on basis of historical ratios from prior year level or a three year average. in some cases company's trend line, mgmt guidance, or sector trends may suggest improving or declining wc efficiency ratios, impacting fcf projections. in absence of such guidance, the banker typically assumes constant wc ratios in line with historical levels throughout proj period

rd x (1-t) x d/d+e + re x e/(d+e)

a company's capital structure or total cap comprises debt and equity. rd and re represents cost of debt and equity

when employing a mid year convention for the projection period, mid year discounting is also applied for tv under PGM as banker is discounting a perpetual future fcf assumed to be received throughout the year. the EMM however, typically based on the LTM trading multiples of comp cos for calendar year end ebitda or ebit, uses year end discounting

a company's projected fcf and tv are each discounted to the present and summed to provide tev

firms that offer employees a defined benefit plan such as pension promise to make pmts to employees after retirement. these future pmts are difficult to estimate bc required distributions will vary based on many variables such as benefits promised, plan participants and their beneficiary's life expectancies, and the rate of return the plan expects to earn on the current and future contributions. to account for there future obligations and det whether the plan has adequate current assets to meet the promised benefit, a firm can estimate and then discount the future pmt obligations to their pv. calc performed using the discount rate

a plan that adopts a higher or larger discount rate implies that a greater portion of its future obligations will be satisfied through earnings and growth on the invested principal. using a high discount rate in this regard is considered aggressive bc if the higher expected return is not achieved the plan may be underfunded and unable to meet its obligations

inv= value company's raw materials, WIP, and FG. DIH = inv/cogs x 365. measures days it takes company to sell inv. inc in inv reps a use of cash. therefore, cos strive to minimize dih and turn inventory as quickly as possible so as to minimize amt of cash it ties up. idle inv susceptible to damage, theft, or obsolescence due to newer products or tech

alternate approach for measuring company's efficiency at selling inv = inv turns ratio. measures # of times a company turns over its inv in given year = cogs / inv. issuing debt or equity would not impact a company's inv turns. it would impact other ratios including liquidity, leverage, and interest coverage

for a dcf constructed on the basis of ebitda and ebit projections, dep and amort can simply be calculated as the diff between the two. in this scenario, however, the banker often makes a simplifying assumption that dep and capex are in line by the final year of the proj period so as to ensure that the company's ppe base remains steady in perpetuity. otherwise, the company's valuation would be influenced by an expanding or diminishing ppe base, which would not be representative of a steady state business

amortization differs from dep in that it reduces the value of definite life intangible assets as opposed to tangible assets. definite life intangible assets include contractual rights such as non compete clauses, copyrights, licenses, patents, TMs, or other intellectual property as well as information technology and customer lists, among others. these intangibles are amortized according to a det or useful life. indefinite life intangible assets, most notably goodwill, are NOT amortized. rather goodwill is held on the bs and tested annually for impairment

AR= amts owed to company for p/s sold on credit. ar/sales x 365= DSO gauge of how well a company is managing collection of AR by measuring number of days it takes to collect pmt after sale of p/s. the lower a company's DSO, the faster it receives cash from credit sales

an inc in a/r reps a use of cash. hence, companies strive to minimize their dso so as to speed up their collection of cash. inc in dso can be due to inc customer leverage or reneg of terms, worsening of customer credit, poor collection systems, or change in product mix for ex. this inc in cash cycle dec short term liquidity as company has less cash on hand to fund short term business operations and meet current debt oblig

the change in nwc from year to year is imp for calc fcf as it represents an annual source or use of cash for the company. an inc in nwc over a given period (i.e. when current assets increase more than current liab) is a use of cash. typically for a growing company, which tends to inc its spending on inv to support sales growth. similarly, A/R tends to inc in line with sales growth which reps a use fo cash, as it is incremental cash that has not yet been collected. conversely, an inc in a/p rep a source of cash, as it is money that has been retained by the company as opposed to paid out

an inc in nwc is a use of cash, subtracted from EBIAT. if net change is negative, add to ebiat. change in nwc = nwcn - nwc(n-1)

step 5. calculate PV and det valuation. target's projected FCF and terminal value are discounted to the present and summed to calculate its TEV. implied equity value and share price can then be derived from the calculated TEV. PV calc performed by multiplying the FCF for each year in projection period as well as TV by respective discount factor. discount factor represents the PV of one dollar received at a given future date assuming a given discount rate

as a dcf incorporates numerous assumptions about key performance drivers, wacc, and TV, it is used to produce a valuation range rather than a single value. the exercise of driving a valuation range by varying key inputs is called sensitivity analysis. core dcf valuation drivers, such as wacc, exit multipe, or perpetuity growth rate, sales growth rates, and margins are the most commonly sensitized inputs. once det, the valuation range implied by the dcf should be compared to those derived from other methods such as comp co, acq co, and lbo as a sanity check

terminal value = present value of the terminal value can represent as much as three quarters or more of the dcf valuation, which decreases the relevance of the projection period's annual fcf

assumes constant capital structure = basic dcf does not provide flexibility to change the company's capital structure over the projection period

like dep, amort can be projected as a % of sales or by building a detailed schedule based upon a company's existing intangible assets. however, amortization is often combined with dep as a single line item within a company's finanicials. more common to simply model amort with dep as part of one line item

assuming dep and amort are combined as one line item, d&a projected in accordance with one of the approaches described under dep heading as a percentage of sales or capex, through a detailed schedule, or as a diff between ebitda and ebit

dep on which time period is referenced, premium of mrp may vary substantially. many ibs have firm wide policy of governing mrp in order to ensure consistency in valuation work across various projects and depts. mrp employed on wall st typically ranges from approx 4% to 8%. consequently, it is imp for the banker to consult with senior colleagues for guidance on approp mrp

beta= measure of covariance between rate of return on a company's stock and overall market return (systematic risk), with S&P 500 traditionally used as proxy for the market. market has beta of 1.0, stock with beta of 1.0 should have expected return equal to that of market. beta of less than 1.0 has lower systematic risk, and a stock with greater than 1.0 has higher systematic risk. this is captured in capm with higher beta stock exhibiting higher cost of equity

capm based on premise that equity investors need to be compensated for their assumption of systematic risk in the form of a risk premium, or amount of market return in excess of a stated RF. systematic risk= of overall market, aka non-diversifiable risk. co's level of systematic risk dep on covariance of its share price with movements in the overall market, as measured by its beta

by contrast, non-systematic or specific risk is company or sector specific and can be avoided through diversification. hence, equity investors are not compensated for it (in the form of a premium). as general rule, the smaller the company and the more specified its product offering, the higher its non-systematic risk

ebiat or after tax ebit= can be sourced from firm's income statement. as in dcf model, these figures may require adjustments, e.g. for one time or extraordinary events to properly estimate the firm's after tax earnings

capital invested= typically be sourced from the firm's adjusted book value. analysts generally avoid using the market value of the firm (based on the stock price) for capital invested bc that figure includes both capital invested and expected future growth. on exam, required capital will likely be provided in actual question rather than buried in company financials

wacc and exit multiple table for TEV. create an output table. input wacc and exit multiple ranges. link top left corner to model output for TEV. highlight entire data table, alt awt. link row input cell to cell containing exit multiple driver of 7.0x and column input cell to cell containing wacc driver of 10%

center shared portion displays tev range. as exit multiple inc, tev inc accordingly, conversely, as discount rate increases, tev decreases

as the proportion of debt in cap structure increases, wacc gradually decreases due to the tax deductibility of interest expense. wacc continues to dec up to the point where the optimal capital structure is reached. once this threshold is surpassed, the cost of potential financial distress (i.e. the negative effects of an over leveraged capital structure, including the inc probability of insolvency) begins to override the tax advantages of debt. as a result, both debt and equity investors demand a higher yield for their inc risk, thereby driving wacc upward beyond the optimal cap structure threshold

cost of equity wacc cost of debt tax effected chart on page 162

an issuer's cost of debt is rat eat which it can currently borrow money. alternatively, could be referred to as the current discount rate on debt

cost of equity is the required annual rate of return that company's equity investor expect to receive (including divs). unlike the cost of debt, which can be deducted from a company's outstanding maturities, a company's cost of equity is not readily observable in the market. to calculate re, use capm

conversely, a plan that uses a lower discount rate would be considered more conservative, as it will fund more of its obligations with current contributions and rely less upon market returns to meet its future obligations. to calc the current plan assets required to meet future obligations, assuming a particular discount rate, an analyst can calc a discount factor that can then be applied to the future obligation amt to det the current req

discount factor = 1/(1 + discount rate)^n

in some cases, analyst may need to take prior period div and apply growth rate to calc expected div for current period. value of stock = prior period div x 1+ growth rate / capm - growth rate

economic value added calc permits financial professionals to measure firm's value but requires fewer estimates than a dcf model. eva seeks to quantify the value created by firm based on the firm's invested capital and discount rate. single year's eva. eva calc as difference between 1) firm's after tax ebit (i.e. ebiat or nopat) and 2) capital invested multiplied by firm's cost of capital i.e. wacc

dep exp are typically scheduled over several years corresponding to the useful life of each of the company's respective asset classes. the straight line method assumes uniform depreciation over the estimated useful life of an asset. most other methods fall under category of accelerated dep, which assumes that an asset loses most of its value in the early years of its life. i.e. the asset is dep on an accelerated schedule allowing for greater deductions earlier on

for dcf modeling purposes, dep is often projected as a % of sales or capex based on historical levels as it is directly related to a company's capital spending, which, in turn, tends to support top line growth. an alternative approach is to build a detailed pp&e schedule based on the company's existing depreciable net pp&e base and incremental capex projections. this approach involves assuming an average remaining life for current depreciable net PPe as well as a depreciation period for new capex. while more technically sound tahn the quick and dirty method of proj dep as a % of sales or capex, building a PPE schedule generally does not yield a substantially different result

for private companies, a robust dcf often depends on receiving financial projections from company management. in practice, however, this is not always possible. therefore, the banker must develop the skill set necessary to forecast financial performance in the absence of mgmt projections. in these instances, the banker typically relies upon historical financial performance, sector trends, and consensus estimates for public comp cos to drive defensible projections

for public companies, banker often sources top line projections for first two or three years of projection period fro consensus estimates. similarly, for private companies, consensus estimates for peer companies can be used as a proxy for expected sales growth rates provided the trend line is consistent with historical performance and sector outlook

in some cases, dcf may be constructed on the basis of ebitda and ebit projections alone, thereby excluding line item detail for cogs and sg&a. this approach generally requires that NWC be driven as a percentage of sales, as cogs detail for driving inventory and accounts payable is unavailable. however, the inclusion of cogs and sg&a detail allows the banker to drive multiple operating scenarios on the basis of gross margin and/or SG&A efficiency

for public companies, ebitda and ebit projections for future two or three year period are typically sourced from or benchmarked against consensus estimates if avail. these projections inherently capture both gross profit performance and SG&A expenses. a common approach for projecting ebitda and ebit for the outer years is to hold their margins constant at the level represented by the last year provided by the consensus estimates if the last year of estimates is representative of a steady state level. as previously discussed, however, increasing or decreasing levels of profitability may be modeled throughout the projection period, perhaps due to product mix changes, cyclicality, operating leverage, or pricing power/pressure

once the top line projections are established, it is essential to give them a sanity check vs the target's historical growth rates as well as peer estimates and sector.market outlook. even when sourcing information from consensus estimates, each year's growth assumptions need to be justifiable, whether on the basis of market share gains/declines, end market trends, product mix changes, demand shifts, pricing increases, or acquisitions, for example. furthermore the banker must ensure that sales projections are consistent with other related assumptions in the dcf, such as those for capex and working capital. for ex, higher top line growth typically requires the support of higher levels of capex and working capital

for public companies, the banker typically relies upon historical cogs, (gross margin), and sg&A levels as a percentage of sales and/or sources estimates from research to drive the initial years of the projection period if avail. for the outer years, it is common to hold gross margin and SG&a as a percentage of sales constant, although the banker may assume a slight improvement or decline if justified by company trends or outlook for the sector/market. similarly, for private companies, the banker usually relies upon historical trends to drive gross profit and sg&a projections, typically holding margins constant at the prior historical year levels. at the same time, the banker may also examine research estimates for peer companies to help craft/support the assumptions and provide insight on trends

first step in performing dcf as with any valuation exercise is to study and learn as much as possible about target and its sector. a thorough understanding of target's business model, financial profile, value proposition, end markets, competitors, and key risks is essential for developing a framework for valuation. the banker needs to be able to craft and support a realistic set of financial projections as well as wacc and TV assumptions for target. performing this task is invariably easier when valuing a public company as opposed to private due to avail of info

for public company, careful reading of recent SEC filings e.g. 10k, 10q, 8k, earnings call transcripts, IPs, provides solid intro to business and financial charac. to det key performance drivers, the MD&A sections of the most recent 10k and 10q are an imp source of information, as they provide a synopsis of the company's financial and operational performance during the prior reporting periods, as well as management's outlook for the company. equity research reports add additional color and perspective while typically providing financial performance estimates for the future two or three year period

cost of debt reflects credit profile at target cap structure, based on multitude of factors including size, sector, outlook, cyclicality, credit ratings, credit stats, cash flow generation, financial policy, and acquisition strategy, among others. assuming the company is currently at its target cap struc, cost of debt is generally derived from the blended yield on its outstanding debt instruments, which may include a mix of public and private debt. in the event the company is not currently at its target cap structure, the cost of debt must be derived from peer companies

for publicly traded bonds, cost of debt is det based on current yield on all outstanding issues. for private debt, such as revolving credit facilities and term loans, banker consults with an in house DCM specialist to ascertain the current yield. market based approaches such as these are generally preferred, as the current yield on a company's outstanding debt serves as the best indicator of its expected rd and reflects the risk of default

capex are the funds that a company uses to purchase, improve, expand, or replace physical assets, such as buildings, equip, facilities, and machinery. capex is capitalized on bs once the expenditure is made and then expensed over its useful life as depreciation on the company's income statement. as opposed to dep, capex represent actual cash outflows and consequently must be subtracted from EBIAT in calc of FCF (in the year in which the purchase is made)

historical capex is disclosed directly on company's cfs under investing activities section and also discussed in MD&A section of a public company's 10k and 10q. historical levels generally serve as a reliable proxy for projecting future capex. however, capex projections may deviate from historical levels in accordance with company's strategy, sector, or phase of operations. for ex, a company in expansion mode might have elevated capex levels for some portion of the projection period, while one in harvest or cash conservation mode might limit its capex

what is a proxy for fcf? net income + D&A what is a proxy for unlevered fcf? ebitda minus capex

historical performance provides valuable insight for devo defensible assumptions to project FCF. past growth rates, profit margins, and other ratios are usually a reliable indicator of future performance, especially for mature companies in noncyclical sectors. while it is informative to review historical data from as long a time horizon as possible, typically the prior three year period serves as a good proxy for projecting future financial performance

two ways to det tv? emm or pgm

how might one model or value a firm that plans to inc its dividend growth rate? use caution when modeling a firm that plans to inc divs by a specific dividend growth rate. sometimes the rate will apply to the total dividends. other times it will apply to the per share dividend. this is an imp distinction if the firm executes a stock buyback or otherwise changes its share count

when is trading comps most useful? least useful? when there is a clear universe of comps in a particular sector or industry. less useful for a co with no clear competitors or comps. also not useful to compare cos with substantial differences in NWC

if two firms have substantial diff in nwc, what would be a more approp valuation method? dcf

similarly if implied exit multiple from pgm is not in line with normalized trading multiples for target or its peers, its perp growth rate should be revisited. implied exit multiple = tv/ebitda

implied exit multiple = tv x (1+wacc)^0.5 / ebitda

implied perpetuity growth rate= (tv x wacc) - fcftv) / (tv + fcftv)

implied perp growth rate= ((tv x wacc) - fcf x (1+wacc)^0.5)/ (tv + fcf x (1+ wacc)^0.5)

for private companies, the banker looks at historical trends as well as consensus estimates for peer companies for insight on projected margins. in the absence of sufficient info to justify improving or declining margins, the banker may simply hold margins constant at the prior historical year level to establish a baseline set of projections

in a dcf analysis, ebit typically serves as the springboard for calculating fcf. to bride from ebit to fcf, several additional items need to be determined, including the marginal tax rate, d&a, capex, and changes in nwc

the development of alternative cases requires a sound understanding of company specific performance drivers as well as sector trends, the banker enters the various assumptions that drive these cases into assumptions pages, which feed into dcf output page. switch or toggle function allows banker to move between cases without having to re-input the financial data by entering a number or letter that corresponds to a particular set of assumptions into a single cell

in many instances, a dcf is performed without the benefit of receiving the initial set of projections. for publicly traded companies, consensus research estimates for financial stats, such as sales, ebitda, and ebit which are generally provided for a future two or three year period, are typically used to form the basis for developing a set of projections. individual equity research reports may provide additional financial detail, including in some instances a full scale two year or more projection model

ibbotson provides size premiums for companies based on their market cap tiered in deciles

levered beta = unlevered beta x (1 + (1 - t) x Debt/Equity)

rd = rf + levered beta x (rm-rf)

rf= expected rate of return by investing in riskless security. us gov sec, t bills, t notes, t bonds accepted by market as risk free bc backed by full faith of us fed gov. interpolated yields for gov secs can be located on bloomberg, as well as usd of treasury website, among others. actual rf used in capm varies with the prevailing yields for a chosen security

ibs may differ on accepted proxies for appropriate rf with some using yield on 10 yr treasury note and others preferring yield on longer term treasuries. the general goal is to use as long dated an instrument as possible to match the expected life of the company (assuming a going concern) but practical considerations also need to be taken into account. due to the moratorium on the issuance of a 30 year treasury bond and shortage of securities with 30 year maturities, ibootson associates uses an interpolated yield for a 20 year bond as the basis for rf

market risk premium= spread of expected market return, usually based off S&P 500 over rf. ppl differ over which historical time period is most relevant for observing mrp. some believe more recent periods such as last 10 years or post wwII era are more appropriate while others prefer to examine the pre great depression era to the present

for public companies, future planned capex is often discussed in md&a section of 10k. research reports may also provide capex estimates for future two or three year period. in absence of specific guidance, capex is generally driven as a percentage of sales in line with historical levels due to the fact that top line growth typically needs to be supported by growth in company's asset base

nwc= non cash current assets less non interest bearing current liabilities. it serves as a measure of how much cash a company needs to fund its operations on an ongoing basis. cash is excluded when making this calc as the entire purpose is to det how much additional cash the company has created or spent. all necessary components to det a company's nwc can be found on its bs. below are main current assets and current liabilities line items: AR, INV, Prepaid expenses and other current assets. CL = AP, accrued liabilities, other current liabilities

in the absence of current market data (e.g. for companies with debt that is not actively traded). an alternative approach to calculate company's weighted rd on basis of the at issuance coupons of its current debt maturities. this approach however is not always accurate, as it is backward looking and may not reflect company's cost of raising debt capital under prevailing market conditions. a preferred, albeit more time consuming approach in these instances is to approximate a company's cost of debt based on its current or implied credit ratings at the target cap structure and the cost of debt for comparable credits, typically with guidance from an in house DCM professional

once det, cost of debt is tax effected at company's marginal tax rate as interest payments are tax deductible

eva = [ebit x (1-t)] - [capital invested x wacc]

or eva = ebiat - (capital invested x wacc)

imp to understand both 1) perp formula and 2) impact of discount rate on value of perp

perp formula. imagine an investment generated 1mm cash every year for rest of time and its relevant discount rate is 10% value of perp = 1,000,000 / 0.10 = 10mm

as the exit multiple is a critical driver of TV, and hence overall value in a dcf, the banker subjects it to sensitivity analysis. ex. if range for exit multiple based on comp cos is 6.5x to 7.5x, a common approach would be to create a valuation output table premised on exit multiples of 6, 6.5, 7, 7.5, and 8.0x. the formula for calc TV using EMM = ebitdan x exit multiple

pgm calcs tv by treating a co's terminal year fcf as a perpetuity growing at an assumed rate. method relies on wacc calculation performed in step 3, and requires banker to make an assumption regarding co's long term sustainable growth rate. typically chosen on basis of the co's expected LT industry growth rate, which generally tends to be within range of 2-4% (i.e. nominal gdp growth). as with exit multiple, perp growth rate can also be sensitized to produce valuation range

tv = fcfn x (1+g) / (r-g)

pgm often used in conjunction with emm with each serving as sanity check on the other. ex. if implied perp growth rate as derived from emm is too high or low, could be indicator that exit multiple assumptions are unrealistic

plan a future obligations $250mm in 20 years. 12% aggressive discount rate. plan estimates it can earn 12% on its investments. discount factor = 1/(1+12%)^20 = .104. PV of future pension obligations = 250mm x .104 = 25.92mm. bulk of funding is obtained through future investment returns

plan b future obligations $250mm in 20 years. discount rate 4% conservative. discount factor = 1/(1+4%)^20 = .456. present value of future pension obligations = 250 x. 456 = 145.09. plan b's initial contribution rate is much higher bc estimated rate of return is much lower

discount factor is applied to a given future financial stat to det its pv.

pv fcf = fcf x discount factor

PV centers around notion that a dollar today is worth more than a dollar tomorrow, TVM. due to fact that a dollar earns money through investments (capital appreciation) and/or through interest (e.g. in a money market account). in a dcf, a company's projected fcf and tv and discounted to pv at company's wacc in accordance with tvm

pv performed by multiplying fcf for each year and tv by its respective discount factor. discount factor is fractional value representing the PV of one dollar received at a future date given an assumed discount rate. for ex, assuming a 10% discount rate, the discount factor for one dollar received at the end of one year is 0.91

size premium is based on empirical evidence suggesting that smaller cos are riskier and therefore should have a higher re. some degree contradicts capm, relies on notion that smaller cos risk is not entirely captured in their betas given limited trading volumes of their stock, making covariance calculations inexact. therefore, banker may choose to add size premium to capm for smaller cos to account for the perceived higher risk and therefore expected higher return

re = rf + bl x (rm - rf) + SP

dcf incorporates numerous assumptions, each of which can have a sizeable impact on valuation. as a result, dcf output is viewed in terms of a valuation range based on series of key input assumptions. exercise of deriving valuation range by varying key inputs is called sensitivity analysis

sensitivity analysis is a testament to the notion that valuation is as much an art as a science. key valuation drivers such as wacc, exit multiple, and perpetuity growth rate are the most commonly sensitized inputs in a dcf. banker may also perform additional sensitivity analysis on key financial performance drivers, such as sales growth rates and profit margins ebitda or ebit. valuation outputs produced by sensitivity analysis are typically displayed in a data table

cons= dependence on financial projections accurate forecasting of financial performance is challenging, especially as the projection period lengthens

sensitivity to assumptions= relatively small changes in key assumptions such as growth rates, margins, wacc, or exit multiple, can produce meaningfully diff valuation ranges

depreciation is a non cash expense that approximates reduction of book value of a company's long term fixed assets or PPE over an estimated useful life and reduces reported earnings. amortization like dep, is a non cash expense that reduces value of a company's definite life intangible assets and also reduces reported earnings

some companies report D&A tog as a sep line item on is, but these expenses are more commonly included in cogs especially for manufacturers of goods, and to a lesser extent, SG&A. regardless, D&A is explicitly disclosed in the cfs as well as notes to a company's financial statements. as d&a is a non cash expense, added back to ebiat in calc of fcf. hence, while D&A dec a company's reported earnings, it does not decrease its fcf

for private, non-filing companies, the banker often relies upon company management to provide materials containing basic business and financial info. in an organized M&A sale process, this info is typically provided in the form of a confidential information memorandum (CIM). in the absence of this info, alternative sources (e.g. company websites, trade journals, and news articles as well as sec filings and research reports for public competitors, customers, and suppliers) must be used to learn basic company info and form basis for devo the assumptions to drive financial projections

step 2. project fcf. the projection of the target's unlevered FCF forms the core of a dcf. unlevered fcf which we simply refer to as fcf is cash generated by company after paying all cash operating expenses and taxes as well as funding of capex and working capital, but prior to payment of any interest expense. the target's projected fcf is driven by assumptions underlying its future financial performance, including sales growth rates, profit margins, capex, and working capital requirements. historical performance, combined with third party and or management guidance helps in developing these assumptions. the use of realistic fcf projections is critical, as it has the greatest effect on a valuation in a dcf

in a dcf, the target's fcf is typically projected for a period of five years, but this period may vary dep on target's sectors, stage of devo, and the predictability of its fcf. however, five years is typically sufficient for spanning at least one business/economic cycle and allowing for the successful realization of in process or planned initiatives. the goal is to project fcf to a point in the future when the target's financial performance is deemed to have reached a steady state that can serve as the basis for a terminal value calculation

step 3. calculate wacc. rate used to discount the target's projected GCG and terminal value to the present. designed to fairly reflect the target's business and financial risks. as it names connotes, represents weighted average of required return on invested capital (debt and equity). aka discount rate or cost of capital. as debt and equity components generally have significantly different risk profiles and tax ramifications, wacc is dependent on capital structure

wacc is predicated on choosing a target capital structure for the company that is consistent with its LT strategy. target cap structure is represented by the debt to total capitalization and equity to total cap ratios. in absence of explicit company guidance on target cap structure, the banker examines the company's current and historical debt to total cap ratios as well as cap of its peers. public comps provide meaningful benchmark for target cap structure as it is assumed that their management teams are seeking to maximize shareholder value

the approach used to det target's cap struc may be diff firm to firm. for public companies, existing cap structure generally used as target cap struc as long as it is comfortably within range of comparables. if it is at the extremes, of or outside the range, then the mean or median for comps may serve as a better rep of target cap struc. for private companies, the mean or median for comps typically used. once target cap struc chosen, assumed to be held constant throughout projection period

wacc= broadly accepted standard for use as discount rate to calc PV of fcf and TV. weighted average of the required return on invested capital in given company. debt and equity have diff risk profiles and tax ramifications, wacc is dep on a company's target capital structure

the discount rate has other important uses. for ex, a company would use the discount rate to estimate the required upfront investment for pension obligations that may come due years in the future. a company using a higher discount rate would estimate a lower PV on pension plan obligations and thus require less funding. this is a risky assumption, as the company is counting on less upfront investment and strong investment performance to produce the required cash to fund its pension

for publicly traded comps, implied equity value is divided by company's fully diluted shares outstanding to calculate implied share price

the existence of ITM options and warrants, however, creates a circular reference in basic formula shown above between the company's fully diluted shares outstanding count and implied share price. in other words, equity value per share is dep on number of fully diluted shares outstanding, which in turn is dep on implied share price. this is remedied in model by activating the iteration function in excel

for private, non filing companies or smaller divisions of public companies, for which segmented info is not provided, company management is often relied upon to provide materials containing basic business and financial information. in an organized m&a sale process, this info is typically provided in the form of a CIM. in the absence of this information, alternative sources must be used, such as company websites, trade journals, news articles, as well as sec filings and research reports for public competitors, customers and suppliers. for those private companies that were once public filers, or operated as subsidiaries of public filers, it can be informative to read through old filings or research reports

the next level of analysis involves det key drivers of a company's performance (particularly sales growth, profitability, and fcf generation) with the goal of crafting or supporting a defensible set of FCF projections. these drivers can be both internal (such as opening new facilities/stores, devo new products, securing new customer contracts, and improving operational and or working capital efficiency) as well as external (such as acquisitions, end market trends, consumer buying patterns, macroeconomic factors, or even legislative/regulatory changes)

in a dcf, a company's fcf is typically projected for period of 5 years. projection period may be longer dep on company's sector, stage of devo, and underlying predictability of its financial performance. given inherent difficulties in accurately projecting a company's financial perf over an extended period of time (and through various business and economic cycles), a terminal value is used to capture the remaining value of the target beyond the projection period (i.e. its "going concern" value)

the projected FCF and terminal value are discounted to present at target's wacc, discount rate commensurate with financial and business risks. PV of FCF and TV are summed to determine an enterprise value, which serves as the basis for DCF valuation. wacc and terminal value assumptions typically have substantial impact on output, with even slight variations producing meaningful differences in valuation. as a result, dcf output is viewed in terms of a valuation range based on a range of key input assumptions rather than as a single value. the impact of these assumptions on valuation is tested using sensitivity analysis

first step in calculating fcf from ebit is to net out estimated taxes. result is tax effected ebit, known as EBIAT, or NOPAT. a marginal tax rate of 21-25% is generally assumed for modeling purposes, but the company's actual tax rate (effective tax rate) in previous years can also serve as a reference point. it is important to understand that a company's effective tax rate, or the rate that it actually pays in taxes, often differs from the marginal tax rate due to the use of tax credit, non-deductible expenses (such as government fines), deferred tax asset valuation allowances, and other company specific tax policies

the tax cuts and jobs act of 2017 reduced federal corporate tax rate from 35% to 21%. companies in most jurisdictions will pay more than 21% due to state and local taxes. the exam will either provide the marginal tax rate or expect you to calculate the effective tax rate. certain practice questions will use the older marginal tax rate, around 35-40%. it is not necessary to memorize the current corporate tax rate

step 4. determine TV. the dcf approach to valuation is based on det the PV of future FCF produced by the target. given the challenges of projecting the target's fcf indefinitely, a terminal value is used to quantify the remaining value of the target after the projection period. the TV typically accounts for a substantial portion of the target's value in a DCF. therefore, it is imp that the target's financial data in the final year of the projection period, terminal year, represents a steady state or normalized level of financial performance, as opposed to a cyclical high or low

there are two widely accepted methods used to calc a company's terminal value- EMM and PGM. emm calculates remaining value of target after projection period on basis of a multiple of the target's terminal year EBITDA or EBIT. pgm calculates terminal value by treating target's terminal year FCF as a perpetuity growing at an assumed rate

another way to calc tev given a firm's annual cash flow, discount rate, and growth rate = annual cash flow/ wacc - growth rate

to derive implied equity value, company's net debt, ps, and nci are subtracted from calculated tev

as with comp cos and precedent trans, once a dcf valuation range is det, it should be compared to valuation ranges derived from other methods. if output produces a notably diff result, advisable to revisit assumptions and fine tune. common steps that can skew dcf valuation include use of unrealistic financial projections, which generally has the largest impact, wacc, or tv assumptions. substantial diff in valuation implied by dcf vs other methods, however, doesn't mean the analysis is necessarily flawed. multiples based valuation methods may fail to account for company specific factors that may imply a higher or lower valuation

to value a stream of steady cash flows payable in perpetuity (forever) the future pmts must be discounted to their pv. to convert those future pmts into their pv, the cash flow is divided by an appropriate discount rate. value of perpetuity = cash flow / discount rate. higher the discount rate, the lower the pv of future cash flows. selecting approp discount rate can be challenging and subjective

therefore, the dcf customarily begins by laying out target's historical financial data for prior three year period, this historical financial data is sourced from target's financial statements with adjustments made for non recurring items and recent events, as appropriate to provide a normalized basis for projecting financial performance

typically banker projects the target's FCF for a period of five years dep on its sector, stage of devo, and predictability of its financial performance. critical to project fcf to a point in future where target's performance reaches a steady state or normalized level. for mature companies in established industries, five years is often sufficient for allowing a company to reach its steady state. a five year projection period typically spans at least one business cycle and allows sufficient time for successful realization of in process or planned initiatives

wacc based on market value of debt and equity

use book value to estimate capital invested and market value to estimate wacc in the EVA formula

to account for the fact that annual fcf is received throughout the year rather than at year end, it is typically discounted in accordance with mid year convention. assumes that company's fcf is received evenly throughout the year, thereby approximating a steady and more realistic fcf generation. it is useful to note that a mid year convention would not be appropriate for highly seasonal businesses

use of mid year convention results in slightly higher valuation than year end discounting due to fact that fcf received sooner. discount factor = 1 / (1 + wacc)^(n-0.5)

expected dividends and growth rates may be provided or can be sourced from firm's financial statements. cost of equity is calculated using capm

using these variables, value of stock can be det as follows: value of stock = expected divs / capm - growth rate

dcf= premised on principle that the value of a company, division, business or collection of assets (target) can be derived from PV of projected free cash flow. projected fcf derived from variety of assumptions and judgments about financial perf including sales growth rates, profit margins, capex, and nwc req. wide range of applications= M&A situations, ipos, restructurings, and investment decisions. dcf also useful to compare companies which have diff trends in NWC

valuation implied for a target by a DCF is also known as its intrinsic value as opposed to its market value, which is the value ascribed by the market at a given point in time. as a result, when performing a comprehensive valuation, a dcf serves as an imp alternative to market based valuation techniques, such as comp co and acq comps, which can be distorted by a number of factors including market aberrations (e.g. post subprime credit crunch). as such, dcf plays an important role as a check on the prevailing market valuation for a publicly traded company. a dcf is also valuable when there are limited or no pure play peer companies or comp acqs

dividend discount model = equity valuation method that values an equity stake, such as a share of common stock based on pv of its future cash flows, the dividends, that the ownership stake will produce. in other words, the value or price of the share is calculated as the expected dividends it will pay in perpetuity discounted based on the riskiness of those cash flows. model doesn't consider return generated by the eventual sale of the shares. focus on valuing a share in a firm growing at a stable rate paying regular dividends

valuation requires there inputs 1) expected divs the share will produce, 2) growth rate, 3) firm's cost of equity

how are future cash flows discounted to pv? using wacc

what are two stages in a dcf? projection period and tv

discount factor = 1 / (1+wacc)^n

what happens to a dcf valuation if target's discount rate or wacc inc? valuation will fall

when is a trans comp more useful, least useful? trans comp useful when there have been a number of mergers or acquisitions in a sector. in particular, recent trans are more useful than older transactions. trans may have occurred in a diff stage of the industry life cycle. for ex. in a mature industry where companies are routinely sold for 4-5x ebitda, using a trans comp from 10 years ago when the industry was in its growth phase and companies were selling for 15-25x ebitda would not be useful

what is a dcf how does it det valuation? values co based on its expected fcfs discounted to PV. useful in industries where companies have significant earnings volatility but more stable cash flows

if total 2016 dividends were increased by 10% to 2.2mm, rather than the 2016 dividend per share, the total 2016 dividends calculated above would be incorrect

what is the best valuation model to examine a deal's IRR= LBO. timing of cash flows being received will impact the IRR

what types of acquirers perform LBO analyses? FS, including PE firms and merchant banks, often perform lbo

what types of valuations are useful in an lbo analysis? what financial ratio is not useful? 1. comp co, acq comps dcf. a banker, however, would not look at debt/capitalization ratios when considering an LBO

in situations where target is in the early stages of rapid growth, however, it may be more appropriate to build a longer term projection model e.g. 10 years or more to allow the target to reach a steady state level of cash flow. in addition, a longer projection period is often used for businesses in sectors with long term contracted revenue streams, such as natural resources, satellite communications, or utilities

whether advising on the buy side or sell side of an organized M&A sale process, the banker typically receives five years of financial projections for the target which is usually labeled the management case. at the same time, the banker must develop a sufficient degree of comfort to support and defend these assumptions. often the banker makes adjustments to the mgmt projections that incorporate assumptions deemed more probable, known as the base case, while also crafting upside and downside cases