IB
DCF Walkthrough
(1) The premise behind a DCF is finding the enterprise value of a firm through that firm's discounted cash flows. (2) To begin, we project our Free Cash Flow for a firm usually on a 5-10 year horizon. (3) We discount those cash flows using a discount rate known as the WACC (weighted average cost of capital)-- which is a blended return required by all investors; both debt and equity. We then sum these discounted cash flows. (4) We then couple the discounted cash flows with the terminal value-- which is everything past our 5-10 year horizon. We can find the terminal value by using a multiples method (e.g. EV/EBITDA) or the Gordon Growth method (know the formula) (5) We sum the discounted cash flows and the terminal value to come up with an estimated total enterprise value of our firm.
Tax Shield
A reduction in tax liability by reducing taxable income without affecting pretax cash flows
Why is debt added to the Market Capitalization in the Enterprise Value forumla
Because a company that is acquiring a company would also need to pay off it's debts - so it should be included in the price/cost.
CAPEX
Capital Expenditures
Levered Free Cash Flow
Cash available to the firm after taking in financial obligations into account
Free Cash Flow formula
Cash from Operations minus Capital Expenditures
What does a negative change in operating working capital mean?
Current assets are increasing at a faster rate than current liabilities. This is a bad for a cash flow
What does a positive change in operating working capital mean?
Current liabilities are increasing at a faster rate than current assets This is good for cash flow
Unlevered Free Cash Flow Formula
EBIT − Taxes + D&A - CAPEX +/− Change in Working Capital
Limitations of Using EV
EV includes total debt, but it's important to consider how the debt is being utilized by the company's management. For example, capital intensive industries such as the oil and gas industry typically carry significant amounts of debt, which is used to foster growth. The debt could be used to purchase plant and equipment. As a result, the EV would be skewed for companies with a large amount of debt as compared to industries with little or no debt.
What is the difference between enterprise value and equity value?
Enterprise Value represents the value of the operations of a company attributable to all providers of capital. Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders.
Of the three main valuation methodologies, which ones are likely to result in higher/lower value?
Firstly, the Precedent Transactions methodology is likely to give a higher valuation than the Comparable Company methodology. This is because when companies are purchased, the target's shareholders are typically paid a price that is higher than the target's current stock price. Technically speaking, the purchase price includes a "control premium." Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium and therefore likely result in a higher valuation than a public market valuation (minority interest based valuation methodology). The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation than the Comparable Company analysis because DCF is also a control based methodology and because most projections tend to be pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or assumptions.
Levered Free Cash Flow Formula
NI + D&A +/- NWC - CapEx
Get to unlevered cash flow from NI
NI + Interest + D&A + Change in Operating Working Capital
Free Cash Flow to Equity formula
Operating Cash Flow - CapEx + Net Debt Issued
WACC
The average cost of financing a firm, it measures the risk factor by which future free cash flows are discounted
How do you use the three main valuation methodologies to conclude value?
The best way to answer this question is to say that you calculate a valuation range for each of the three methodologies and then "triangulate" the three ranges to conclude a valuation range for the company or asset being valued. You may also put more weight on one or two of the methodologies if you think that they give you a more accurate valuation. For example, if you have good comps and good precedent transactions but have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent Transaction analyses than on your DCF.
What is the change in working capital trying to measure?
What is increasing more? Current assets (excluding cash) or current liabilities (excluding debt)
discounted cash flow (DCF) analysis
a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of a company today, based on projections of how much money it will generate in the future. DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment.
Price to Book Value (P/BV)
dividing the price of a share of stock by the book value per share. So if a company has $100 million dollars in net assets and 10 million shares outstanding, then the book value for that company is $10 a shares ($100 million in assets / 10 million shares
capital expenditures
funds used for the purchase, improvement, or maintenance of long-term assets
Net working capital is a measure of the firms ______
liquidity, operational efficiency and its short-term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.
Operating Assets
long-term assets that are used by the company in the normal course of operations
What is the market rate of return minus the risk-free rate
market risk premium
What is the formula for Enterprise Value?
market value of equity (MVE) + debt + preferred stock + minority interest - cash.
market value of equity (MVE)
measure of a company's value is calculated by multiplying the current stock price by the total number of outstanding shares
PP&E
property, plant, and equipment
What is the Discount Rate?
refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
Operating working capital measures ____
the amount of cash required to finance the components of a company's operating cycle -- the process by which a business buys and sells inventory, pays suppliers and collects payment from customers.
Replacement value
the amount of money a business must currently spend to replace an essential asset Replacing an asset can be an expensive decision, and companies analyze the net present value (NPV) of the future cash inflows and outflows to make purchasing decisions.
Retained earnings
the amount of net income retained in the corporation
CAPM calculates _____
the cost of equity
Present value (PV)
the current value of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.
Net working capital
the difference between a company's current assets, such as cash, accounts receivable (customers' unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.
Gordon Growth Model
the intrinsic value of a stock based on a future series of dividends that grow at a constant rate
price to earnings ratio
the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS)
Market Capital
the total dollar market value of a company's outstanding shares of stock
Terminal value
the value of a firm beyond the forecast period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.
Free Cash Flow to the Firm is also called ____
unlevered free cash flow
How does $10 of depreciation impact income from operations?
$10 decrease in income from operations
What are the three main valuation methodologies?
(1) comparable company analysis, (2) precedent transaction analysis and (3) discounted cash flow ("DCF") analysis.
Operating working capital formula
(Current Assets - Cash) - (Current Liabilities - debt)
What is the 10 year treasury rate?
3-4.5%
How would $10 of depreciation impact the cash flow statement with a 20% tax?
Adjustment of non-cash charges increase by $10 Cash flow from operations increases by $2
current assets
Assets that companies expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
Which financial statement has PP&E on it?
Balance sheet
Why is cash subtracted in the Enterprise Value formula
Because, if acquired, the cash the company has on hand can be used to pay off it's debts which reduces the cost/price for the acquirer
What does CAPM stand for?
Capital Asset Pricing Model
Why is debt excluded from liabilities when calculating operating working capital
Debt is a financing, not an operating activity
WACC formula
Debt/EV(interest rate)(1-tax) + Equity/EV(
LBO analysis
Determines the maximum purchase price for a business that can be paid based on certain leverage (debt) levels and equity return parameters.
Unlevered Cash Flow
EBIT - Tax + D&A - Change in NWC - Cap Ex
Gordon Growth Method for Finding Terminal Value
FCF * (1 + perpetuity growth rate)/(WACC - perpetuity growth rate)
What is the first step in a DCF analysis?
In order to do a DCF analysis, first we need to project free cash flow for a period of time (say, five years).
How does $10 of depreciation impact the balance sheet? 33% tax
Increase in Cash/Current assets by $3 (tax shield) Accumulated depreciation increases by $10 Net PP&E decreases by $10 Retained earnings fall by $7
What is the benefit of depreciation?
Increase in cash flow due to the tax shield
Why does market capitalization properly represent a firm's value?
It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other.
Why is a positive change in operating working capital good?
It means that the company has more cash flow available to them
Free Cash Flow to Equity is also called ____
Levered Free Cash Flow
Multiple Method of Terminal Value
Multiple * Financial metric of the terminal year of projection period (usually EBITDA)
Get to levered cash flow from NI
NI + D&A +/- Change in Operating Working Capital - CapEx
Operating Cash Flow Formula
Net Income + Depreciation and Amortization + Non Cash Items - Changes in NWC
operating cash flow formula
Net Income + Non cash items + changes in working capital
How to get to EBITDA from the bottom of the income statement
Net Income + Taxes + Interest + Depreciation and Amortization
Free Cash Flow forumula
Operating Cash Flow - CapEX
What are some common valuation metrics?
Probably the most common valuation metric used in banking is Enterprise Value (EV)/EBITDA. Some others include EV/Sales, EV/EBIT, Price to Earnings (P/E) and Price to Book Value (P/BV).
What is the risk-free rate
Rate for a loan with 100% certainty of payback. Most common example is the U.S. 10-year treasury note
CAPM
Risk free rate + (beta * market risk premium)
How does $10 of depreciation impact income tax expenses? 40% tax
Tax expense decreases by $4
Gordon Growth Model Formula
To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow forever. This growth rate should be modest, for example, average calculate long-term expected GDP growth or inflation. To terminal value we multiply the last year's free cash flow by 1 plus the chosen growth rate, and then divide by the discount rate less growth rate.
What is the difference between EBITA and Operating Cash Flow
With Operating Cash Flow you don't add back taxes or interest from NI You do add non-cash items back and it adjusts for changes NWC
EV/EBITDA
a financial valuation ratio that measures a company's return on investment (ROI). The EBITDA/EV ratio may be preferred over other measures of return because it is normalized for differences between companies. Using EBITDA normalizes for differences in capital structure, taxation, and fixed asset accounting. The enterprise value (EV) also normalizes for differences in a company's capital structure.
Operating Cash Flow intutition
a measure of the amount of cash that is generated and consumed by the normal operating activities of the business
Comparable Company analysis
a process used to evaluate the value of a company using the metrics of other businesses of similar size in the same industry. Comparable company analysis operates under the assumption that similar companies will have similar valuation multiples, such as EV/EBITDA.
What does levered beta measure?
a stocks volatility relative to the movements in the equity markets
precedent transaction analysis
a valuation method in which the price paid for similar companies in the past is considered an indicator of a company's value.
Amortization
an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time. often used for the reduction of a loan balance through payments made over a period of time
Control premium
an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company in order to acquire a controlling share in that company.
What items are in an unlevered free cash flow
available to all investors (cash isn't available to debt holders reoccurring to the company's core business
Unlevered Cash Flow
cash flow without considering the firm's capital structure
per-share-earnings
company's net income divided by the number of common shares outstanding
Working Capital
current assets - current liabilities
How does $10 of depreciation impact net income (40% tax)
decreases NI by $6
what is the market risk premium?
difference between expected return in equity markets and risk-free rate
What is PP&E defined as on the balance sheet?
fixed assets
What does Unlevered Free Cash Flow Show?
how much cash is available to the firm before taking financial obligations into account
Free Cash Flow to Equity intuition
how much of the cash flow available to equity investors, meaning cash available after paying debt holders and reinvesting capital in the business
What are some other possible valuation methodologies in addition to the main three?
leverage buyout (LBO) analysis, replacement value and liquidation value.
Current Liabilities
liabilities due within a short time, usually within a year
What kind of expense is depreciation?
non-cash operating expense
Operating Liabilities
obligations arising from the firm's primary business operations
In a DCF analysis, what is the step after projecting free cash flows for a period of time?
predict the value of the company/assets for the years beyond the projection period
Why use unlevered cash flow in a DCF
simple, gives consistent results, and doesn't matter what the companies capital structure is.
Examples of Non Cash Items
stock-based compensation, unrealized gains/losses, write downs
Free Cash Flow intutition
the amount of cash necessary for discretionary spending by the company after necessary capital investment
market rate of return
the financial return an individual can expect from investing money in typical financial vehicles, like stocks or bonds
Cost of Equity
the return that equity investors require on their investment in the firm
Liquidation Value
the total worth of a company's physical assets if it were to go out of business and the assets sold. The liquidation value is the value of company real estate, fixtures, equipment, and inventory. Intangible assets are excluded from a company's liquidation value.
What is a firm's enterprise value?
the value of a business' core operations to all the investors in a company
Why is EBITDA used as a proxy for CF?
used because it makes easy comparability among companies, less reliable proxy for companies with a lot of CapEx