Valuation Basics and DCF Models

Cash flows from assets are considered prior to any debt payments but after the firm has reinvested to create growth assets.

You must subtract the value of all debt.

The value for equity will be lesser than the value derived from an equity valuation.

<p>The discount rate incorporates the cost of raising both debt and equity financing, weighted by their proportional usage.</p> Signup and view all the answers

<p>Present value represents the value of the entire firm, reflecting all claims on the firm.</p> Signup and view all the answers

<p>FCFE = Non-cash Net Income - (Cap Ex - Depreciation) - Change in non-cash WC - (Debt repaid - Debt issued)</p> Signup and view all the answers

<p>Expected FCFE is calculated as Expected net income multiplied by (1 - Equity Reinvestment rate), indicating how much of the net income is retained.</p> Signup and view all the answers

<p>The value of equity is the sum of the value of equity in non-cash assets and cash.</p> Signup and view all the answers

<p>The length of a high growth period affects the present value of FCFE during that time, influencing overall valuation.</p> Signup and view all the answers

<p>Stable growth refers to the scenario when net income and FCFE grow at a constant rate indefinitely.</p> Signup and view all the answers

<p>Intrinsic valuation is primarily based on the fundamentals or intrinsic characteristics of an asset, particularly its expected cash flows.</p> Signup and view all the answers

<p>DCF valuation estimates intrinsic value by calculating the present value of expected cash flows while adjusting for risk through a discount rate.</p> Signup and view all the answers

<p>The discount rate reflects the risk of the cash flows and is used to discount the expected cash flows of the asset over its life.</p> Signup and view all the answers

<p>You can either discount expected cash flows at a risk-adjusted discount rate or discount certainty equivalents at the risk-free rate.</p> Signup and view all the answers

<p>'IT' implies that if a factor does not affect expected cash flows or their riskiness, it will not impact the asset's value.</p> Signup and view all the answers

<p>Making estimates of future expected cash flows is crucial as uncertainty is not an excuse for avoiding valuation; being wrong is acceptable.</p> Signup and view all the answers

<p>For an asset to have value, it must have positive expected cash flows at some point during its lifetime.</p> Signup and view all the answers

<p>Certainty equivalents are guaranteed cash flows that replace expected cash flows, which can be discounted at the risk-free rate.</p> Signup and view all the answers

<p>The value of equity is overstated by $175 when cash flows are incorrectly discounted.</p> Signup and view all the answers

<p>The value of equity is understated by $260 due to the improper valuation method.</p> Signup and view all the answers

<p>This approach results in an overstated value of equity by $540.</p> Signup and view all the answers

<p>The cash flows represent firm pre-debt cash flows and equity after debt cash flows.</p> Signup and view all the answers

<p>The terminal value signifies the expected growth of the firm beyond the initial forecast period.</p> Signup and view all the answers

<p>Firms in this phase are assumed to grow at a constant rate forever.</p> Signup and view all the answers

<p>Expected growth in operating earnings is a key component of DCF valuation.</p> Signup and view all the answers

<p>Proper matching ensures that valuations are not overstated or understated and reflect true value.</p> Signup and view all the answers

<p>The cost of equity represents the rate of return demanded by equity investors.</p> Signup and view all the answers

<p>FCFF is calculated as after-tax operating income minus capital expenditures, depreciation, and the change in non-cash working capital.</p> Signup and view all the answers

<p>The factors deducted are capital expenditures, depreciation, and changes in non-cash working capital.</p> Signup and view all the answers

<p>The reinvestment rate is the portion of expected operating income that is needed to sustain growth.</p> Signup and view all the answers

<p>It determines the cost of equity, which is crucial for valuation models like the Dividend Discount Model.</p> Signup and view all the answers

<p>The value of equity is calculated as the value of operating assets and cash &amp; non-operating assets minus debt.</p> Signup and view all the answers

<p>The weighted average cost of capital is derived by averaging the costs of equity and debt weighted by their proportions in the overall capital structure.</p> Signup and view all the answers

<p>A higher retention ratio can lead to lower expected dividends, as more net income is reinvested rather than paid out.</p> Signup and view all the answers

<p>Stable growth signifies a phase where operating income and FCFF grow at a constant rate indefinitely.</p> Signup and view all the answers

<p>When FCFE grows at a constant rate, it indicates a relationship that helps in assessing the cost of equity for valuation.</p> Signup and view all the answers

<p>The components include the present value of FCFF projected during the high growth period.</p> Signup and view all the answers

<p>Steady state refers to the period when dividends grow at a constant rate forever, simplifying the valuation process.</p> Signup and view all the answers

<p>It signifies the duration during which dividends are expected to grow at an above-normal rate before transitioning to stable growth.</p> Signup and view all the answers

The value of a firm is the present value of all future cash flows from its assets, discounted at the cost of capital. This cost of capital reflects the risk of the firm's business activities and the way it finances its operations.

Equity value is the value of the firm's equity claims, which represents the ownership interest in the firm. It is calculated by subtracting the value of all debt from the firm value.

The cost of capital used to discount firm cash flows should reflect the risk of both debt and equity financing, and their proportions in the firm’s capital structure. This cost of capital is used to determine the present value of the firm's future cash flows, which represents the firm's value.

Cash flows considered in firm valuation represent the cash flows generated by the firm's assets, before debt payments but after any reinvestments made to create future growth opportunities. These cash flows are used to determine the present value of the firm.

Growth assets are the assets that the firm invests in to create future growth opportunities. They are not included in the value of the firm's assets in place, but they are considered in the firm's cash flow forecasts to account for future growth.

The inherent worth of an asset based on its fundamental qualities, including anticipated cash flows and their uncertainty.

A valuation method that estimates an asset's worth by discounting its expected future cash flows at a risk-adjusted rate.

The rate used in DCF to reflect the risk associated with receiving future cash flows.

The two primary ways to approach DCF valuation: discounting expected cash flows at a risk-adjusted rate or discounting certainty equivalents at the risk-free rate.

An idea in valuation: a change that does not alter expected cash flows or their risk does not impact the asset's value.

Valuation requires making estimates, even if those estimates might be wrong. Uncertainty is not an excuse for inaction.

A fundamental principle of valuation: an asset must be expected to generate positive cash flow sometime in the future to have value.

The cash flows that would be accepted with certainty, representing the equivalent value of uncertain expected cash flows. Used in DCF to discount at the risk-free rate.

The rate at which a company's net income is expected to grow over time.

The percentage of net income that a company chooses to pay out as dividends to shareholders.

The percentage of net income that a company retains for reinvestment in its business.

The present value (PV) of all expected future dividends, discounted back to the present day.

The period during which a company's net income and dividends are expected to grow at a high rate.

Discounting cash flows to equity using the cost of capital results in an overstated equity value. This error arises because the cost of capital reflects both debt and equity financing, while equity cash flows only consider equity financing.

Discounting cash flows to the firm using the cost of equity leads to an understated equity value. This error occurs because the cost of equity only considers equity financing, while firm cash flows encompass both debt and equity financing.

Discounting cash flows to the firm using the cost of equity and forgetting to subtract debt results in an overstated equity value. This error arises from directly applying the firm's value to equity without accounting for debt financing.

A valuation method that uses projected cash flows and discounts them back to their present value to determine the company's intrinsic value.

The first step in DCF valuation involves determining the appropriate cash flows for the company. This step requires considering the specific characteristics of the company and its industry.

A generic DCF valuation model uses the projected cash flows of a company to derive its present value. The model considers the growth rate of the company, both pre- and post-debt, and calculates the terminal value, assuming a stable growth phase in the future.

The terminal value in a DCF model represents the present value of all cash flows beyond the explicit forecast period. It is calculated by assuming the company reaches a stable growth phase where cash flows grow at a constant rate forever.

The rate of return that equity investors demand for investing in a company. It reflects the risk associated with the company's operations and its financial structure.

The cash flow available to equity holders after all operating expenses, debt payments, and necessary reinvestments are made.

The rate at which a company can grow its net income in the long term, assuming stable growth conditions.

Investments made by the company to generate future growth, typically involving capital expenditures and working capital increases.

The period of time during which a company's net income and FCFE grow at a higher rate than the stable growth rate.

The cash flow available to the firm after all operating expenses, taxes, and investments in fixed capital and working capital are deducted. It represents the cash flow generated by the company's core business operations.

The rate of return that a company is expected to earn on its future investments. It is determined by the expected growth rate of operating income and the reinvestment rate needed to sustain that growth.

The rate at which a company reinvests its earnings back into its operations to support future growth. It indicates the percentage of operating income that is reinvested.

Valuing the entire business, including both debt and equity, by discounting the future free cash flows to the firm (FCFF) at the company's cost of capital. This method determines the total value of the firm before subtracting the value of debt to arrive at the equity value.

The weighted average cost of capital (WACC) reflects the average cost of debt and equity financing used by the company. It represents the expected return required by investors for providing capital to the firm.

A period when a company's operating income and free cash flow are expected to grow at a stable and predictable rate for the foreseeable future. This period typically ensues after a period of high growth.