Valuation Basics PDF

THE ESSENCE OF INTRINSIC VALUE ------------------------------ - In [intrinsic valuation], you value an asset based upon its fundamentals (or intrinsic characteristics. - For [cash flow generating assets], the intrinsic value will be a function of the magnitude of the [expected cash...

THE ESSENCE OF INTRINSIC VALUE ------------------------------ - In [intrinsic valuation], you value an asset based upon its fundamentals (or intrinsic characteristics. - For [cash flow generating assets], the intrinsic value will be a function of the magnitude of the [expected cash flows] on the asset over its lifetime and the [ uncertainty] about receiving those cash flows. - Discounted cash flow (DCF) valuation is a tool for estimating intrinsic value, where the expected value of an asset is written as the present value of the expected cash flows on the asset, with either the cash flows or the discount rate adjusted to reflect the risk - Intrinsic valuation models predate the modern DCF model, since investors through the ages have found ways to weight in expected cash flows into value. THE TWO FACES OF DCF VALUATION ------------------------------ - The value of a risky asset can be estimated by discounting the expected cash flows on the asset over its life at a risk-adjusted discount rate: - Alternatively, we can replace the expected cash flows with the guaranteed cash flows we would have accepted as an alternative (certainty equivalents) and discount these at the riskfree rate:  RISK ADJUSTED VALUE: TWO BASIC PROPOSITIONS ------------------------------------------- - The value of an asset is the risk-adjusted present value of the cash flows: 1. [The "IT" proposition:] If IT does not affect the expected cash flows or the riskiness of the cash flows, IT cannot affect value. 2. [The "DON'T BE A WUSS" proposition:] Valuation requires that you make estimates of expected cash flows in the future, not that you be right about those cashflows. So, uncertainty is not an excuse for not making estimates. 3. [The "DUH" proposition]: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. 4. [The "DON'T FREAK OUT" proposition]: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate. DCF CHOICES: EQUITY VERSUS FIRM VALUATION ----------------------------------------- EQUITY VALUATION ---------------- *Figure 5.5: Equity Valuation* FIRM OR BUSINESS VALUATION -------------------------- FIRM VALUE AND EQUITY VALUE --------------------------- - To get from firm value to equity value, which of the following would you need to do? a. Subtract out the value of long-term debt b. Subtract out the value of all debt c. Subtract the value of any debt that was included in the cost of capital calculation d. Subtract out the value of all liabilities in the firm - Doing so, will give you a value for the equity which is e. greater than the value you would have got in an equity valuation f. lesser than the value you would have got in an equity valuation g. equal to the value you would have got in an equity valuation CASH FLOWS AND DISCOUNT RATES ----------------------------- - Assume that you are analyzing a company with the following cashflows for the next five years. -- -- ------- -- \$ 40 \$ 40 \$ 40 \$ 40 \$ 40 -- -- ------- -- - Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) - The current market value of equity is \$1,073 and the value of debt outstanding is \$800. EQUITY VERSUS FIRM VALUATION ---------------------------- - Method 1: Discount CF to Equity at Cost of Equity to get value of equity - Cost of Equity = 13.625% - Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 + (83.49+1603)/1.136255 = **\$1073** - Method 2: Discount CF to Firm at Cost of Capital to get value of firm - Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5% - Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94% - PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = \$1873 - Value of Equity = Value of Firm - Market Value of Debt FIRST PRINCIPLE OF VALUATION ---------------------------- - [Discounting Consistency Principle]: Never mix and match cash flows and discount rates. - [The Mismatch Effect]: Mismatching cash flows to discount rates is deadly. - Discounting cashflows after debt cash flows (equity cash flows) at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity - Discounting pre-debt cashflows (cash flows to the firm) at the cost of equity will yield a downward biased estimate of the value of the firm. - **Error 1:** Discount CF to Equity at Cost of Capital to get equity value - PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 + (83.49+1603)/1.09945 = \$1248 - Value of equity is **overstated by \$175**. - **Error 2:** Discount CF to Firm at Cost of Equity to get firm value - PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 + (123.49+2363)/1.136255 = \$1613 - PV of Equity = \$1612.86 - \$800 = \$813 - Value of Equity is **understated by \$ 260**. - **Error 3:** Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too high a value for equity - Value of Equity = \$ 1613 - Value of Equity is **overstated by \$ 540** DCF: FIRST STEPS ================ GENERIC DCF VALUATION MODEL --------------------------- SAME INGREDIENTS, DIFFERENT APPROACHES... ----------------------------------------- +-----------------+-----------------+-----------------+-----------------+ | **Input** | **Dividend | **FCFE | **FCFF (firm) | | | Discount | (Potential | valuation | | | Model** | dividend) | model** | | | | discount | | | | | model** | | +=================+=================+=================+=================+ | Cash flow | Dividend | Potential | FCFF = Cash | | | | dividends | flows before | | | | | debt payments | | | | = FCFE = Cash | but after | | | | flows after | reinvestment | | | | taxes, | needs and | | | | reinvestment | taxes. | | | | needs and debt | | | | | cash flows | | +-----------------+-----------------+-----------------+-----------------+ | Expected growth | In equity | In equity | In operating | | | income and | income and FCFE | income and FCFF | | | dividends | | | +-----------------+-----------------+-----------------+-----------------+ | Discount rate | Cost of equity | Cost of equity | Cost of capital | +-----------------+-----------------+-----------------+-----------------+ | Steady state | When dividends | When FCFE grow | When FCFF grow | | | grow at | at constant | at constant | | | constant rate | rate forever | rate forever | | | forever | | | +-----------------+-----------------+-----------------+-----------------+  - (Cap Ex - Depreciation) - Change in non-cash WC - (Debt repaid - Debt issued) TO VALUING THE ENTIRE BUSINESS: THE FCFF MODEL ---------------------------------------------- - (Cap Ex - Depreciation) - Change in non-cash WC DCF: THE PROCESS ================ THE SEQUENCE ------------ 1. [Get a handle on the past and the cross-section]: While the past is the past (and should have little relevance in determining value), you can get clues about the future by looking at what your firm has done in the past, and what other companies in the business are doing now. 2. [Risk and Discount Rates]: Traditional financial theory (unfortunately) has put too much of a focus on risk and discount rates, but they do remain ingredients in valuing a company. 3. [Estimate growth and future cash flows]: This is where the rubber meets the road in valuation. Estimating future cash flows is never easy, should not be mechanical and should be built around your story. 4. [Apply Closure to cash flows]: Since you cannot estimate cash flows forever, you need to find a way to bring your valuation to closure. 5. [Tie up loose ends]: Check to see what else in your business needs to be valued or adjusted for to get to value per share.