CORPORATE VALUATION PART 1
Think of company as collection of projects (mix of NPV’s of these projects).
Objective of firm: create wealth by initiating and managing investments that
generate future cash flows that are worth more than amount invested.
• Avoid decision errors based on flawed or incomplete analysis.
• Valuation provides tools for the evaluation of new investment
opportunities.
Valuation techniques can be applied to projects, enterprises, financial assets.
Incremental costs: opening store in Tilburg might lead to customer loss in
Eindhoven.
Estimated future earnings
Growth rates
Investments that create value: NPV, economic question: competitive advantage.
DCF Principle: most widely used tool in valuation, good theoretical reasons for
using method.
1. Forecast amount and timing of cash flows.
2. Estimate appropriate discount rate (cost of capital).
3. Discount the cash flows.
T
CF t
Can be applied to projects (classical NPV analysis: NPV 0 =CF 0 + ∑
t=1 (1+r t ) ) and
enterprise valuation (determine price for takeover, determine fair stock price).
NPV Analysis: logic behind valuation: takes money you get from project, so that
you can compare investments with same type of risk as investor.
Gordon Growth Model: useful variant of basis NPV formula, great for back-of-the-
envelope calculations.
Fair valuation makes NPV = 0.
Share of stock gives right to dividend. If you put dividend in NPV you will see
fair price of future dividend stream = fair stock price.
Because this is not easily applicable simplified assumptions are used: same
discount rate for all periods, constant dividend growth ( d t =d t−1 ×(1+ g) ). This
gives Gordon Growth Model (geometric series):
∞
(1+ g)t d 0 (1+ g)
P0=d 0 ∑ t
=
t=1 (1+r ) r −g
d0: current dividend from company statements
r: cost of equity capital
g: several possibilities: g cannot be higher than GDP growth (3-4%) forever!
Use analyst forecast (find growth estimate on yahoo finance).
g = plowback-ratio * ROE
, Example: valuate hotel for assessment
D0 = room price
G = growth of room price
Use GGM to value stable cash flow projects or companies:
Utility companies
Value of renting out flat in Tilburg (replace dividends by rent received net of
cost for renovation etc.)
Caution: results very sensitive to values of r and g.
Focus on cash flows not on accounting numbers to valuate:
Use financial statements (or pro forma statements) to derive cash flows.
Cash flow statement does not give you cash flows you need!
Focus on incremental cash flows: difference between cash flows that would arise
if project is accepted and free cash flows would arise if project is rejected, cash
flows generate by project, side effects created by project (cannibalization,
opportunity cost), ignore sunk costs, allocated overhead costs are mostly not equal
to incremental overhead costs.
Two ways to value projects: market value is used.
1. Forecast FCF to Equity Holders (EFCF): indirect method, discount at cost
of equity, get equity value.
2. Forecast FCF to All Claimholders in the Project (PFCF): direct method,
equity- and debt holders, discount at WACC, get project value.
Using PFCF is more common approach: Value(Project) = Value(Equity) +
Value(Debt).
Free cash flow: NOPAT + DA – NWC – CAPEX = EBIT(1 – T) + DA – WC – CAPEX.
Note: calculate taxes as if project was 100% equity financed (unlevered free
cash flow). Reason will become clear later.
Revenues
- Cost of goods sold
Gross Profit
- Operating expenses
EBITDA
- Depreciation and amortization
EBIT
- Taxes
NOPAT (Net operating profit after taxes)
+ Depreciation and amortization
- CAPEX
- NWC
FCF
Corrections are made, because we are interested in cash flows:
Think of company as collection of projects (mix of NPV’s of these projects).
Objective of firm: create wealth by initiating and managing investments that
generate future cash flows that are worth more than amount invested.
• Avoid decision errors based on flawed or incomplete analysis.
• Valuation provides tools for the evaluation of new investment
opportunities.
Valuation techniques can be applied to projects, enterprises, financial assets.
Incremental costs: opening store in Tilburg might lead to customer loss in
Eindhoven.
Estimated future earnings
Growth rates
Investments that create value: NPV, economic question: competitive advantage.
DCF Principle: most widely used tool in valuation, good theoretical reasons for
using method.
1. Forecast amount and timing of cash flows.
2. Estimate appropriate discount rate (cost of capital).
3. Discount the cash flows.
T
CF t
Can be applied to projects (classical NPV analysis: NPV 0 =CF 0 + ∑
t=1 (1+r t ) ) and
enterprise valuation (determine price for takeover, determine fair stock price).
NPV Analysis: logic behind valuation: takes money you get from project, so that
you can compare investments with same type of risk as investor.
Gordon Growth Model: useful variant of basis NPV formula, great for back-of-the-
envelope calculations.
Fair valuation makes NPV = 0.
Share of stock gives right to dividend. If you put dividend in NPV you will see
fair price of future dividend stream = fair stock price.
Because this is not easily applicable simplified assumptions are used: same
discount rate for all periods, constant dividend growth ( d t =d t−1 ×(1+ g) ). This
gives Gordon Growth Model (geometric series):
∞
(1+ g)t d 0 (1+ g)
P0=d 0 ∑ t
=
t=1 (1+r ) r −g
d0: current dividend from company statements
r: cost of equity capital
g: several possibilities: g cannot be higher than GDP growth (3-4%) forever!
Use analyst forecast (find growth estimate on yahoo finance).
g = plowback-ratio * ROE
, Example: valuate hotel for assessment
D0 = room price
G = growth of room price
Use GGM to value stable cash flow projects or companies:
Utility companies
Value of renting out flat in Tilburg (replace dividends by rent received net of
cost for renovation etc.)
Caution: results very sensitive to values of r and g.
Focus on cash flows not on accounting numbers to valuate:
Use financial statements (or pro forma statements) to derive cash flows.
Cash flow statement does not give you cash flows you need!
Focus on incremental cash flows: difference between cash flows that would arise
if project is accepted and free cash flows would arise if project is rejected, cash
flows generate by project, side effects created by project (cannibalization,
opportunity cost), ignore sunk costs, allocated overhead costs are mostly not equal
to incremental overhead costs.
Two ways to value projects: market value is used.
1. Forecast FCF to Equity Holders (EFCF): indirect method, discount at cost
of equity, get equity value.
2. Forecast FCF to All Claimholders in the Project (PFCF): direct method,
equity- and debt holders, discount at WACC, get project value.
Using PFCF is more common approach: Value(Project) = Value(Equity) +
Value(Debt).
Free cash flow: NOPAT + DA – NWC – CAPEX = EBIT(1 – T) + DA – WC – CAPEX.
Note: calculate taxes as if project was 100% equity financed (unlevered free
cash flow). Reason will become clear later.
Revenues
- Cost of goods sold
Gross Profit
- Operating expenses
EBITDA
- Depreciation and amortization
EBIT
- Taxes
NOPAT (Net operating profit after taxes)
+ Depreciation and amortization
- CAPEX
- NWC
FCF
Corrections are made, because we are interested in cash flows:
