2. Valuation

3. 3 3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value

4. 4 3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value

5. DCF Valuation Spreadsheet Approach

6. Economic Valuation  PV= C 1+k... + C 1+k 1n 1 2 2 1 C k n. 012n k C 1 C n C 2 Value... ++ +

7. Capital Projects As Cash Flow Tradeoffs Initial Outlay Net Benefits Additional Outlay Capital Recovery TIME Match initial investment with the combined PV of all future cash flows

8. Capital Project Valuation Annual cash flow Investment $100 NPV = $13 $20 1 2 3 4 5 610 k

9. Discounting Example Cash Discount P.V.Cumul. Yr FlowFactor*Cash Flow P.V. 1$ 20.9091$ 18.18 $ 18.18 2 20.8264 16.53 34.71 3 20.7513 15.03 49.74 10 20.3855 7.71 113.00 * Discount Factor = 1/(1+.10) n

10. Corporate Value infinity Value = Cash Flow t t=0 (1 + Cost of Capital) t

11. Free cash flow is the basis of value! Investors watch this pattern…… ….which is “cash in and cash out” Free cash flow = NOPAT adjusted for depreciation and other accounting elements Less net investment in working capital, fixed assets, capitalized R&D, etc. Trend Time

12. PLEASE DO NOT DISTURB Working on A big project !!!

13. STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION

17. Portal.com Example

22. Portal.com 2001 Valuation Cash Flows Customers $12,000 Revenue Customers $12,000 Revenue Cash Expense COGS 3,500 SG&A 3,000 ------- $6,500 Cash Expense COGS 3,500 SG&A 3,000 ------- $6,500 Investment $2,000 Investment $2,000 Working Capital Cash 150 Receivables 1,100 Inventory 1,100 Payables -1,010 -------- $1,340 Working Capital Cash 150 Receivables 1,100 Inventory 1,100 Payables -1,010 -------- $1,340 Taxes $2,100 Taxes $2,100 Available to Shareholders and Debt Suppliers $60 Available to Shareholders and Debt Suppliers $60

23. Company Valuation Annual cash flow 1 2 3 4 5 7,044 Terminal Value k 0 60 170 327 545 845

24. Free Cash Flow Valuation $5,245 $0$5,245 $2,000 $3,245 Value of Operating Cash Flows Marketable Securities & Non-operating Cash Flows Market Value of Entity Market Value of Debt and other Liabilities Market Value of Equity

25. Adjusted Present Value (APV) Value of the project as if it were financed with equity Interest tax shields Costs of financial distress Subsidies Hedges Issue costs + APV = Base-case value Value of financing side effects APV =

27. DCF Valuation Formula Approaches

28. Company Valuation Free Cash Flow Formulas NOPAT 0 = initial after-tax earnings before interest and taxes (EBIT) b = rate of investment per period divided by NOPAT g = growth in free cash flows. The subscripts s and c refer to the supernormal growth rate and the constant growth rate. n = number of periods of supernormal growth k = the company’s weighted average cost of capital WACC No growth: NOPAT 0 V = ------------------ k Constant growth: NOPAT 0 (1 - b)(1 + g) V = -------------------------------- k - g

29. Company Valuation Free Cash Flow Formulas NOPAT 0 = initial after-tax earnings before interest and taxes (EBIT) b = rate of investment per period divided by NOPAT g = growth in free cash flows. The subscripts s and c refer to the supernormal growth rate and the constant growth rate. n = number of periods of supernormal growth k = the company’s weighted average cost of capital WACC Temporary supernormal growth, then no growth: n (1 + g) t NOPAT 0 (1 + g) n+1 V = NOPAT 0 (1 - b)  ----------------- + --------------------------- t=1 (1 + k) t k (1 + k) n Temporary supernormal growth, then constant growth: n (1 + g s ) t NOPAT 0 (1 - b s ) (1 + g s ) n+1 V = NOPAT 0 (1 - b)  ----------------- + --------------------- x ------------- t=1 (1 + k) t k - g (1 + k) n

30. DCF Approaches to Estimate Continuing Value g = 0In a perfectly competitive market, in the long-term companies earn their cost of capital, resulting in zero economic profit and hence zero cash flow growth rate g = industry average Zero growth rates may be too conservative in the cases of some industries. In that case, it is reasonable to assume that companies’ cash flow will grow at the average industry rate g = Forecasted long-term inflation growth rate Usually, both revenues and costs are equally affected by inflation and hence inflation has no or little effect on a firm’s growth rate. In some cases, especially in certain consumer industries, inflation affects the revenues more than the costs. In this case, the forecasted perpetual inflation growth rate is a good proxy for the firm’s revenue growth rate and consequently its cash flow growth rate. g = Forecasted long-term GDP growth rate It is reasonable that in the long-term the growth rate of companies will fade to that of the growth rate of the overall economy. If a company grows at a sustained rate higher than that of the economy, eventually it will become larger than the economy itself, which of course is not possible.

32. Valuation Framework NOPAT R - K V = ------------- + ------------ * I * T K K WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX K = COST OF CAPITAL R = RETURN ON CAPITAL I = ANNUAL INCREMENTAL INVESTMENT T = NO. OF YEARS THAT I CAN BE INVESTED AT R > K V = AS IS VALUE + VALUE GROWTH OPPORTUNITIES

33. 3 Factors in Value Creation Ê ROI > WACC Ë Amount of Investment Ì Interval of Competitive Advantage Note: –Forward-looking –Expected cash flows

34. Value Creation - Another View Value Created = (Return On Investment - Cost of Capital) X Capital employed Dependent Upon: F Cost of Capital Spread F Duration of Spread F Amount of Capital Employed

35. Economic Profit (EP) (R - K)xcapital NOPAT-K x capital Operating profits -a capital charge EP ties directly to NPV: NPV = market value - capital NPV = the present value of projected EP Market value = Capital + PV of projected EP K = WACC R = NOPAT / Capital

36. Economic Profit Discounted Cash Flow Approach: Yr. 0Yr. 1Yr. 2 NOPAT$250$250... P.V. Perpetuity $2,500 Investment($1,000) NPV @ 10% $1,500

37. Economic Profit Discounted EP Approach: Yr. 0Yr. 1Yr. 2 Nopat $250$250... Investment $1,000 Capital Charge $100$100... EP$150$150... NPV @ 10% $1,500

38. NPV and the Regulatory Process F Remember: NPV = Cash Inflow - Cash Outflow where Cash Inflow = Revenues - Costs F But in a regulated environment, Revenues = Costs + Return x Investment F Therefore, the NPV is always zero

39. NPV and the Regulatory Process but R = C + KI =0 t=1 n NPV = - I (R - C) t (1 + K) t t=1 n (C + KI - C) t (1 + K) t - I = t=1 n (KI) t (1 + K) t - I= = (KI) K - I

40. 40 3 Valuation Frameworks Discounted Cash Flow (DCF) Comparables Option Value

41. Comparables: An Example MULTIPLIERCOMPANY DATAVALUE 1.5 x book value$23.2$34.8 9 x cash flow$3.6$32.4 7 x EBIT$4.3$30.1 25 x 2000 earnings$1.5$37.5 20 x 2001 earnings$1.7$33.0 ------------------ Average Estimate $33.6