A Complete Corporate Valuation for a Simple Company Chapter 2 A Complete Corporate Valuation for a Simple Company DES Chapter 2

Three types of value Book value: company’s historical value as shown on its financial statements. Market value: current price an asset can be bought or sold. Intrinsic value: estimate of the value an individual buyer places on an asset. Also called its fundamental value. DES Chapter 2

OBJECTIVE: Provide sound basis for estimating stock’s intrinsic value. The process is known as fundamental valuation—Warren Buffet =success identifying a company’s fundamental value. OBJECTIVE: Provide sound basis for estimating stock’s intrinsic value. DES Chapter 2

Three basic concepts of valuation Investors can only spend cash so "Cash is good and more cash better." Cash today is worth more than cash tomorrow. Risky cash flows are worth less than safe cash flows. Imply value of a company depends on size, timing, & riskiness of its cash flows. DES Chapter 2

Valuation of a Simple Company: Mayberry Personal Receivers, Inc. (MPR) Investors are: Debtholders Stockholders DES Chapter 2 9

Debtholders and the value of debt Bond with 10 yrs to maturity pays 9% coupon. $1,000 is the face or maturity value (FV) $90 is coupon pmt (9%x$1000 FV) N= 10 yrs DES Chapter 2

What do investors require? MPR’s bonds compete in market with other bonds. If investors can earn 9% on similar investments, then MPR has to offer at least 9% on its bonds to attract investors. The required rate of return is 9%. rD = 9% DES Chapter 2

More investors… MPR’s shares of stock also compete in market for investors. Stockholders = owners of firm, and value of ownership is value of asset, less any debt owed. Ex: Suppose MPR’s worth $501 million. It owes $150 million to debtholders. So MPR’s equity worth = $501 – 150 = $351 million. DES Chapter 2

Cash flows received by equity holders Dividends: Not fixed—usually grow No maturity date Riskier than bond payments The required return on equity, rS, compensates investors for this risk. MPR’s rS is 12%. DES Chapter 2

Discounted dividend valuation MPR’s last dividend, D0,was $2.34 per share, and expected to grow at 5% per year. The price today of the stock based on this at 12% required return: If co. doesn’t pay dividends, doesn’t work! DES Chapter 2

The Corporate Valuation Model PV of cash flows available to all investors—called free cash flows (FCFs). Discount free cash flows at average rate of return reqr’d by all investors—WACC (weighted average cost of capital) DES Chapter 2

Steps in the corporate value model Determine WACC Estimate expected future FCF’s Find value of company DES Chapter 2

Estimating the Weighted Average Cost of Capital (WACC) Company has two types of investors Debtholders Stockholders Each type of investor expects to receive a return for their investment The return an investor receives is a “cost of capital” from company’s viewpoint. One person’s return is another’s cost. DES Chapter 2

Cost of Debt MPR’s cost of debt: rD = 9%. Interest deductable, so cost is after-tax rate on debt. If tax rate is 40%, then after-tax cost of debt: After-tax rD = 9%(1-0.4) = 5.4%. DES Chapter 2

Cost of Equity Cost of equity, rs, is higher than cost of debt because stock is riskier. MPR: rs = 12% DES Chapter 2

Weighted Average Cost of Capital WACC is average of costs to all investors, weighted by target % of firm financed by each For MPR, target % equity financing equity: wS = 70% Target % debt financing: wD = 30% DES Chapter 2 (More….)

WACC (Continued) WACC = wD rD (1-T) + wS rS = 0.3(9%)(1 - 0.4) + 0.7(12%) = 10.02% DES Chapter 2

Free Cash Flow (FCF) FCF=amount of cash available from operations for distribution to all investors (stockholders and debtholders) after making necessary investments to support operations. Firm’s value depends upon amount of FCF generated. DES Chapter 2

Calculating FCF FCF = net operating profit after taxes (NOPAT) minus investment in operating capital DES Chapter 2

Financial Statements Balance sheet Assets (all of MPR’s assets are used in operations) Operating assets Operating current assets Property, plant, and equipment (PPE) DES Chapter 2

Operating Current Assets Operating current assets: CA needed to support operations. Op CA include: cash, inventory, receivables. Op CA exclude: s/t investments, because not part of ops. DES Chapter 2

Operating Current Liabilities Operating current liabilities: are normal part of operations. Op CL include: accounts payable and accruals. Op CA exclude: notes payable, because is financing source, not operating. DES Chapter 2

Balance Sheet: Assets 2001 2002 2003 Op. CA 162,000.0 168,000.0 176,400.0 Total CA 162,000.0 168,000.0 176,400.0 Net PPE 199,000.0 210,042.0 220,500.0 Tot. Assets 361,000.0 378,042.0 396,900.0 DES Chapter 2

Balance Sheet: Claims 2001 2002 2003 Op. CL 57,911.5 62,999.7 66,150.0 2001 2002 2003 Op. CL 57,911.5 62,999.7 66,150.0 Total CL 57,911.5 62,999.7 66,150.0 L-T Debt 136,253.0 143,061.0 150,223.0 Total Liab. 194,164.5 206,060.7 216,373.0 Equity 166,835.5 171,981.3 180,527.0 TL & Eq. 361,000.0 378,042.0 396,900.0 DES Chapter 2

Income Statement 2001 2002 2003 Sales 400,000.0 420,000.0 441,000.0 2001 2002 2003 Sales 400,000.0 420,000.0 441,000.0 Costs 344,000.0 361,994.2 374,881.6 Op. prof. 56,000.0 58,005.8 66,118.4 Interest 11,678.7 12,262.8 12,875.5 EBT 44,321.3 45,743.0 53,242.9 Taxes (40%) 17,728.4 18,297.2 21,297.2 NI 26,592.7 27,445.8 31,945.7 Dividends 21,200.0 22,300.0 23,400.0 Add. RE 5,392.7 5,145.8 8,545.7 DES Chapter 2

NOPAT (Net Operating Profit After Taxes) NOPAT: amount of after-tax profit from operations. NOPAT: amt of net income, or earnings, a company with no debt or interest-income/expense would have. NOPAT = (Operating profit) (1-T) = EBIT (1-T) DES Chapter 2

Calculating NOPAT NOPAT = (Operating profit) (1-T) = EBIT (1-T) NOPAT03 = 66.1184 (1-0.4) = 39.67104 million. DES Chapter 2

Calculating Operating Capital Operating capital (total operating capital, or just capital): amount of assets required to support the company’s operations, less liabilities arising from those ops. S/T piece: net operating working capital (NOWC). L/T piece:factories, land, equipment. DES Chapter 2

Net Operating Working Capital NOWC = Operating current assets – Operating current liabilities Net amount tied up in “things” needed to run company on a day-to-day basis. DES Chapter 2

Net Operating Working Capital NOWC = Operating CA – Operating CL NOWC03 = $176.4 – $66.15 = $110.25 million DES Chapter 2

Operating Capital Operating capital = Net operating working capital (NOWC) plus Long-term capital, such as factories, land, equipment. DES Chapter 2

Operating Capital = NOWC + LT Op. Capital = $330.75 million ::In 2003 MPR had $330.75 million tied up in capital needed to support its operations. Investors supplied this money. Not available for distribution. DES Chapter 2

Investment in operating capital Operating capital in 2002: $315.0423 million Operating capital in 2003: $330.75 million MPR makes net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2003. DES Chapter 2

Calculating FCF FCF = NOPAT – Investment in operating capital = $39.67104 – $15.7077 = $23.96334 million DES Chapter 2

There are five ways for a company to use FCF 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.) DES Chapter 2

NOPAT Non-operating income Working Capital Fixed Assets Dividends Working Capital Buy back stock Pay interest Fixed Assets Pay principal Buy non-op assets Free Cash Flow Bucket Reinvestment Bucket DES Chapter 2

How Did MPR use its FCF? Paid dividends: $23.4 million Paid after-tax interest of: $12,875.5 (1-0.4) = $7.7253 million Totals $31.1253 million. Is $7.162 million more than $23.9 million FCF available. Comes from? MPR increased borrowing by $150.223 – $143.061) = $7.162 million to make up difference. DES Chapter 2

Corporate Valuation Forecast financial statements and use them to project FCF. Discount the FCFs at the WACC This gives the value of operations DES Chapter 2

Value of Operations: Requires projecting free cash flows out forever. DES Chapter 2

Constant growth If free cash flows expected to grow at 5% constant rate: 2003 2004 2005 2006 2007 2008 FCF 23.963 25.161 26.419 27.740 29.127 30.584 Use constant growth approach as would with constant growth dividends to get stock price today Po DES Chapter 2

Constant Growth Formula The summation can be replaced by a single formula: DES Chapter 2

The value of operations DES Chapter 2

Value of Equity Sources of Corporate Value Claims on Corporate Value Value of operations = $501.225 million Value of non-operating assets = $0 (in this case) Claims on Corporate Value Value of Debt = $150.223 million Value of Equity = ? Value of Equity = $501.225 - $150.223 = $351.002 million. DES Chapter 2

Value of Equity Price per share = Equity / # of shares = $351 million / 10 million shares = $35.10 per share DES Chapter 2

A picture of the breakdown of MPR’s value DES Chapter 2

Return on Invested Capital (ROIC) ROIC: used to evaluate Firm’s performance: ROIC = NOPAT / Total operating capital at beginning of year DES Chapter 2

ROIC calculation ROIC03 = NOPAT03 / Capital02 ROIC good because greater than return investors require (WACC), of 10.02%. So MPR added value during year. DES Chapter 2

Economic Value Added (EVATM) (also called Economic Profit) EVA: another key measure of operating performance. EVA:trademarked by Stern Stewart, Inc. Measures amount of profit firm earned, over and above amount of profit investors required. EP = NOPATt – WACC(Capitalt-1) DES Chapter 2

EVA = NOPAT- (WACC)(Begng. Capital) Calculating EVA EVA = NOPAT- (WACC)(Begng. Capital) EVA03 = NOPAT03 – (0.1002)(Capital02) EVA03 = $39.67104 – (0.1002)(315.0423) = $39.67104 – $31.56742 = $8.1038 million (More…) DES Chapter 2

Economic profit… In 2003 MPR earned about $8 million more than its investors required. Another way to calculate EP: EPt = (ROIC – WACC)Capitalt-1 = (0.125923 – 0.1002)$315.0423 = $8.1038 million DES Chapter 2

Intuition behind EP If ROIC – WACC spread positive, then firm generates more than enough “profit,” & increases value. But, if ROIC – WACC spread negative, then firm destroys value, in the sense that investors would be better off taking their money and investing it elsewhere. DES Chapter 2

Applications of the corporate valuation model Mergers and acquisitions Evaluate how much a target is worth under various operating scenarios Value-based management Make decisions with the goal of increasing the company’s value Fundamental investing Identify firms that are worth more than current stock price DES Chapter 2