A Complete Corporate Valuation for a Simple Company

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

Objective: Objective is to provide a sound basis for estimating the intrinsic value of a stock. This intrinsic value is also called its fundamental value. The process is known as fundamental valuation—Warren Buffet is very successful at identifying a company’s fundamental value!

The three basic concepts of valuation Investors can only spend cash so "Cash is good and more cash is better." Cash today is worth more than cash tomorrow. Risky cash flows are worth less than safe cash flows. These three imply the value of a company depends on the size, timing, and riskiness of its cash flows.

Steps in the corporate valuation Determine weighted average cost of capital Estimate expected future free cash flows---cash flows available to all investors—called free cash flows (FCFs). Discount free cash flows at the average rate of return required by all investors Find value of company

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.

Cost of Debt MPR’s cost of debt: rD = 9%. But MPR can deduct interest, so cost to MPR is after-tax rate on debt. If tax rate is 40%, then after-tax cost of debt is: After-tax rD = 9%(1-0.4) = 5.4%.

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

Weighted Average Cost of Capital WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type. For MPR, target percent financed by equity: wS = 70% For MPR, target percent financed by debt: wD = 30% (More….)

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

Free Cash Flow (FCF) FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A company’s value depends upon the amount of FCF it can generate.

Calculating FCF FCF = net operating profit after taxes minus investment in operating capital

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

Operating Current Assets Operating current assets are the CA needed to support operations. Op CA include: cash, inventory, receivables. Op CA exclude: short-term investments, because these are not a part of operations.

Operating Current Liabilities Operating current liabilities are the CL resulting as a normal part of operations. Op CL include: accounts payable and accruals. Op CA exclude: notes payable, because this is a source of financing, not a part of operations.

Balance Sheet: Assets 2014 2015 2016 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

Balance Sheet: Claims 2014 2015 2016 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

Income Statement 2014 2015 2016 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

NOPAT (Net Operating Profit After Taxes) NOPAT is the amount of after-tax profit generated by operations. NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have. NOPAT = (Operating profit) (1-T) = EBIT (1-T)

Calculating NOPAT NOPAT = (Operating profit) (1-T) = EBIT (1-T) NOPAT16 = 66.1184 (1-0.4) = 39.67104 million.

Calculating Operating Capital Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations. The short-term component is net operating working capital (NOWC). The long-term component is factories, land, equipment.

Net Operating Working Capital NOWC = Operating current assets – Operating current liabilities This is the net amount tied up in the “things” needed to run the company on a day-to-day basis.

Net Operating Working Capital NOWC = Operating CA – Operating CL NOWC16 = $176.4 – $66.15 = $110.25 million

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

Operating Capital = NOWC + LT Op. Capital Capital16 = $110.25 + $220.50 = $330.75 million This means in 2016 MPR had $330.75 million tied up in capital needed to support its operations. Investors supplied this money. It isn’t available for distribution.

Investment in operating capital Operating capital in 2015 was $315.0423 million Operating capital in 2016 was $330.75 million MPR had to make a net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2016.

Calculating FCF FCF = NOPAT – Investment in operating capital FCF16 = $39.67104 – (330.75 – 315.0423) = $39.67104 – $15.7077 = $23.96334 million

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.)

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

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 For a total of $31.1253 million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from? MPR increased its borrowing by $150.223 – $143.061) = $7.162 million to make up the difference.

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

Value of Operations: Of course, this requires projecting free cash flows out forever.

Constant growth If free cash flows are expected to grow at a constant rate of 5%, then this is easy: 2016 2017 2018 2019 2020 2021 FCF 23.963 25.161 26.419 27.740 29.127 30.584 There is an easy formula for the present value of free cash flows that grow forever at a constant rate…

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

The value of operations

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, or just $351 million.

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

A picture of the breakdown of MPR’s value

Return on Invested Capital (ROIC) ROIC can be used to evaluate MPR’s performance: ROIC = NOPAT / Total operating capital in place at the beginning of the year

ROIC calculation ROIC16 = NOPAT16 / Capital15 ROIC16 = 39.67104 / 315.0423 = 12.6%. This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So MPR added value during 2016.

Economic Value Added (EVATM) (also called Economic Profit) EVA is another key measure of operating performance. EVA is trademarked by Stern Stewart, Inc. It measures the amount of profit the company earned, over and above the amount of profit that investors required. EP = NOPATt – WACC(Capitalt-1)

Calculating EVA EVA = NOPAT- (WACC)(Begng. Capital) EVA16 = NOPAT16 – (0.1002)(Capital15) EVA16 = $39.67104 – (0.1002)(315.0423) = $39.67104 – $31.56742 = $8.1038 million (More…)

Economic profit… This shows that in 2016 MPR earned about $8 million more than its investors required. Another way to calculate EP is EPt = (ROIC – WACC)Capitalt-1 = (0.125923 – 0.1002)$315.0423 = $8.1038 million

Intuition behind EP If the ROIC – WACC spread is positive, then the firm is generating more than enough “profit,” and is increasing value. But, if the ROIC – WACC spread is negative, then the firm is destroying value, in the sense that investors would be better off taking their money and investing it elsewhere.

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 the current stock price