1. A Complete Corporate Valuation for a Simple Company
Chapter 2
A Complete Corporate Valuation for a Simple Company
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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.
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3. 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.
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4. 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.
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5. Valuation of a Simple Company: Mayberry Personal Receivers, Inc. (MPR)
Investors are:
Debtholders
Stockholders
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6. 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
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7. 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%
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8. 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.
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9. 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%.
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10. 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!
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11. 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)
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12. Steps in the corporate value model
Determine WACC
Estimate expected future FCF’s
Find value of company
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13. 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.
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14. 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%.
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15. Cost of Equity
Cost of equity, rs, is higher than cost of debt because stock is riskier.
MPR: rs = 12%
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16. 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%
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(More….)

17. WACC (Continued) WACC = wD rD (1-T) + wS rS
= 0.3(9%)( ) + 0.7(12%)
= 10.02%
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18. 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.
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19. Calculating FCF
FCF = net operating profit after taxes (NOPAT) minus investment in operating capital
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20. Financial Statements Balance sheet
Assets (all of MPR’s assets are used in operations)
Operating assets
Operating current assets
Property, plant, and equipment (PPE)
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21. 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.
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22. 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.
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23. Balance Sheet: Assets
Op. CA 162, , ,400.0
Total CA 162, , ,400.0
Net PPE 199, , ,500.0
Tot. Assets 361, , ,900.0
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24. Balance Sheet: Claims 2001 2002 2003 Op. CL 57,911.5 62,999.7 66,150.0
Op. CL 57, , ,150.0
Total CL 57, , ,150.0
L-T Debt 136, , ,223.0
Total Liab. 194, , ,373.0
Equity 166, , ,527.0
TL & Eq. 361, , ,900.0
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25. Income Statement 2001 2002 2003 Sales 400,000.0 420,000.0 441,000.0
Sales 400, , ,000.0
Costs 344, , ,881.6
Op. prof. 56, , ,118.4
Interest 11, , ,875.5
EBT 44, , ,242.9
Taxes (40%) 17, , ,297.2
NI 26, , ,945.7
Dividends 21, , ,400.0
Add. RE 5, , ,545.7
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26. 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)
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27. Calculating NOPAT NOPAT = (Operating profit) (1-T) = EBIT (1-T)
NOPAT03 = (1-0.4) = million.
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28. 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.
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29. 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.
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30. Net Operating Working Capital
NOWC = Operating CA – Operating CL
NOWC03 = $176.4 – $66.15
= $ million
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31. Operating Capital Operating capital =
Net operating working capital (NOWC) plus
Long-term capital, such as factories, land, equipment.
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32. Operating Capital = NOWC + LT Op. Capital
= $ million
::In 2003 MPR had $ million tied up in capital needed to support its operations. Investors supplied this money. Not available for distribution.
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33. Investment in operating capital
Operating capital in 2002: $ million
Operating capital in 2003: $ million
MPR makes net investment of $ – $ = $ million in operating capital in 2003.
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34. Calculating FCF FCF = NOPAT – Investment in operating capital
= $ – $
= $ million
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35. 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.)
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36. 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
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37. How Did MPR use its FCF? Paid dividends: $23.4 million
Paid after-tax interest of: $12,875.5 (1-0.4) = $ million
Totals $ million. Is $7.162 million more than $23.9 million FCF available.
Comes from?
MPR increased borrowing by $ – $ ) = $7.162 million to make up difference.
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38. Corporate Valuation
Forecast financial statements and use them to project FCF.
Discount the FCFs at the WACC
This gives the value of operations
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39. Value of Operations: Requires projecting free cash flows out forever.
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40. Constant growth
If free cash flows expected to grow at 5% constant rate:
FCF
Use constant growth approach as would with constant growth dividends to get stock price today Po
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41. Constant Growth Formula
The summation can be replaced by a single formula:
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42. The value of operations
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43. Value of Equity Sources of Corporate Value Claims on Corporate Value
Value of operations = $ million
Value of non-operating assets = $0 (in this case)
Claims on Corporate Value
Value of Debt = $ million
Value of Equity = ?
Value of Equity = $ $ = $ million.
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44. Value of Equity Price per share = Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share
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45. A picture of the breakdown of MPR’s value
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46. Return on Invested Capital (ROIC)
ROIC: used to evaluate Firm’s performance:
ROIC = NOPAT / Total operating capital at beginning of year
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47. ROIC calculation ROIC03 = NOPAT03 / Capital02
ROIC good because greater than return investors require (WACC), of 10.02%. So MPR added value during year.
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48. 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)
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49. EVA = NOPAT- (WACC)(Begng. Capital)
Calculating EVA
EVA = NOPAT- (WACC)(Begng. Capital)
EVA03 = NOPAT03 – (0.1002)(Capital02)
EVA03 = $ – (0.1002)( )
= $ – $
= $ million
(More…)
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50. Economic profit…
In 2003 MPR earned about $8 million more than its investors required.
Another way to calculate EP:
EPt = (ROIC – WACC)Capitalt-1
= ( – )$
= $ million
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51. 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.
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52. 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
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