1. Frameworks for Valuation

2. Using DCF to Value Companies
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Using DCF to Value Companies
There are five well-known frameworks for valuing a company using DCF, the most common being enterprise DCF.
In theory, each framework will generate the same value. In practice, the ease of implementation and the interpretation of results varies across frameworks.
In this presentation, we examine how to value a company using each of the five frameworks.
Model
Measure
Discount factor
Assessment
Enterprise discounted cash flow
Free cash flow
Weighted average
cost of capital
Works best for projects, business units, and companies that manage their capital structure to a target level
Economic profit
Explicitly highlights when a company creates value
Adjusted present value
Unlevered cost of equity
Highlights changing capital structure more easily than WACC-based models.
Capital cash flow
Compresses free cash flow and the interest tax shield in one number, making it difficult to compare performance among companies and over time
Equity cash flow
Cash flow to equity
Levered cost of equity
Difficult to implement correctly because capital structure is embedded within cash flow. Best used when valuing financial institutions
Frameworks for DCF-Based Valuation

3. The Valuation Process using Enterprise DCF
Valuation is an iterative process…
1. Analyze Historical Performance
By thoroughly analyzing the past, we can document whether the company has created value, whether it has grown, and how it compares with its competitors.
5. Calculate and Interpret Results
Once the model is complete, examine valuation results to ensure your findings are technically correct, your assumptions are realistic, and your interpretations plausible.
2. Forecast Financials & Cash Flows
Project financials over the short and medium term. Short-term forecasts should be consistent with announced operating plans. Medium-term forecasts should focus on operating drivers, such as margins, and capital turnover.
4. Compute the Cost of Capital
To value the enterprise, free cash flow is discounted by the weighted average cost of capital. The cost of capital is the blended rate of return for all sources of capital, specifically debt & equity.
3. Estimate a Continuing Value
To forecast cash flows in the long-term future, use a perpetuity that focuses on the company’s key value drivers, specifically ROIC and growth.
Begin the process by analyzing historical performance…

4. Analyze Historical Performance: Analyzing ROIC
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Analyze Historical Performance: Analyzing ROIC
1. Analyze Historical Performance
Before projecting future cash flow, examine the company’s historical performance. A good analysis focuses on the key drivers of value: return on invested capital (ROIC) and growth.
ROIC measures a company’s ability to create value.
Both Home Depot and Lowe’s improved ROIC between 2001 and Historically speaking, Home Depot has performed better than Lowe’s. Going forward, will Home Depot be able to maintain this advantage?
ROIC Analysis: Home Depot vs. Lowes
Home Depot
Lowe's
2001
2002
2003
How do we compute ROIC?

5. Analyze Historical Performance: Computing ROIC
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Analyze Historical Performance: Computing ROIC
NOPLAT
After-tax operating profit equals revenues minus operating costs, less any taxes that would have been paid if the firm held only core assets and were finance only with equity.
Invested Capital
Invested capital equals the operating assets required for core business activities (such as inventory and PP&E) less any financing provided by customers, employees, and suppliers (such as accounts payable).
Home Depot
Lowe’s
2001
2002
2003
2003
Net sales
Cost of merchandise sold
Selling, general and admin
Depreciation
Operating lease interest
53,553
(37,406)
(10,451)
(756)
288
58,247
(40,139)
(11,375)
(895)
260
64,816
(44,236)
(12,658)
(1,075)
276
30,838
(21,231)
(5,671)
(758)
114
Adjusted EBITA
5,228
6,098
7,123
3,292
Operating taxes
(2,020)
(2,117)
(2,040)
(1,069)
NOPLAT
3,208
3,981
5,083
2,223
Invested capital
Operating working capital
Net property and equipment
Capitalized operating leases
Net other assets
2,552
15,375
5,459
(216)
2,746
17,168
5,890
(247)
2,674
20,063
6,554
(524)
1,363
11,945
2,762
211
Invested capital (w/o goodwill)
23,170
25,557
28,767
16,281
ROIC is computed by comparing after-tax operating profits to invested capital
Intangibles and goodwill
Cumulative amortization
419 46
575 54
833 55
730
Invested capital (w/ goodwill)
23,635
26,185
29,655
17,012
ROIC w/ goodwill (average)
14.3%
16.0%
18.2%
13.9%

6. Forecast Financials: ROIC versus WACC
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Forecast Financials: ROIC versus WACC
2. Forecast Financials
To compute a company’s value using enterprise DCF, future free cash flow is discounted by the weighted average cost of capital. Rather than forecast FCF directly, however, forecast the financials that drive free cash flow.
One of the primary drivers of free cash flow is return on invested capital. For simplicity, we assume each company’s financial performance will remain constant. In actuality, these figures will change over time, and this must be modeled.
Forecasting ROIC: Home Depot versus Lowe’s

7. Forecast Financials: Free Cash Flow
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Forecast Financials: Free Cash Flow
Forecast Free Cash Flow (FCF)
Free cash flow, which is driven by revenue growth and return on invested capital, provides the basis for enterprise DCF valuation.
The computation of FCF should be consistent with that of ROIC. Free cash flow begins with NOPLAT, adds depreciation, and subtracts investments in invested capital.
Historical
NOPLAT
Depreciation
2001
2002
2003
Gross cash flow
Investment in operating working capital
Net capital expenditures
Investment in capitalized operating leases
Investments in intangibles and goodwill
Decrease (increase) in net other assets
Increase (decrease) in other comp income
Gross investment
Free cash flow ($ millions)
3,208
756
3,964
834
(3,063)
(775)
(113)
105
(153)
(3,165)
799
3,981
895
4,876
(194)
(2,688)
(430)
(164) 31
138
(3,307)
1,569
5,083
1,075
6,157 72
(3,970)
(664)
(259)
277
172
(4,372)
1,785
2004
2005
2006
5,185
1,193
6,378
(294)
(3,399)
(721)
(92) 58
(4,448)
1,930
5,741
1,321
7,062
(318)
(3,708)
(780)
(99) 62
(4,843)
2,219
6,342
1,459
7,801
(344)
(4,036)
(842)
(107) 67
(5,261)
2,539
Forecast
Gross
Cash
Flow
Investments in
Invested
Capital
NOPLAT plus depreciation, less investments in invested capital

8. Continuing Value 3. Continuing Value
To estimate a company’s value, we separate a company’s expected cash flow into two periods and define the company’s value as follows:
Present Value of Cash Flow
during Explicit Forecast Period
Value = +
Present Value of Cash Flow
after Explicit Forecast Period
The second term is the continuing value: the value of the company’s expected cash flow beyond the explicit forecast period.
Explicit Forecast Period
Continuing Value

9. Continuing Value: The Key Value Driver Formula
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Continuing Value: The Key Value Driver Formula
Although many continuing-value models exist, we prefer the key value driver model. The key value driver formula is superior to alternative methodologies because it is based on cash flow and links cash flow to growth and ROIC. g
RONIC
1 -
NOPLATt + 1
RONIC is the return on new investment, return on existing investment is captured in NOPLAT
Continuing valuet =
WACC - g
4.0%
9.3%
$12,415
1 -
Continuing valuet =
9.3% - 4.0%
The continuing value is measured as of This value must still be discounted to present day. =
$133,360

10. Weighted Average Cost of Capital
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Weighted Average Cost of Capital
4. Weighted Average Cost of Capital
When performing and Enterprise DCF, make sure to choose the cash flows and discount factor consistently. Since free cash flows are the cash flows available to all investors, the discount factor for free cash flow must represent the risk faced by all investors.
The weighted average cost of capital (WACC) blends the required rates of return for debt kd and equity ke based on their target market values.
Target (market-based) weights on debt and equity
Home Depot Cost of Capital
After-tax opportunity cost
Contribution to weighted average
Proportion of total capital
8.3
91.7
2.9
9.9
0.2
9.1
100.0%
9.3%
After-tax cost of debt
After-tax cost of equity

11. Putting It all Together: Enterprise DCF Valuation
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Putting It all Together: Enterprise DCF Valuation
Home Depot Valuation
Free cash flow (FCF)
$ Million
Discount factor
@ 9.3%
Present value of FCF
$ Million
Year
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Continuing value
1,930
2,219
2,539
2,893
3,283
3,711
4,180
4,691
5,246
5,849
133,360
0.915
0.837
0.766
0.700
0.641
0.586
0.536
0.491
0.449
0.411
1,766
1,857
1,944
2,026
2,104
2,175
2,241
2,301
2,355
2,402
54,757
To determine the value of operations, discount free cash flow at the weighted average cost of capital.
To determine the enterprise value, add the value of non-operating assets, such as excess cash.
Present value of cash flow
75,928
Mid-year adjustment factor
1,046
Value of operations
79,384
Value of excess cash
Value of other nonoperating assets
1,609 84
To determine the equity value, subtract the value of non-equity financial claims, such as debt and capitalized operating leases.
Enterprise value
81,077
Value of debt
Value of capitalized operating leases
(1,365)
(6,554)
Equity value
73,158

12. Economic Profit Valuation Models
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Economic Profit Valuation Models
Model
Measure
Discount factor
Assessment
Enterprise discounted cash flow
Free cash flow
Weighted average
cost of capital
Works best for projects, business units, and companies that manage their capital structure to a target level
Economic profit
Explicitly highlights when a company creates value
Adjusted present value
Unlevered cost of equity
Highlights changing capital structure more easily than WACC-based models.
Capital cash flow
Compresses free cash flow and the interest tax shield in one number, making it difficult to compare performance among companies and over time
Equity cash flow
Cash flow to equity
Levered cost of equity
Difficult to implement correctly because capital structure is embedded within cash flow. Best used when valuing financial institutions
Frameworks for DCF-Based Valuation
The economic profit model highlights how and when the company creates value yet leads to a valuation that is identical to that of enterprise DCF.
An advantage of the economic profit model over the DCF model is that economic profit is a useful measure for understanding a company’s performance in any single year, whereas free cash flow is not.

13. Defining Economic Profit
Economic profit translates size, return on capital, and cost of capital into a single measure. Economic profit equals the spread between the return on invested capital and the cost of capital times the amount of invested capital.
Economic profit = Invested Capital x (ROIC – WACC)
The above formula for economic profit can be rearranged and defined as after-tax operating profits less a charge for the capital used by the company:
Economic profit = NOPLAT - (Invested Capital x WACC)
This approach shows that economic profit is similar in concept to accounting net income, but it explicitly charges a company for all its capital, not just the interest on its debt.

14. Economic Profit at Home Depot
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Economic Profit at Home Depot
2002
2001
2003
2004 E
Method 1
ROIC
- WACC
15.0%
10.1%
16.8%
9.0%
19.4%
9.3%
17.5%
Invested capital
WACC
Capital charge
21,379
2,159
23,635
2,124
26,185
2,438
29,655
2,761
= Economic spread
X Invested capital
= Economic profit
( in $ millions)
4.9%
1,048
7.9%
1,857
2,645
8.2%
2,424
NOPLAT
Economic profit
3,208
(2,159)
3,981
(2,124)
5,083
(2,438)
5,185
(2,761)
Method 2
Consider both measures of economic profit for Home Depot. Since Home Depot has been earning returns greater than its cost of capital, its historical economic profit is positive.
Not every company has a positive economic profit. In fact many companies earn an accounting profit (net income greater than zero), but can’t earn their cost of capital.

15. Discounted Economic Profit Leads to Same Results as DCF
To demonstrate how economic profit can be used to value a company—and to demonstrate its equivalence to enterprise DCF, consider a stream of growing cash flows valued using the growing-perpetuity formula,
Using a few algebraic transformations and the assumption that the company’s ROIC on new projects equals the company’s current ROIC, we can transform the cash flow perpetuity into an economic-profit based key value driver model,
Substituting the definition of economic profit,

16. Home Depot: Economic Profit Valuation
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Home Depot: Economic Profit Valuation
Home Depot Valuation
Present value of economic profit
$ Million
Invested
Capital
$ Million
Economic profit
$ Million
Discount
factor
@ 9.3%
ROIC
Percent
WACC
Percent
Year
2004
29,655
17.5
9.3
2,424
0.915
2,217
The value of operations equals:
the sum of discounted economic profit
2005
32,910
17.4
9.3
2,677
0.837
2,241
2006
36,432
17.4
9.3
2,950
0.766
2,259
2007
40,235
17.4
9.3
3,242
0.700
2,271
2008
44,329
17.3
9.3
3,556
0.641
2,278
2009
48,729
17.3
9.3
3,890
0.586
2,281
2010
53,445
17.3
9.3
4,247
0.536
2,278
2011
58,488
17.2
9.3
4,627
0.491
2,270 +
2012
63,870
17.2
9.3
5,031
0.449
2,258
2013
69,600
17.2
9.3
5,458
0.411
2,241
current invested capital
57,671
0.411
Continuing value
23,679
46,273
Present value of economic profit
Invested capital*2004
29,655
75,928
Economic Profit leads to the same value for operations as Enterprise DCF!
Invested capital plus present value of economic profit
1.046
Mid-year adjustment factor
79,384
Value of operations
* Measured at the beginning of the year